INVESTMENTS:Analysis and ManagementThird Canadian Edition

W. Sean ClearyCharles P. Jones

Prepared by Khalil TorabzadehUniversity of Lethbridge

Chapter 2Investment 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 ObjectivesCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Figure 2-1 Major Types of Financial AssetsCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Examples: Savings deposits, Canada Savings Bonds (CSBs), Guaranteed Investment Certificates (GICs)Commonly owned by individualsRepresent direct exchange of claims between issuer and investorUsually safe investments which are easy to convert to cash without loss of valueNon-Marketable Financial AssetsCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Major types include:Money Market SecuritiesCapital Market SecuritiesDerivative SecuritiesMarketable Financial AssetsCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Money Market SecuritiesExamples: Treasury bills, commercial paper, Eurodollars, repurchase agreements, bankers acceptances (B/As)Marketable: claims are negotiable or saleable in the marketplaceShort-term, liquid, relatively low-risk debt instrumentsIssued by governments and private firms

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

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)Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Treasury Bills:Due to government backing, there is a very low risk of default Widely distributed and actively traded high liquidityIn 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 rateTreasury Bills (T-bills)Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

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 PaperCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Eurodollars:Dollar-denominated deposits held in foreign banks or in offices of Canadian banks located abroadAlthough this market originally developed in Europe, dollar-denominated deposits can now be made in many countries, such as those of AsiaConsist of both time deposits and certificates of deposit (CDs), with the latter constituting the largest component of the Eurodollar marketsMaturities are mostly short-term, often less than six monthsEurodollarsCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Repurchase Agreements (RPs):agreements between a borrower and lender (typically institutions) to sell and repurchase money market securitiesborrower 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 datematurity is generally very short, from 3 to 14 days, and sometimes overnightminimum denomination is typically $100,000 Repurchase AgreementsCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

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 dateDiffer from commercial paper because the associated payments are guaranteed by a bank, and thus possess the credit risk associated with that bankIssued in minimum denominations of $100,000Typical maturities range from 30 to 180 days, with 90 days being the most common Bankers AcceptancesCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Major types include:Fixed-Income SecuritiesEquity Securities

Capital Market Securities Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Fixed-Income SecuritiesMarketable debt with maturity greater than one yearMore risky than money market securitiesFixed-income securities have a specified payment scheduleDates and amount of interest and principal payments known in advance

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Bonds long-term debt instrumentsMajor bond types:Government of Canada bonds U.S. Treasury bondsProvincial bondsProvincially-guaranteed bonds Ontario HydroU.S. federal agency securities GNMAs (Ginnie Maes), FNMAs (Fannie Maes)Fixed-Income SecuritiesCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Major bond types (contd):Corporate bondsUsually pay semi-annual interest, are callable, carry a sinking fund provision, and have a par value of $1,000Convertible bonds may be exchanged for another assetRisk that issuer may default on paymentsFixed-Income SecuritiesCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

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 CharacteristicsCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Extendible Bonds: gives the investor an option to extend the maturity dateRetractable Bonds: gives the investor an option to redeem the bond at par prior to maturityIssuers 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 investmentsWhen bond prices fall (yields rise):they can trade as short-term debtBond CharacteristicsCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

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 offeredPermits the holding of a two-way security:The safety of a bondThe capital gains potential of a shareIf the common shares of the company are split, the convertible debt provides protection against dilution by adjusting the conversion privilegeConvertibles are normally callableBond CharacteristicsCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

The market price of convertible debt depends on the value of the underlying common stockWhen the stock is selling well below the conversion price, the convertible debt is more like straight debtWhen the stock approaches conversion price, a premium appearsWhen the stock rises above the conversion price, the debt will rise accordingly, and will then be selling off the stockBond Characteristics Convertible Bonds (contd)Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Asset-backed securities are securitized assetsE.g. mortgage-backed securitiesInvestors assume little default risk as most mortgages are guaranteed by a federal government agencyAsset-Backed SecuritiesCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Represent an ownership interestPreferred stockPreferred shareholders are paid after bondholders but before common shareholdersDividend known, fixed in advanceMay be cumulative if dividend omittedEquity SecuritiesCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Income trustsPay out a portion of cash flows generated from underlying assetsE.g. royalty trusts and real estate investment trusts (REITs)Common stockCommon shareholders are residual claimants on income and assetsCommon shareholders can elect board of directors and vote on important issuesEquity SecuritiesCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Securities whose value is derived from some underlying securityFutures and options contracts are standardized and performance is guaranteed by a third partyRisk management toolsWarrants are options issued by firmsDerivative SecuritiesCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Exchange-traded options are created by investors, not corporationsCall (Put) gives the buyer the right but not the obligation to purchase (sell) a fixed quantity of shares at a a fixed price up to a certain dateOptions are being traded in the secondary market at a price called premiumIncreases return possibilitiesOptionsCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Forward Contract: A customized agreement between a buyer and seller to make future delivery of a fixed asset at a fixed price. These contracts are sold through the over-the-counter market. Futures contract: A standardized agreement between a buyer and seller to make future delivery of a fixed asset at a fixed priceA good faith deposit called margin, is required of both the buyer and seller to reduce default riskUsed to hedge the risk of price changesForward and Futures ContractsCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Interest income from debt securities is taxable at the full marginal rateDividends and capital gains afford investors a tax breakDividends received from Canadian corporations are taxable for all provinces except QuebecCapital gain: only 50% is taxableAppendix 2ATaxation of Investment Income in CanadaCleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

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