Chapter

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

3 Overview of Security Types

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Security Types

• 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, and– How its prices are quoted in the financial press.

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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

• 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 or 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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Money Market Instruments

• 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 do calculate prices from the quoted rates.

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• Example of a Discount Note – Treasury Bill– Sold at a value below the face value or “pay-off” value of the bill

at maturity– Difference between buying price (discount price) and redemption

price (selling price) is the earned interest– Buying Price of $10,000 face value T-Bill is based on bank

discount basis…we will do this later, for 180 day T-Bill at 3.5% discount, price is $9,825 and thus interest is $175

• Example of a Bank CD– Price is the face value– Interest is stated for the CD on an annual basis– Redemption value is interest plus face value– Example: $10,000 x 1.025 = $10,250 with $250 as the interest

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Fixed-Income Securities

• Examples: U.S. 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 it is possible that you cannot sell these securities quickly.)

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Quote Example: Fixed-Income Securities

• Price Quotations in The Wall Street Journal (most columns are self-explanatory):

Company (Ticker) Coupon Maturity

Last Price Last yield

EST Spread UST

Est. $ VOL (000’s)

KeyCorp Capital Vii (KEY) 5.700 Jun 15, 2035 97.308 5.892 149 30 37,800

HSBC Finance Corp (HSBC) 6.500 Jan 24, 2006 101.283 3.925 n.a. n.a. 37,468

BellSouth Corp (BLS) 4.750 Nov 15, 2012 99.778 4.785 60 10 36,901

You will receive 5.70% of the bond’s face value each year in 2 semi-annual payments.

The estimated yield spread over a particular U.S. Treasury Issue that matures in 2030.

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Equities

• 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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Common Stock

• Examples: IBM shares, Microsoft shares, Intel 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 Stock Price Quotes Onlineat http://finance.yahoo.com

First, enter symbol.

Resulting Screen

Click on “Real-Time ECN”

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Preferred Stock

• Example: Citigroup preferred stock.

• 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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Derivatives, I.

• 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.– More to the point…a derivative asset “derives” its value or price based

on the price of the underlying asset.

– One example is a futures contract…we will study these later• You can buy a contract (or sell a contract) for future delivery of wheat• If you buy the contract, you agree to take delivery of a pre-set amount of

wheat (5,000 bushels) at an agreed upon price today.• If you sell the contract, you agree to make delivery of a pre-set amount of

wheat at an agreed upon price today• The Value of this future contract is based on the underlying value of wheat

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Derivatives, II.

• 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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Option Contracts, I.

• 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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Useful Internet Sites

• www.nasdbondinfo.com (current corporate bond prices)• www.investinginbonds.com (bond basics)• www.nasd.com (learn more about TRACE)• www.fool.com (Are you a “Foolish investor?”)• www.stocktickercompany.com (reproduction stock tickers.)• www.cbot.com (Chicago Board of Trade)• www.cme.com (Chicago Mercantile Exchange)• www.nymex.com (New York Mercantile Exchange)• www.cboe.com (Chicago Board Options Exchange)• finance.yahoo.com (prices for option chains)

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Chapter Review, I.

• 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, II.

• Derivatives

– Futures

– Option Contracts, Calls and Puts