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Chapter 4Chapter 4Overview of Security TypesOverview of Security Types

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Price quotes for all types of investments are easy to find, but what do they mean? Learn

the answers for:

1. Various types of interest-bearing assets.

2. Equity securities.

3. Futures contracts.

4. Option contracts.Ayşe Yüce – Ryerson UniversityAyşe Yüce – Ryerson University

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Learning ObjectivesLearning Objectives

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Our goal in this chapter is to introduce the different types of securities that investors routinely buy and sell in financial markets around the world.

For each security type, we will examine: Its distinguishing characteristics Its potential gains and losses How its prices are quoted in the financial

press.

Security TypesSecurity Types

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Basic Types Major Subtypes

Interest-bearing Money market instruments

Fixed-income securities

Equities Common stock Preferred stock

Derivatives Futures Options

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Classifying SecuritiesClassifying Securities

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Money market instruments are short-term debt obligations of large corporations and governments. These securities promise to make one future payment. When they are issued, their lives are less than one

year.

Fixed-income securities are longer-term debt obligations of corporations and governments. These securities promise to make fixed payments

according to a pre-set schedule. When they are issued, their lives exceed one year.

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Interest Bearing AssetsInterest Bearing Assets

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Examples: U.S. Treasury bills (T-bills), bank certificates of deposit (CDs), corporate and municipal money market instruments.

Potential gains/losses: A known future payment, except

when the borrower defaults (i.e., does not pay).

Price quotations: Usually, the instruments are sold on a discount basis, and only the interest rates are quoted.

Therefore, investors must be able to Therefore, investors must be able to calculate prices from the quoted rates.calculate prices from the quoted rates.

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Money Market InstrumentsMoney Market Instruments

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Examples: Treasury notes, corporate bonds, car loans, student

loans.

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

except when the borrower defaults. Possibility of gain (loss) from fall (rise) in interest rates Depending on the debt issue, illiquidity can be a problem.

Illiquidity means that you might not be able Illiquidity means that you might not be able to sell securities quickly for their current to sell securities quickly for their current

market value.market value.

Fixed Income SecuritiesFixed Income Securities

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Price Quotations from www.wsj.com—the online version of The Wall Street Journal (some columns are self-explanatory):

You will receive 2.20% 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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Quote Example: Fixed Income Quote Example: Fixed Income SecuritiesSecurities

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Common stock: Represents ownership in a corporation. A part owner receives a pro rated share of whatever is left over after all obligations have been met in the event of a liquidation.

Preferred stock: The dividend is usually fixed and must be paid before any dividends for the common shareholders. In the event of a liquidation, preferred shares have a particular face value.

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EquitiesEquities

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Examples: RIM shares, Microsoft shares, Tim Horton's shares, Dell shares, etc.

Potential gains/losses: Many companies pay cash dividends to their

shareholders. However, neither the timing nor the amount of any dividend is guaranteed.

The stock value may rise or fall depending on the prospects for the company and market-wide circumstances.

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Common StockCommon Stock

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Common Stock Price QuotesCommon Stock Price Quotes

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First, enter symbol.

Resulting Screen

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

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Information is a bit harder to find for preferred stock versus common stock.

Example: Bank of America (BAC) preferred stock Find all the BAC preferred stock issues via a Google search—one

source is: quantumonline.com. One issue has a ticker of: BAC-J (BAC-PJ is its symbol at Yahoo!)

Potential gains/losses: Dividends are “promised.” However, there is no

legal requirement that the dividends be paid, as long as no common dividends are distributed.

The stock value may rise or fall depending on the prospects for the company and market-wide circumstances.

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Preferred StockPreferred Stock

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Primary asset: Security originally sold by a business or government to raise money.

Derivative asset: A financial asset that is derived from an existing traded asset, rather than issued by a business or government to raise capital. More generally, any financial asset that is not a primary asset.

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DerivativesDerivatives

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Futures contract: An agreement made today regarding the terms of a trade that will take place later.

Option contract: An agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specified price for a set period of time.

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DerivativesDerivatives

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Examples: financial futures (i.e., TSX/S&P, S&P 500, T-bonds, foreign currencies, and others), commodity futures (i.e., wheat, crude oil, cattle, and others).

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.

Note that enormous gains and losses are possible.

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Futures ContractsFutures Contracts

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Source: Markets Data Center at www.wsj.com. Ayşe Yüce – Ryerson UniversityAyşe Yüce – Ryerson University

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Futures Contracts: Futures Contracts: Online Price QuotesOnline Price Quotes

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Source: www.cmegroup.com

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Futures Price Quotes Online Futures Price Quotes Online

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A call option gives the owner the right, but not the obligation, to buy something, while a put option gives the owner the right, but not the obligation, to sell something.

The “something” can be an asset, a commodity, or an index.

The price you pay today to buy an option is called the option premium.

The specified price at which the underlying asset can be bought or sold is called the strike price, or exercise price.

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Options ContractsOptions Contracts

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An American option can be exercised anytime up to and including the expiration date, while a European option can be exercised only on the expiration date.

Options differ from futures in two main ways: Holders of call options have no obligation to buy

the underlying asset. Holders of put options have no obligation to sell

the underlying asset. To avoid this obligation, buyers of calls and puts

must pay a price today. Holders of futures contracts do not pay for the contract today.

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Options ContractsOptions Contracts

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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, the call buyer loses the entire premium.

Sellers:Profit when the market price minus the strike price is

less than the option premium.Best case, the call seller collects the entire premium.Worst case, theoretically unlimited losses.

Note that, Note that, for buyersfor buyers, losses are limited, , losses are limited, but gains are not.but gains are not.

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Options ContractsOptions Contracts

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Potential gains and losses from put options:

Buyers:Profit when the strike price minus the market price is

greater than the option premium. Best case, market price (for the underlying) is zero. Worst case, the put buyer loses the entire premium.

Sellers:Profit when the strike price minus the market price is less

than the option premium.Best case, the put seller collects the entire premium.Worst case, market price (for the underlying) is zero.

Note that, Note that, for buyers and sellersfor buyers and sellers, , gains and losses are limited.gains and losses are limited.

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Options ContractsOptions Contracts

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Source: www.finance.yahoo.com Ayşe Yüce – Ryerson UniversityAyşe Yüce – Ryerson University

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Options Contracts: Options Contracts: Online Price Online Price

Quotes for Nike (NKE) OptionsQuotes for Nike (NKE) Options

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Stocks: Suppose you have $10,000 for investments. 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 versus Investing in Stocks versus OptionsOptions

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Options: A call option with a $50 strike price and 3 months to

maturity is also available at a premium of $4.

Traded option contracts are on a bundle of 100 shares.

One call contract costs $4 100 = $400, so number of contracts bought = $10,000 / $400 = 25 (for 25 100 = 2,500 shares)

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

If Macron is selling for $45 per share 3 months later, loss = ($0 2,500) – $10,000 = -$10,000

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Investing in Stocks versus Investing in Stocks versus OptionsOptions

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www.m-x.ca (Montreal Exchange)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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Useful Internet SitesUseful Internet Sites

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Classifying Securities

Interest-Bearing Assets Money Market Instruments Fixed-Income Securities

Equities Common Stock Preferred Stock Common and Preferred Stock Price Quotes

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Chapter Review Chapter Review

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Derivatives Futures Contracts Futures Price Quotes Gains and Losses on Futures Contracts

Option Contracts Option Terminology Options versus Futures Option Price Quotes Gains and Losses on Option Contracts Investing in Stocks versus Options

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Chapter Review Chapter Review