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Chapter 4Overview of

Security Types

• Classifying Securities• Interest-Bearing Assets• Equities• Derivatives• Option Contracts

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© 2009 McGraw-Hill Ryerson Limited

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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 Options Futures

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Interest-Bearing AssetsMoney 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.

Examples: 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 calculate prices from the quoted rates.

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Interest Bearing SecuritiesFixed-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.

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 to sell securities quickly for their current market value.

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.

Quote Example: Fixed-Income Securities

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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.

Examples: RIM shares, Royal Bank shares, Magna 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.

Common Stock Price Quotes

Common Stock Price Quotes Onlineat http://finance.yahoo.com

First, enter symbol.

Resulting Screen

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Equities 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.

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 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.

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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Futures Contracts

Examples: financial futures (i.e., S&P/TSX 60, 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.

Source: www.cmegroup.com

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Futures Contracts: Price Quotes

© 2009 McGraw-Hill Ryerson Limited

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Option Contracts A call option gives the owner the right, but not the obligation, to

buy an asset, while a put option gives the owner the right, but not the obligation, to sell an asset.

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.

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.

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Option Contracts 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.

Potential gains and losses: Buyers of options profit if the strike price is better than the market price,

and if the difference is greater than the option premium. In the worst case, buyers lose the entire premium.

Sellers of options gain the premium if the market price is better than strike price. Here, the gain is limited but the loss is not.

Online Price Quotes for Nike (NKE) options

Source: www.finance.yahoo.com

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Investing in Stocks versus Options, I.

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 Options, II.

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.

• A call contract costs $4 100 = $400, so 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

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)

Ayşe Yüce Copyright © 2012 McGraw-Hill Ryerson

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