Chapter 2.Financial Instruments

7/31/2019 Chapter 2.Financial Instruments

1/30

CHAPTER TWO : FINANCIAL INSTRUMENTS ON THE

FINANCIAL MARKETS

1. Stocks

Introduction

Stocks are among the most talked about and most popular investmentopportunities available. Shares of stock represent partial ownership in acompany. Ownership in the company is determined by the number of shares we own divided by the total number of shares outstanding.

For many companies, shares of stock are limited to the founders of the

company and/or their employees. These companies are called "private"companies because their stock is owned privately; that is to say, it is not possible for the public to buy shares in the company. All corporationsstart out private; after all, the founders of the company usually want tomaintain control over the company and its profits. However, after acompany has grown for a while, the private owners will sometimesdecide to sell shares of stock in the company to the public. This is what iscalled "going public" or performing an "initial public offering".Companies choose to sell shares of their stock to the public in order to

raise money for the company. They might need this money in order toexpand their operations, pay off existing debt, develop a new product, or for any number of other reasons.

Categories of stocks Stocks can be classified into many different categories. The two mostfundamental categories of stock are common stock and preferred stock,which differ in the rights that they confer upon their owners.

Common Stock

Most shares of stock are called "common shares". If we own a share of common stock, then we are a partial owner of the company. We are alsoentitled to certain voting rights regarding company matters. Typically,common stock shareholders receive one vote per share to elect thecompany's board of directors (although the number of votes is not alwaysdirectly proportional to the number of shares owned). The board of directors is the group of individuals that represents the owners of thecorporation and oversees major decisions for the company. Common

INTERNATIONAL INVESTMENTS AND TRANSNATIONALCOMPANIES

51


2/30

stock shareholders also receive voting rights regarding other companymatters such as stock splits and company objectives.

In addition to voting rights, common shareholders sometimes enjoy what

are called "preemptive rights." Preemptive rights allow commonshareholders to maintain their proportional ownership in the company inthe event that the company issues another offering of stock. This meansthat common shareholders with preemptive rights have the right but notthe obligation to purchase as many new shares of the stock as it wouldtake to maintain their proportional ownership in the company.

But although common stock entitles its holders to a number of differentrights and privileges, it does have one major drawback: common stock

shareholders are the last in line to receive the company's assets. Thismeans that common stock shareholders receive dividend payments onlyafter all preferred shareholders have received their dividend payments . Italso means that if the company goes bankrupt, the common stock shareholders receive whatever assets are left over only after all creditors,

bondholders, and preferred shareholders have been paid in full.

Preferred Stock

The other fundamental category of stock is preferred stock. Like commonstock, preferred stock represents partial ownership in a company,although preferred stock shareholders do not enjoy any of the votingrights of common stockholders. Also unlike common stock, preferredstock pays a fixed dividend that does not fluctuate, although the companydoes not have to pay this dividend if it lacks the financial ability to do so.The main benefit to owning preferred stock is that you have a greater claim on the company's assets than common stockholders. Preferredshareholders always receive their dividends first and, in the event thecompany goes bankrupt, preferred shareholders are paid off beforecommon stockholders. In general, there are four different types of

preferred stock: cumulative : these shares give their owners the right to

"accumulate" dividend payments that were skipped due to financial problems; if the company later resumes paying dividends,cumulative shareholders receive their missed payments first.

non-cumulative: these shares do not give their owners back payments for skipped dividends.

participating: these shares may receive higher than normal

dividend payments if the company turns a larger than expected profit.


52


3/30


4/30

health care, financial, energy, consumer cyclicals, basic materials, capitalgoods, and communications services. Cyclical Stocks

Stocks can be classified according to how they react to business cycles.Cyclical stocks are stocks of companies whose profits move up and downaccording to the business cycle. Cyclical companies tend to make

products or provide services that are in lower demand during downturnsin the economy and higher demand during upswings. The automobile,steel, and housing industries are all examples of cyclical businesses.

Defensive Stocks

Defensive stocks are the opposite of cyclical stocks: they tend to do wellduring poor economic conditions. They are issued by companies whose

products and services enjoy a steady demand. Food and utilities stocksare defensive stocks since people typically do not cut back on their foodor electricity consumption during a downturn in the economy. Butalthough defensive stocks tend to hold up well during economicdownturns, their performance during upswings in the economy tends to

be lackluster compared to that of cyclical stocks.

Stock Classes

Although common stock usually entitles you to one vote for every sharethat you own, this is not always the case. Some companies have different"classes" of common stock that vary based on how many votes areattached to them. So, for example, one share of Class A stock in a certaincompany might give you 10 votes per share, while one share of Class Bstock in the same company might only give you one vote per share. Andsometimes it is the case that a certain class of common stock will have novoting rights attached to it at all.

The company will typically issue the class of shares with the fewestnumber of votes attached to it to the public, while reserving the class withthe largest number of votes for the owners.


54


5/30

Splits and Buybacks

A corporation whose stock is performing well may opt to split its shares,distributing additional shares to existing shareholders. The price per share

immediately adjusts to reflect the change, since buyers and sellers of thestock all know about the split. A company will usually decide to split itsstock if the price of the stock gets very high. High stock prices are

problematic for companies because they make it seem as though the stock is too expensive. By splitting a stock, companies hope to make their equity more attractive, especially to those investors that could not affordthe high price.

A buyback is a corporation's repurchase of stocks or bonds that it has

previously issued. In the case of stocks, this reduces the number of sharesoutstanding, giving each remaining shareholder a larger percentageownership of the company. This is usually considered a sign that thecompany's management is optimistic about the future and believes thatthe current share price is undervalued.

Initial Public Offerings

Initial Public Offerings (IPOs) are the first time a company sells its stock to the public. Sometimes IPOs are associated with huge first-day gains;other times, when the market is cold, they flop. It's often difficult for anindividual investor to realize the huge gains, since in most cases onlyinstitutional investors have access to the stock at the offering price. Bythe time the general public can trade the stock, most of its first-day gainshave already been made. However, a savvy and informed investor shouldstill watch the IPO market, because this is the first opportunity to buythese stocks.

REASONS FOR AN IPO

When a privately held corporation needs to raise additional capital, it caneither take on debt or sell partial ownership. If the corporation chooses tosell ownership to the public, it engages in an IPO. Corporations choose to"go public" instead of issuing debt securities for several reasons. Themost common reason is that capital raised through an IPO does not haveto be repaid, whereas debt securities such as bonds must be repaid withinterest. Despite this apparent benefit, there are also many drawbacks to

an IPO. A large drawback to going public is that the current owners of the privately held corporation lose a part of their ownership. Corporations


55


6/30

weigh the costs and benefits of an IPO carefully before performing anIPO.

If a corporation decides that it is going to perform an IPO, it will first hire

an investment bank to facilitate the sale of its shares to the public. This process is commonly called "underwriting".

Measuring a Stock's Risk

Basically, stocks are subject to two types of risk - market risk andnonmarket risk. Nonmarket risk, also called specific risk, is the risk thatevents specific to a company or its industry will adversely affect the

stock's price. Market risk, on the other hand, is the risk that a particular stock's price will be affected by overall stock market movements.

Nonmarket risk can be reduced through diversification. By owningseveral different stocks in different industries whose stock prices haveshown little correlation to each other, you reduce the risk that nonmarketfactors will adversely affect your total portfolio.

No matter how many stocks we own, we can't totally eliminate marketrisk. However, you can measure a stock's historical response to marketmovements and select those with a level of volatility you are comfortablewith. Beta and standard deviation are two tools commonly used tomeasure stock risk.

BETA Beta, which can be found in a number of published services, is astatistical measure of the impact stock market movements havehistorically had on a stock's price. By comparing the returns of theStandard & Poor's 500 (S&P 500) to a particular stock's returns, a patterndevelops that indicates the stock's exposure to stock market risk.

The S&P 500 is an unmanaged index generally considered representativeof the U.S. stock market and has a beta of 1. A stock with a beta of 1means that, on average, it moves parallel with the S&P 500 - the stock should rise 10% when the S&P 500 rises 10% and decline 10% when theS&P 500 declines 10%. A beta greater than 1 indicates the stock shouldrise or fall to a greater extent than stock market movements, while a beta

less than 1 means the stock should rise or fall to a lesser extent than the


56


7/30


8/30


9/30

Categories of bonds

There are many types of bonds. The different types of bonds are usuallydefined by the issuer, though some are defined by the characteristics of the bonds. The major types of bonds are:

Corporate Bonds Municipal Bonds Treasury Bonds Agency Bonds/Mortgage-Backed Securities Zero-Coupon Bonds

Corporate BondsBonds issued by a corporation are called corporate bonds. When acompany needs to raise funds for some type of investment or expenditure,they often turn to the public markets for funding. One way to do this is toissue additional stock in the company, but this has implications on thevalue of the shares and dilutes ownership. The other major option is tosell bonds to the public and take on debt. Selling bonds is often moreattractive to companies than getting a loan from a bank.

Corporate bonds are very common and you can find prices and other information in the financial or business sections of major newspapers.Most corporate bonds have a different par value and carry variousmaturity dates. Generally, these bonds pay higher rates than governmentor municipal bonds due to the increased risk. Corporate bonds have awide range of ratings and yields because the financial health of the issuerscan vary widely.

If a company goes bankrupt, both bondholders and stockholders canmake a claim on the company's assets. However, one of the benefits of

being a bondholder is that your claim takes precedence over that of stockholders in a liquidation situation. Additionally, some corporate

bonds are "secured." This means that the debt obligation is backed bysome asset that can be liquidated in order to pay off the interest and

principal. Corporations will often issue mortgage bonds, which are backed by real estate or physical equipment. These bonds are safer thanunsecured bonds, which are backed only by the "full faith and credit" of the company - which basically means you are taking their word for it.

Most corporate bonds are straightforward with a fixed coupon rate that


59


10/30

doesn't change until maturity. There are some variations, however. Some bonds will have a floating rate, which means the interest paid in thecoupon will be pegged to some independent index like the money marketinterest rate or the rate on a short term Treasury Bill. While these bonds

insure you against a change in interest rates, they tend to offer lower yields. Another type of bond that might be issued is a zero coupon bond,which has no interest payments at all prior to maturity .

Here is a brief look at what to consider when evaluating corporate bonds: Coupon Yield and its permutations Maturity Duration

Rating Callability Convertibility

The yield of a bond is, roughly speaking, the return on the bond. Theyield is expressed as an annual percentage of the face amount. There areseveral different measures of yield: nominal yield, current yield, and yieldto maturity.

Nominal yield is equal to the coupon rate; that is, the return on the bond without accounting for any outside factors. If we purchase the bond at par value and hold to maturity, this will be the annualreturn we receive on the bond.

Current yield is a measure of the return on the bond in relation tothe current price. It can differ from the coupon rate.

Yield to maturity is the overall return on the bond if it is held tomaturity. It reflects all the interest payments that are availablethrough maturity and the principal that will be repaid, and assumesthat all coupon payments will be reinvested at the current yield onthe bond. This is the most valuable measure of yield because itreflects the total income that we can receive.

Duration is a weighted measure of the length of time the bond will payout. Unlike maturity, duration takes into account interest payments thatoccur throughout the course of holding the bond. Basically, duration is aweighted average of the maturity of all the income streams from a bondor portfolio of bonds. So, for a two-year bond with 4 coupon paymentsevery six months of $50 and a $1000 face value, duration (in years) is .5[(50/1200)] + 1[(50/1200)]+ 1.5[(50/1200)]+ 2[(50/1200)] +

2[(1000/1200)] = 1.875 years. Notice that the duration on any bond that pays coupons will be below the maturity because there is some amount of


60


11/30

the payments that are going to come before the maturity date.

As discussed earlier, the yield of a bond will be influenced by the risk of default by the issuer. Naturally, there is far more risk associated with a

small telecom company's bond than with the federal government's.Investors need to be compensated for the additional risk. Conveniently,there are bond rating services that do most of the legwork for you indetermining the default risk for a given issue. The biggest names in bondratings are Moody's Investors Services, Fitch IBCA, and Standard&Poor's. These companies analyze each issuer's financial position andassign a letter grade that ranks their likelihood of successfully repayingthe debts incurred. The basic ranking system is as follows (eachranking system is a little different, but this should be a useful general

guide): AAA - Highest quality, with the least likelihood of default. AA - High likelihood of repayment; together with AAA bonds these

are considered "high grade bonds." A - Quite safe, thought to be a good medium-grade bond. There is

some risk if conditions become quite difficult. BAA or BBB - Somewhere in the middle, they aren't extremely safe,

but they are not a great risk either. Anything with BAA or higher iscalled an "investment grade bond."

BA or BB - The future of this issuer is somewhat in doubt. Bonds ator below this ranking are called "speculative."

B - These bonds are fairly speculative. Significant risk of default if conditions become difficult.

CAA or CCC - These bonds are highly speculative. Bonds with thisranking or lower are considered junk bonds.

CA or CC - Significant risk of default, highly speculative. C - In some rankings this is just another grade of junk bonds, others

use it to mean that these bonds are no longer paying interest or are

in default already. D - Bonds that have been defaulted on N - Not rated, usually because the company did not want the issue to

be rated or because the company is too new to have a credit historyto base a rating on.

When a bond is issued, it will be either callable or non-callable. Acallable bond is one in which the company can require the bondholder tosell the bond back to the company. Buying back outstanding bonds is

called "redeeming" or "calling". A company will often call a bond if it is paying a higher coupon than the current market interest rates. Basically,


61


12/30

the company can reissue the same bonds at a lower interest rate, savingthem some amount on all the coupon payments; this process is called"refunding." Generally, callable bonds will carry something called call

protection. This means that there is some period of time during which the

bond cannot be called.

Municipal Bonds

Municipal bonds are bonds issued by any municipal organizationincluding cities, counties, states, and school districts. The purpose of these bonds is for general expenditures or to fund specific projects suchas highways, new schools, or an athletic stadium. These bonds offer themunicipality the opportunity to raise funds without directly raising taxes.Of course, the funds needed to repay the bonds will often come from atax increase.

Generally, municipal bonds are considered safer than corporate bonds because a local government is far less likely to go bankrupt than acorporation-however, it has happened in the past, so be aware of the

possibility. Because of this safety and the tax benefits, municipal bondsgenerally have a lower yield than corporate bonds.

Treasury Bonds

Treasury bonds are issued by the government of the United States inorder to pay for government projects. The money paid out for a Treasury

bond is essentially a loan to the government. As with any loan, repaymentof principal is accompanied by a fixed interest rate. These bonds areguaranteed by the 'full faith and credit' of the government, meaning thatthey are extremely low risk.

The government sells Treasury bonds by auction in the primary market, but they can also be purchased through a broker in the secondary market.Treasury bonds are marketable securities, meaning that they can be tradedafter the initial purchase. Additionally, they are highly liquid becausethere is an active secondary market for them. Prices on the secondarymarket and at auction are determined by interest rates. One possibledownside to Treasury bonds is that if interest rates increase during theterm of the bond, the money invested will be earning less interest than itcould earn elsewhere. Accordingly, the resale value of the bond willdecrease as well. Rising inflation can also eat into the interest earned on


62


13/30

Treasury bonds. Because there is almost no risk of default by thegovernment, the return on Treasury bonds is relatively low, and a highinflation rate can erase most of the gains by reducing the value of the

principal and interest payments.

Agency Bonds/Mortgage-Backed Securities

Other government agencies and organizations issue securities to fundtheir own projects. While these bonds often deliver higher returns thanTreasury securities because some of them are not explicitly guaranteed bythe government, they must often be purchased from brokers, incurring acommission. They are considered very safe investments because they

would most likely be honored by the government if default occurred. Themost common agency bonds are mortgage-backed securities.

Mortgage-backed securities are debt obligations with a pool of mortgagesas collateral. They fall into the general category of asset-backedsecurities, which package a group of securities and offer investors accessto the cash flows generated by the underlying securities.

Mortgage backed securities are a relatively low-risk investment vehicle.For example, securities issued by the Government National MortgageAssociation (Ginnie Mae) are particularly safe because they are backed

by the full faith and credit of the U.S. government. One downside to theseinvestments is the risk of prepayment by borrowers, or paying back partor all of the loan before it becomes due, which can lower returns byreducing the interest paid on a given mortgage.

ZERO COUPON BONDS

Some bonds, called zero coupon bonds, don't pay out any interest prior to

maturity. These bonds are sold at a deep discount because all of the valuefrom the bond occurs at maturity when the principal is returned to the

bondholder along with interest. These bonds are also known as "zeros."Zeros are more volatile than bonds that have regular interest payments.The main benefit of zero coupon bonds is if we are saving for a specificevent that will occur at a specific time.

Benefits and risks associated with bonds

While bonds traditionally earn lower returns than stocks, that does not


63


14/30

mean there isn't a place in our portfolio for bonds. The most commonreason for investors to purchase bonds are below:

Diversification - Bonds tend to be less volatile than stocks and cantherefore stabilize the value of your portfolio during times when

the stock market struggles. Stability - If investors know they will need access to large sums of

money in the near future-for then it does not make sense to placethat money in a highly volatile investment like stocks. Because themajority of the return on bonds comes from the interest payments(the coupon payments), fluctuations in the price of a bond willhave little impact on the value of the investment.

Consistent Income - Unlike stock dividends, coupon payments areconsistently distributed at regular intervals.

Bonds are not riskless investments. While they are usually consideredmuch safer than stocks, bonds can still lose value while we hold them.Here is a brief look at some of the risks associated with bonds:

Interest rate risk - Bond prices are inversely related to interest rates,so if interest rates increase, the price of the bond will decrease.

Credit Risk - Just as individuals occasionally default on their loansor mortgages, some organizations that issue bonds occasionallydefault on their obligations. Bonds issued by corporations are morelikely to be defaulted on-companies often go bankrupt.Municipalities occasionally default as well, although it is much lesscommon.

Call Risk - Some bonds can be called by the company that issuedthem. That means the bonds have to be redeemed by the

bondholder, usually so that the issuer can issue new bonds at alower interest rate.

Inflation Risk - With few exceptions, the interest rate on your bondis set when it is issued, as is the principal that will be returned atmaturity. If there is significant inflation over the time you held the

bond, the real value (what you can purchase with the income) of your investment will suffer.

3. Mutual funds

Introduction

A mutual fund is a special type of company that pools together money

from many investors and invests it on behalf of the group, in accordancewith a stated set of objectives. Mutual funds raise the money by selling


64


15/30

shares of the fund to the public, much like any other company can sellstock in itself to the public. Funds then take the money they receive fromthe sale of their shares (along with any money made from previousinvestments) and use it to purchase various investment vehicles, such as

stocks, bonds and money market instruments. In return for the moneythey give to the fund when purchasing shares, shareholders receive anequity position in the fund and, in effect, in each of its underlyingsecurities. For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund willfluctuate daily, depending upon the performance of the securities held bythe fund.

Mutual funds can offer you the following benefits: Diversification can reduce our overall investment risk by spreadingour risk across many different assets . With a mutual fund we candiversify your holdings both across companies (e.g. by buyinga mutual fund that owns stock in 100 different companies) andacross asset classes (e.g. by buying a mutual fund that owns stocks,

bonds, and other securities). When some assets are falling in price,others are likely to be rising, so diversification results in less risk than if we purchased just one or two investments.

Choice: Mutual funds come in a wide variety of types. Somemutual funds invest exclusively in a particular sector (e.g. energyfunds), while others might target growth opportunities in general.The key is for you to find the mutual funds that most closely matchour own particular investment objectives.

Liquidity is the ease with which we can convert your assets--withrelatively low depreciation in value--into cash. In the case of mutual funds, it's as easy to sell a share of a mutual fund as it is tosell a share of stock.

Low Investment Minimums: We do not need to be exceptionallywealthy in order to invest in a mutual fund.

Convenience: we don't need to worry about tracking the dozens of different securities in which the fund invests; rather, all we need todo is to keep track of the fund's performance.

Low Transaction Costs: Mutual funds are able to keeptransaction costs -- that is, the costs associated with buying andselling securities -- at a minimum because they benefit fromreduced brokerage commissions for buying and selling largequantities of investments at a single time.


65


16/30


17/30

bought and sold (plus or minus any sales fees). Mutual funds onlycalculate their NAVs once per trading day, at the close of the tradingsession.

Public Offering Price (POP)

The public offering price (POP) is the price at which shares are sold tothe public. For funds that don't charge a sales commission (or "load"), thePOP is simply equal to the Net Asset Value (NAV). For a load fund, thePOP is equal to the NAV plus the sales charge. As with the NAV, thePOP will typically change on a day to day basis.

Stock Mutual Funds

Simply put, stock funds (also sometimes called "equity funds") aremutual funds that invest only in stocks. For that reason, they areconsidered to be more risky than most other types of funds, such as bondfunds or money market funds. Along with the greater risk, however,comes the potential for greater returns. Over long periods of time,equities have historically outperformed both bonds and cash investments,and when stocks do well, stock mutual funds naturally follow suit. Butnot all stock funds are alike -- these funds can vary greatly according totheir stated objectives, their style of management, and the types of companies in which they invest.

GROWTH FUNDS Growth funds are stock funds that invest in stocks with the potential for

long-term capital appreciation. They focus on companies that areexperiencing significant earnings or revenue growth, rather thancompanies that pay out dividends. The hope is that these rapidly growingcompanies will continue to increase in value, thereby allowing the fund toreap the benefits of large capital gains. In general, growth funds are morevolatile than other types of funds -- in bull markets they tend to rise morethan other funds but in bear markets they can fall much lower .

VALUE FUNDS

Value funds invest in companies that are thought to be good bargains --


67


18/30

that is to say, they invest in companies that have low P/E ratios . Theseare the stocks that have fallen out of favor with mainstream investors for one reason or another, either due to changing investor preferences, a poor quarterly earnings report or hard times in a particular industry. Value

stocks are often the stock of mature companies that have stopped growingand that use their earnings to pay dividends . Thus value funds producecurrent income (from the dividends) as well as long-term growth (fromcapital appreciation once the stocks become popular again). They tend tohave more conservative and less volatile returns than growth funds.

AGGRESSIVE GROWTH FUNDS Aggressive growth funds are similar to regular growth funds, only theyare more extreme. Like growth funds, aggressive growth fundstarget stocks of companies that are experiencing very rapid earnings or revenue growth. But aggressive growth funds tend to trade morefrequently and take many more risks than regular growth funds. Anaggressive growth fund might, for example, buy initial public offerings(IPOs) of stock from small companies and then resell that stock veryquickly in order to generate big profits . Some aggressive growth fundsmay even invest in derivatives, such as options, in order to increase their gains . You should note that these funds can be quite volatile and riskyinvestments.

BLEND FUNDS These funds invest in both value and growth stocks so that we can enjoycurrent income and long-term capital appreciation within the same fund.Since blend funds tend to vary considerably it is difficult to makegeneralizations about how risky they are in comparison to other types of mutual funds -- most likely, they are somewhat more risky than value

funds and somewhat less risky than growth funds.

SECTOR FUNDS Sector funds are stock funds that invest in a single sector of the market,such as the energy sector or the biotechnology sector. Sector funds areusually used by investors to achieve growth -- in other words, you wouldchoose sector funds that match the industries that you think are going todo well in the future. Some common sector funds include financial

services funds, gold and precious metals funds, health care funds, and realestate funds, but mutual funds exist for just about every sector. To be


68


19/30

considered a sector fund, a fund must invest at least 25% of its portfolioin one sector, although many sector funds invest all of their holdings

in a single industry. In general, sector funds are more volatile and riskythan mutual funds that invest their assets across a wide variety of

industries.

LARGE CAP, MID CAP, SMALL CAP, AND MICRO CAP FUNDS Stock funds may also be classified according to the market capitalizationof the companies in which they invest. The market capitalization, or "market cap", of a company is simply the value of the company on thestock market -- in other words, it is the number of outstanding shares of the company times the price of those shares. There are three main typesof cap funds: large-cap, mid-cap, and small-cap. In general, the smaller the average market cap of the fund's holdings, the more volatile thereturn; micro-cap funds can be especially risky.

FOCUSED FUNDS Focused funds are funds which hold large positions in a small number of stocks. While many mutual funds hold 100 positions or more, focusedfunds usually have 10 to 40 positions at any given time. They emphasizequality over quantity, and would rather hold just the stocks they have themost confidence in, rather than diversifying across a large number of holdings.

Bond Mutual Funds

As the name suggests, bond mutual funds invest in bonds and other debtsecurities.

Investors typically choose to buy bond funds for two reasons: income anddiversification. Bond funds tend to pay higher dividends than moneymarket and savings accounts, and they usually pay out dividends morefrequently than individual bonds. Bond funds are also considered to be"low risk" investments that can provide stability to a portfolio that isweighted heavily with stock. GOVERNMENTS BOND FUNDS

Governments bond funds invest in debt securities that are issued by the


69


20/30

governments and its agencies. These funds are regarded as the safest of the bond funds because the underlying securities are backed by the fullfaith and credit of the government.

MUNICIPAL BOND FUNDS Municipal bond funds invest in debt securities issued by state and localgovernments to pay for local public projects, such as bridges, schools,and highways.

CORPORATE BOND FUNDS Corporate bond funds are comprised of bonds issued by corporations.Unlike the securities held by governments and municipal bond funds, the

bonds in a corporate bond fund are not backed by any governmentinstitution. Thus it is more likely that the underlying bonds could defaultif the companies that issue them run into financial trouble. Along with thegreater risk, however, comes a greater reward -- the income paid out bycorporate bond funds is typically much greater than that paid bymunicipal or government bond funds. OTHER TYPES OF BOND FUNDS Besides the aforementioned bond funds, there are many other types of

bond funds. Zero-coupon bond funds invest in zero coupon bonds ;international bond funds invest in bonds issued by foreign governmentsand corporations; convertible securities funds invest in bonds that may beconverted into stock .

Other Types of Mutual Funds

The mutual funds in this section cannot be classified as either stock fundsor bond funds. Some, like lifecycle funds and balanced funds, invest in

both stocks and bonds, while others, like money market funds, invest inneither.

MONEY MARKET FUNDS

Money market funds are among the safest and most stable of all the


70


21/30

different types of mutual funds. These funds invest in short term (one dayto one year) debt obligations such as Treasury bills, certificates of deposit, and commercial paper . The main goal is the preservation of

principal, accompanied by modest dividends.

INCOME FUNDS Income funds focus on providing investors with a steady stream of fixedincome. In order to achieve this, they might invest in bonds, governmentsecurities, or preferred stocks that pay high dividends . They areconsidered to be conservative investments, since they stay away from

volatile growth stocks. BALANCED FUNDS

The purpose of balanced funds (also sometimes referred to as "hybridfunds") is to provide investors with a single mutual fund that combines

both growth and income objectives. In order to achieve this goal, balanced funds invest in both stocks (for growth) and bonds (for income).Balanced funds typically invest no more than 50% of their money instocks, with the rest allocated to debt instruments.

ASSET ALLOCATION FUNDS Asset allocation funds are a type of balanced fund that invest in anumber of different asset classes, such as stocks, bonds and cash. Theyare similar to balanced funds, except they invest in many other types of asset classes in addition to stocks and bonds (e.g. money marketaccounts).

INTERNATIONAL, GLOBAL, REGIONAL, AND EMERGING MARKETS FUNDS

Global funds invest throughout the world, including in the U.S. Globalmutual funds can provide more opportunities for diversification thandomestic funds alone. We should take into account, however, that therecan be additional risks associated with global funds involving currencyfluctuations and political and economic instability abroad.

International funds (sometimes referred to as foreign funds) are similar toglobal funds but with one major exception: they do not invest in any


71


22/30

domestic assets. International funds therefore do not offer as great anopportunity for diversification as global funds, but they are useful for investors who want to concentrate their holdings in foreign assets only, or who already have significant domestic investments in their portfolio. As

with global funds, international funds can involve risks associated withcurrency fluctuations and political and economic instability abroad.

Regional funds can be thought of as a particular type of international fundthat focuses on only one particular region -- for example, Western Europeor Latin America. Even more specific are emerging markets funds thatinvest only in the capital markets of foreign countries that are undergoingdramatic economic transitions, such as those economies that aretransforming from an agricultural economy to an industrialized one (as in

the case of many third world countries) or those that are transformingfrom a state-run economy to a free-market one (as in the case of manyformer Eastern bloc countries). Emerging markets funds offer potentiallyhigher-than-normal returns due to these economic transitions, butthey can also involve a significant amount of risk if the economictransition fails or if there is instability in the country or its currency.

MORTGAGE-BACKED SECURITIES FUNDS Mortgage-backed securities funds invest in home mortgage securities thatare offered through several government agencies. Mortgage-backedsecurities funds receive interest payments on the mortgages, which they

pass on to shareholders, as well as principal payments, which they use toreinvest in more securities . These funds are considered to be very safesince mortgage-backed securities from the aforementioned agencies areeither backed by the federal government or they have very high creditratings. However, these funds may suffer from prepayment risks (inwhich case the mortgagor may pay off the principal earlier thananticipated) and interest rate fluctuations (which could cause the value of the fund to go up and down).

HEDGE FUNDS Hedge funds are funds that use a variety of aggressive investing strategies(such as short selling, investing in derivatives, and leverage) to seek higher returns. Hedge funds are exempt from many of the rules andregulations governing other mutual funds, which allows them toaccomplish aggressive investing goals. They are restricted by law to no

more than 100 investors per fund, and as a result most hedge funds setexceptionally high minimum investment amounts.


72


23/30

FUND SUPERMARKETS Fund supermarkets are analogous to grocery supermarkets: they allow

consumers to buy a variety of goods from different producers at onecentral location. In the case of fund supermarkets, the consumers areinvestors, the producers are mutual fund families, and the central locationis a brokerage firm. The primary benefit of such an arrangement issimplicity: we get to buy funds from different families and receive alltheir statements in a single report. Fund supermarkets are also supposedto save on costs, since the funds are usually traded with no commissionsand no transaction fees.

FUNDS OF FUNDS "Funds of funds" (FOFs) are meta-mutual funds; that is, they are mutualfunds that invest in other mutual funds. Just as a normal mutual fundinvests in a number of different securities, so an FOF buys shares of many different mutual funds. These funds were designed to achieve evengreater diversification than normal mutual funds; however, they suffer from several drawbacks. Expense fees on FOFs are typically higher thanthose on regular funds because they include part of the expense feescharged by the underlying funds.

INSTITUTIONAL FUNDS Institutional funds are mutual funds that target pension funds,endowments, the wealthy, and other multi-million dollar investors. Their main objective is to reduce risk, so they invest in hundreds of differentsecurities, which makes these funds among the most diversified fundsavailable. They also do not tend to trade securities very often, so they areable to keep operating costs to a minimum.

SOCIALLY RESPONSIBLE FUNDS Perhaps the most subjective of all the types of mutual funds, sociallyresponsible funds aim to invest only in companies that adhere to certainethical and moral principles. Exactly what this means obviously variesfrom fund to fund, but some examples include: funds that only invest inenvironmentally conscious companies ("green funds"), funds that investin hospitals and health care centers, and funds that avoid investing in

alcohol or tobacco companies. Socially responsible funds try to maximizereturns while staying within these self-imposed boundaries.


73


24/30

CONTRARIAN FUNDS Contrarian funds seek to make a profit by investing in the opposite

direction of the prevailing market sentiment. Contrarian funds will investin bonds when the stock market is high (in anticipation that it will fall)and stocks when the stock market is low (in anticipation it will rise).

GIC FUNDS GIC funds are mutual funds that invest solely in guaranteed investmentcontracts (GICs). GICs are fixed income debt instruments sold byinsurance companies to pensions and other types of retirement plans.

They pay a fixed interest rate over a short period of time, usually about 5years, and they are guaranteed by the insurance agency that issues them,not by the government. As with other mutual funds that invest in debtinstruments, GIC funds are generally considered to be conservativeinvestments.

OPTION AND FUTURES FUNDS Option and futures funds are among the most risky mutual fundsavailable. This is because the fund does not own the securities underlyingthe options or the futures; it only owns the right or the obligation to buyor sell those securities at a certain date in the future . The goal of optionand futures funds is primarily capital appreciation, although sometimesthey are used to hedge against prevailing market conditions. Most optionand futures funds have minimum net worth requirements and are notappropriate investments for inexperienced investors (just as options andfutures aren't appropriate for beginners).

4. Commodities

A commodity is any physical substance, such as food, grains, and metals,which is interchangeable with another product of the same type, andwhich investors buy or sell, usually through futures contracts. The term issometimes used more generally to include any product which trades on acommodity exchange; this would also include foreign currencies andfinancial instruments and indexes. The price of the commodity is subjectto supply and demand factors. Risk is actually the reason exchange

trading of the basic agricultural products began. For example, a farmer risks the cost of producing a product ready for market at sometime in the


74


25/30

future because he doesn't know what the selling price will be. Aspeculator can pay the farmer or anyone else producing commodities

because the speculator wants to make a profit. This is called trading infutures.

The following is a list of commodities available for futures trading: Agricultural: grains, oils, livestock, wood, textiles, food products Metallurgical: metals, petroleum, chemicals Interest Bearing Assets: T-bills, bonds, notes Stock Indices Currencies

Most of these contracts are used by corporations to hedge positions taken

elsewhere. Some futures contracts, notably those for stock indices, aresettled in cash because they are not deliverable goods. The contracts alsovary in terms of the transaction date and the quality level of goods to be

bought and sold. New futures contracts are created continuously, butmany are not liquid enough to trade regularly and are used only ashedges.

Investors can receive advice in the futures market from CommodityTrading Advisors. These advisors make specific recommendations about

buying and selling futures contracts after considering the circumstancesof the investor.

Managed futures accounts result from giving power of attorney to tradefutures to an account manager. Even though the investor is no longer making trades, he is responsible for margin calls, and gains and lossesappear as credits or debits respectively in the managed account.

Commodities pools are analogous to mutual funds in that many investors pool their assets to gain the power to make trades that they could notmake individually. Additional benefits include bypassing marginrequirements and limiting risk to the amount invested in the pool.

Investing with the help of an advisor, manager or pool may have itsadvantages, but it certainly does not eliminate risk or guarantee anydegree of success, and we do not recommend commodities or futuretrading, with or without expert assistance, for any investors who aren'tvery experienced.

5. Futures


75


26/30

A futures contract is a standardized, transferable, exchange-tradedcontract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Generally, the

delivery does not occur; instead, before the contract expires, the holder usually "squares their position" by paying or receiving the difference between the current market price of the underlying asset and the pricestipulated in the contract.

Unlike options, futures contracts convey an obligation to buy. The risk tothe holder is unlimited. Because the payoff pattern is symmetrical, therisk to the seller is unlimited as well. Money lost and gained by each

party on a futures contract are equal and opposite. In other words, futures

trading is a zero-sum proposition.Futures contracts are forward contracts, meaning they represent a pledgeto make a certain transaction at a future date. The exchange of assetsoccurs on the date specified in the contract. Futures are distinguishedfrom generic forward contracts in that they contain standardized terms,trade on a formal exchange, are regulated by overseeing agencies, and areguaranteed by clearinghouses. Also, in order to insure that payment willoccur, futures have a margin requirement that must be settled daily.Finally, by making an offsetting trade, taking delivery of goods, or arranging for an exchange of goods, futures contracts can be closed.

Futures are risky investment vehicle that are appropriate for only thesmallest percentage of highly advanced investors. FUTURES TRADING

Futures contracts are purchased when the investor expects the priceof the underlying security to rise. This is known as going long. Becausehe has purchased the obligation to buy goods at the current price, theholder will profit if the price goes up, allowing him to sell his futurescontract for a profit.

The opposite of going long is going short. In this case, the holder acquiresthe obligation to sell the underlying commodity at the current price. Hewill profit if the price declines before the future date.

Hedgers trade futures for the purpose of keeping price risk in check.

Because the price for a future transaction can be set in the present, the


76


27/30

fluctuations in the interim can be avoided. Hedging with futures can even be used to protect against unfavorable interest rate adjustments.

While hedgers attempt to avoid risk, speculators seek it out in the hope of

turning a profit when prices fluctuate. Speculators trade purely for the purpose of making a profit and never intend to take delivery on goods.

Accounts used to trade futures must be settled with respect to the marginon a daily basis. Gains and losses are tallied on the day that they occur.Margin accounts that fall below a certain level must be credited withadditional funds.

PRICING FUTURES

Futures prices are presented in the same format as cash market prices.When these prices change, they must change by at least a certainminimum amount, called the tick. The tick is set by the exchange.

Prices are also subject to a maximum daily change. These limits are alsodetermined by the exchange. Once a limit is reached, no trading isallowed on the other side of that limit for the duration of the session. Bothlower and upper limits are in effect. Limits were instituted to guardagainst particularly drastic fluctuations in the market.

In addition to these limits, there is also a maximum number of contractsfor a given commodity per person. This limit serves to prevent oneinvestor from gaining such great influence over the price that he can

begin to control it.

6. Options

Options are a type of derivative, which simply means that their valuedepends on the value of an underlying investment. In most cases, theunderlying investment is a stock, but it can also be an index, a currency, acommodity, or any number of other securities.

A stock option is a contract that guarantees the investor who has purchased it the right, but not the obligation, to buy or sell 100 shares of the underlying stock at a fixed price prior to a certain date. Each optionhas a buyer, called the holder, and a seller, known as the writer. If the

option contract is exercised, the writer is responsible for fulfilling theterms of the contract by delivering the shares to the appropriate party. In


77


28/30

the case of a security that cannot be delivered such as an index, thecontract is settled in cash.

There are two basic forms of options. A call option provides the holder

with the right to buy 100 shares of the underlying stock at the strike price,and a put option provides the holder with the right to sell 100 shares of the underlying stock at the strike price. If the price of a stock is going torise, a call option allows the holder to buy stock at the price before theincrease occurs. Similarly, if the price of a stock is falling, a put optionallows the holder to sell at the earlier, higher price.

For the holder, the potential loss is limited to the price paid to acquire theoption. When an option is not exercised, it expires. No shares change

hands and the money spent to purchase the option is lost. The upside,however, is unlimited. Options, like stocks, are therefore said to have anasymmetrical payoff pattern. For the writer, the potential loss is unlimitedunless the contract is covered, meaning that the writer already owns thesecurity underlying the option.

Option Components

An option for a given stock has three main components: an expirationdate, a strike price and a premium. The expiration date tells the month inwhich the option will expire. The strike price is the price at which theholder is allowed to buy or sell the underlying stock at a later date. The

premium is amount that the holder must pay for the right to exercise theoption. Because the holder acquires the right to trade 100 shares, the totalcost of the option, if exercised, is 100 times the premium.

In order to relate them to the price of the underlying stock at any giventime, options are classified as in-the-money, out-of-the-money or at-the-money. A call option is in-the-money when the stock price is above thestrike price and out-of-the-money when the stock price is below the strike

price. For put options, the reverse is true. When the stock price and strike price are equal, both types of options are considered at-the-money.

Valuing and Pricing Options

The price of an option is primarily affected by: The difference between the stock price and the strike price The time remaining for the option to be exercised The volatility of the underlying stock


78


29/30

Affecting the premium to a lesser degree are factors such as interest rates,market conditions, and the dividend rate of the underlying stock.

Exercising Options

Exercising an option consists of buying (in the case of a call option) or selling (in the case of a put option) 100 shares of the underlying stock atthe strike price. Options are classified as American or Europeandepending on the way in which the holder may exercise them. The holder may exercise an American style option at any point between the time of

purchase and the expiration date. A European style option, on the other hand, cannot be exercised until expiration. Most stock options areAmerican style, but some index options are European style.

7. Other Types of Cash Investments

As their name implies, cash investments are easily redeemable withsmall, if any, penalties for withdrawal. Examples of cash investmentsinclude money market funds, bank accounts and certificates of deposit(CDs).

Investors benefit from the low-risk yield and high liquidity of cashinvestments. The downsides to cash investments are the low interest rateand the fact that a favorable interest rate can only be locked intemporarily due to the short periods of time that the interest rate is lockedin.

CERTIFICATES OF DEPOSIT

Traditional CDs are savings certificates that pay a fixed interest rate untilthey reach maturity. Most are issued by banks and have a somewhathigher interest rate than savings accounts. CDs are very flexible in thatthey can be issued in any denomination and have a range of maturities.The most common maturities are three months and six months. When theCD reaches maturity, the holder receives the principal invested plus allinterest earned while the CD matured. One downside to CDs is that thereis a penalty associated with removing funds before the maturity date.

THE MONEY MARKET

The money market is used to buy and sell fixed income securities. Unlikethe bond market, money market investments are short-term. These short-


79


30/30

term loans usually have a maturity of less than six months. Money marketsecurities are generally very safe investments which return a reasonableinterest rate that is most appropriate for temporary cash storage or short-term time horizons. Bid and ask spreads are relatively small due to the

large size of the market.

TYPES OF MONEY MARKET INSTRUMENTS

Treasury Bills are an extremely low-risk investment vehicle. T-Bills areauctioned off and guaranteed by the government. They mature in either 3months, 6 months or 12 months, meaning that they have short enoughterms to avoid the risks associated with rising interest rates. The bills aresold at a discount from face value and can be redeemed for their full

value at maturity. Commercial paper is available in a wide range of denominations. These

promissory notes are short-term debt instruments issued by companies.They can be of either the discounted or interest-bearing variety. Theyusually have a limited or nonexistent secondary market. Commercial

paper is usually issued by companies with high credit ratings, meaningthat the investment is almost always relatively low risk.

There are a variety of other notes available that vary in terms of return,risk and liquidity, but all are relatively safe investments that return amodest interest rate.

Chapter 2.Financial Instruments

Documents

Transcript of Chapter 2.Financial Instruments