Overview of Security Types

3

Overview of Security Types

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Classifying Securities

Basic Types Major Subtypes

Interest-bearing Money market instruments

Fixed-income securities

Equities Common stock Preferred stock

Derivatives Futures Options

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Interest-Bearing Assets

• All interest-bearing assets are basically loans

• Categorized by Maturity• Money market instruments (< 1 year)• Notes (1-10 years)• Bonds (> 10 years)

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Interest-Bearing Assets• Money market instruments

• Short-term debt obligations of large corporations and governments

• One future payment• Issued with maturities less than one year

• Fixed-income securities • Longer-term debt obligations of corporations or

governments• Fixed payments according to a pre-set schedule• Issued with maturities exceeding one year

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Money Market Instruments

• Simplest form of interest-bearing assets• Mature in less than one year• Trade in large denominations• Highly liquid market • Sold on a discount basis• Prices quoted as a % of face value

• Most familiar = U.S. Treasury Bill (“T-bill”)

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Treasury Bill Example

A 26-week T-Bill is quoted at:Price = 99.15Investment Rate = 1.718

• You pay $10,000 x 99.15% = $9,915• In 26 weeks you receive $10,000

• Dollar return = $10,000 - $9,915 = $85• 6-month rate of return = $85 ÷$ 9,915 = 0.86%• Annualized return = (1.0086)2 -1 = 1.72%

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Fixed-Income Securities• Examples:

• U.S. Treasury notes and bonds• Corporate bonds• Car and student loans

• Potential gains/losses:• Fixed coupon payments and final payment at

maturity, unless borrower defaults• Possibility of gain (loss) from fall (rise) in interest

rates• Liquidity

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Quote Example: Fixed-Income Securities• Price quotations from www.wsj.com—the online version of The Wall Street Journal

(some columns are self-explanatory):

You will receive 6.875% of the bond’s face value each year in 2 semi-annual payments.

The price (per $100 face) of the bond when it last traded.

The Yield to Maturity (YTM) of the bond.

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Corporate Bond QuotesCurrentYield(%)

HOME DEPOT INC 93.51 5.875 16-Dec-36 6.365 6.283 AA

HOME DEPOT INC 95.81 5.400 1-Mar-16 6.027 5.636 AA

HOME DEPOT INC 98.70 5.250 16-Dec-13 5.492 5.319 AA

HOME DEPOT INC 100.32 5.200 1-Mar-11 5.101 5.183 AA

Maturity YTM(%)Fitch

RatingsIssue Price Coupon(%)

The first bond in the list matures in 2036

Is currently priced at 93.51% of par (discount)

Pays an annual coupon rate of 5.875%

versus a Yield-to-Maturity of 6.365%

Has a current yield of 6.283% = 5.875/93.51

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Treasury Notes & Bonds• “Fixed-income securities”

• Both pay periodic interest payments – coupon payments – over the life of the instrument

• Price quotes = percent of par… with a unique twist• Percentage = 32nds • Usually indicated by the colon between the

whole percent and the number of 32nds.

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Treasury Note & Bond Quotation

5.000 May 18 95:05 95:07 22 5.51

• Coupon rate = 5%• Note matures in 2018• Bid price = 95 5/32 % of par • Ask price = 95 7/32 % of par • Price change = 22/32nds• YTM based on Ask price = 5.51%

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Equities• Common stock:

• Represents ownership in a corporation. • In the event of liquidation, owner receives pro rated

share of whatever is left after all obligations have been met.

• Preferred stock: • Dividend usually fixed • Dividend must be paid before any dividends paid to

common shareholders. • In the event of a liquidation, preferred shares have a

particular face value.

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Common Stock

Potential gains/losses:• Cash dividends paid to shareholders

• Neither the timing nor the amount of any common stock dividend is guaranteed.

• Stock value may rise or fall

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Common Stock Price Quotes

Fig 3.2

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Common Stock Price Quotes Online at http://finance.yahoo.com

First, enter symbol.

Resulting Screen

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Reading Stock Quotes

• Ticker symbol = HDI• YTD price change = +15.6%

• Change since yesterday’s close = $1.13

• Annual dividend = $.40• % YLD = dividend/closing price

• $.40/ $54.95• PE ratio = 21• Stock closing price = $54.95

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Preferred Stock• “Hybrid” security

• Debt-like qualities• Equity characteristics

• Potential gains/losses:• Dividends are “promised”

• No legal requirement that dividends be paid as long as no common dividends are distributed.

• The stock value may rise or fall

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Primary vs. Derivative Assets• Primary asset:

• Security providing a direct claim on the assets of the issuer

• “Primitive asset”

• Derivative asset: • A financial asset whose value is derived

from an existing traded asset • Value derived from an “underlying asset”

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Futures Contracts

A futures contract = an agreement made today regarding the terms of a trade that will take place in the future.

Terms include: PriceAsset to be deliveredDate of delivery

Two basic categories of futures contracts:

Financial FuturesCommodity Futures

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Futures Contracts• Potential gains/losses:

• At maturity you gain if your contracted price is better than the market price of the underlying asset, and vice versa.

• If you sell your contract before its maturity, you may gain or lose depending on the market price for the contract.

• Enormous gains and losses are possible.

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Futures Contracts: Online Price Quotes

Source: Markets Data Center at www.wsj.com.

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Futures Price Quotes

For the July ’11 contract:

If you bought 2 contracts at the closing price:The “Last” or closing price was 1293-4

Prices are quoted in cents and 1/8ths per bushel

1293-4 = $12.93 +4/8 or $12.9352 contracts = 10,000 bushels x

$12.9350/bushel

= $129,350

CBOT Price = cents per bushel

Contract Last Change Open High Low Volume Open Int

May '11 1279-4 -4 1279-0 1286-0 1266-0 52005 23904

July '11 1293-4 -4 1293-0 1302-0 1280-0 112154 229762

August '11 1281-4 -5 1280-0 1287-0 1269-4 1049 12618

September '11 1241-0 -1 1239-0 1243-0 1231-0 1648 9891

Contract Size: 5,000 bushels

SOYBEANS

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U.S. T-Bond Futures30 Year U.S. Treasury Bonds Futures (US) CBOT

Contract size: US T-Bond with face value of $100,000 or a multiple

EXP LAST Net Chg Open High Low Settle Prev Sett

10Sep 114'315 +0'015 115'090 115'090 114'315 114'315 114'300

10Dec 113'225 +0'015 0'000 113'225 113'210 113'225 113'210

•Treasury bond futures are traded on the CBOT with a contract size of $100,000 or multiples thereof.

•Prices are quoted in points and one-half of 1/32 of a point.

•The December 2010 contract closed at 113’225 which translates to 113 + 22.5/32nds percent or

113.7031% of face value

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Euro FuturesContract size = 125,000 Euros

Open High Low Last Sett Chg

Jun-11 1.5538 1.5585 1.552 1.5531 1.5531 -0.0081

Sep-11 - 1.5543 1.5543 1.5462 1.5462 -0.0081

Dec-11 - 1.548 1.548 1.5397 1.5397 -0.0083

CME EURO FX

SessionMonth

•Euro currency futures are traded on the Chicago Mercantile Exchange (CME).

•Contract size is 125,000 Euros and prices are quoted in U.S. dollars or USD per Euro.

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• Suppose your company will need €1,000,000 in three months to pay for merchandise from Spain.

• The current exchange rate is $1.60 per Euro.

• To hedge your position, you could enter into a contract now and in 3 months you’ll pay $1,600,000 for one million Euros.

• This locks in a future price but it is essentially a bet on the direction of price movements.

Hedging with Futures Contracts

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• If, in three months, the Euro is selling at $1.65:• The company saved by entering into the

futures contract:

($1.65-$1.60) x 1,000,000 = $50,000

• If the exchange rate in three months is $1.55 per Euro:• Hedging has cost the company money:

($1.55 - $1.60) x 1,000,000 = ($50,000)

Gains & Losses on Futures Contracts

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• An option contract is an agreement that gives the owner the right but not the obligation to buy (or sell) a specific asset at a specific price for a specific period of time.

• Two Types of Options:• Call options• Put options

• Two Positions:• Buyer = “Holder” = Long position• Seller = “Writer” = Short position

Options Contracts

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Option Contracts

• American option:• Can be exercised anytime up to and

including the expiration date

• European option:• Can be exercised only on the expiration

date

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Options vs. Futures

• Options holders:• Have no obligation to perform• Pay a premium

• Futures contract holders:• Pay nothing at origination• Are obligated to perform at maturity

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Option Contracts• Potential gains and losses from call

options: • Buyers:

• Profit when the market price minus the strike price is greater than the option premium.

• Best case: theoretically unlimited profits.• Worst case: call buyer loses the entire

premium.Note: For buyers, losses are limited, gains are not.

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Option Contracts• Potential gains and losses from call

options: • Sellers:

• Profit when the market price minus the strike price is less than the option premium.

• Best case: call seller collects the entire premium

• Worst case: theoretically unlimited losses

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Option Contracts: Online Price Quotesfor Hewlett-Packard (HPQ) options

Source: www.finance.yahoo.com

Fig 3.5

Call Options: As strike price , Premium

Put Options: As strike price , Premium

HPQ: $47.80

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Call Option Price Quotes

General Electric Co GE (NYSE) $32.82USD

Symbol LastLast

TradeChg

Open Interest

Vol

GEFE 7.95 8-Apr -0.20 1760 3 25.0

GEFY 6.10 8-Apr 0.00 2340 0 27.5

GEFF 3.10 8-Apr -0.35 6480 13 30.0

CallsStrike Price

• Stock option contracts are for 100 shares of stock• Premiums are quoted on a per share basis• With call options:

• The lower the strike price, the more valuable the option, and the higher the premium

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Suppose you believe the price of General Electric is going to rise over the next two to three months.

General Electric (common stock) $32.003-month call option on GE

with a strike price of $35 $ 2.50

You decide to buy 2 call option contracts (for 100 shares each) for an option premium of $2.50 x 200 = $500

This gives you the right over the next 3 months to buy 200 shares of General Electric for $35 per share.

Buying a Call Option

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In 3 months, General Electric stock= $40 per share:You exercise your optionsBuy 200 shares for $35 each = $7,000Sell them for $40 each = $8,000Your profit = $8,000 - $7,000 - $500 = $500

In 3 months, General Electric stock = $30 per share:You do NOT exercise your optionsYour loss = $500 – what you paid for the option contracts

Buying & Exercising a Call Option

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Put Option Price Quotes

General Electric Co GE (NYSE) $32.82USD

Symbol LastLast

TradeChg

Open Interest

Vol

GERE 0.04 8-Apr 0.00 30545 0 25.0GERY 0.06 8-Apr -0.01 48887 303 27.5GERF 0.24 8-Apr 0.05 68192 201 30.0

PutsStrike Price

•With put options: •The higher the strike price, the more valuable the option.

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Suppose you believe the price of General Electric is going to fall over the next two to three months.

General Electric (common stock) $32.00

3-month put option on GE

with a strike price of $25 $ 1.00

You decide to buy 2 put option contracts (for 100 shares each) for an option premium of $1.00 x 200 = $200

This gives you the right over the next 3 months to sell 200 shares of General Electric for $25 per share.

Buying a Put Option

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In 3 months, General Electric stock =$20 per share:

You exercise your options

Buy 200 shares for $20 = $4,000

Sell 200 shares for $25 each = $5,000

Your profit = $5,000 - $4,000 - $200 = $800

In 3 months, General Electric stock =$40 per share:

You do NOT exercise your options

Your loss = $200 – what you paid for the option contracts

Buying & Exercising a Put Option

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Investing in Stocks vs. OptionsStocks:• Suppose you have $10,000 to invest. Macron

Technology is selling at $50 per share.

• Number of shares bought = $10,000 / $50 = 200

• If Macron is selling for $55 per share 3 months later, gain = ($55 200) - $10,000 = $1,000

• If Macron is selling for $45 per share 3 months later, gain = ($45 200) - $10,000 = -$1,000

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Investing in Stocks vs. OptionsOptions:• A call option with a $50 strike price and 3 months to

maturity is also available at a premium of $4.

• A call contract costs $4 100 = $400, • Number of contracts bought = $10,000 / $400 = 25

(for 25 100 = 2500 shares)

• If Macron is selling for $55 per share 3 months later, gain = {($55 – $50) 2500} - $10,000 = $2,500

• If Macron is selling for $45 per share 3 months later, gain = ($0 2500) – $10,000 = -$10,000

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Share Price # Shares Investment Price Profit50.00$ 200 $10,000 $55 1,000.00$

$45 (1,000.00)$

Premium # Contracts # Shares Investment4.00$ 25 2,500 $10,000 $55 2,500.00$

($50 strike) $45 ($10,000.00)Option

NOW 3 Months Later

Stock

Investing in Stocks vs. Options

Key Point:When buying an option contract:The most you can lose is the option premium.Your potential gain is unlimited.

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Useful Internet Sites• www.nasdbondinfo.com (current corporate bond prices)• www.investinginbonds.com (bond basics)• www.finra.com (learn more about TRACE)• www.fool.com (Are you a “Foolish investor?”)• www.stocktickercompany.com (reproduction stock tickers)• www.cmegroup.com (CME Group)• www.cboe.com (Chicago Board Options Exchange)• finance.yahoo.com (prices for option chains)• www.wsj.com (Online version of The Wall Street Journal)

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3 Chapter End

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Overview of Security Types