Chapter 2

Charles P. Jones and Gerald R. Jensen,

Investments: Analysis and Management,
13th Edition, John Wiley & Sons

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 Commonly owned by individuals
 Are personal transactions between owner and issuer
◦ Owner opens, closes, and maintains account
◦ In contrast, marketable securities trade in
impersonal markets
 Usually very liquid or easy to convert to cash
without loss of value

 Examples: Savings accounts, MMDAs, and CDs

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 Fixed-income: payment specified by a contract
◦ Money market securities and bonds (fixed &
floating rate)

 Equity: represents ownership share in a firm

◦ Common and preferred stock

 Derivative securities: value is derived based on

the prices of other assets
◦ Options, futures, forwards, swaps
 Money Market Securities - securities with
an original maturity of 1 year or less
◦ Include: T-bills, commercial paper,
banker’s acceptances, certificates of deposit
(CDs), repurchase agreements, etc.
 Capital Market Securities - securities with
more than 1 year in original maturity
◦ Include: Common & preferred stock and
bonds
 Negotiable or salable in the marketplace

 Short-term, highly liquid, relatively-low risk debt

instruments—rates tend to move together

 Issued by governments and private firms

 Generally trade in large denominations

 Generally sell on a discount basis

 Generally they are low risk securities

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 Obligations of the federal government
 Commonly referred to as the risk-free
security
 Income earned on T-bills is exempt from
state and local taxes
 Auctioned regularly by the Treasury
◦ Bids can be competitive or non-competitive
 Sell in minimum denominations of $10,000
 Sell on an add-on interest basis

 Insured to $250,000 by the FDIC

◦ For the larger banks the insurance level is

assumed to be much larger

 CDs with denominations of $100,000 or

more are negotiable
 Basically is a short-term, unsecured note
(bond)
 Maturities of 270 days or less are exempt
from SEC registration requirements
 Less liquid than other money market
securities
 Frequently CP is directly placed
 A time draft drawn on and accepted by a
commercial bank
 Generally created by a transaction between
exporters and importers in different
countries
 Maximum maturity is legally established at
180 days
 Federal Funds - short-term lending between
banks generally to maintain required reserves
◦ Other financial inst. have entered this market

 Repurchase Agreements (Repos) - Sale of a

security with the agreement to repurchase the
security at a higher price in the near future
◦ Eliminates price risk for the lender
 Marketable debt with maturity greater than
one year and equity securities, which have
no maturity date
 Riskier than money market securities
 Fixed-income securities have a specified
payment schedule

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 Bonds are long-term debt instruments/IOUs
 Buyer of a newly issued coupon bond lends
money to issuer, issuer agrees to pay
interest and re-pay principal at maturity
 Bonds are fixed-income securities
◦ Buyer knows future cash flows - interest and
principal payments

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 U.S. government/Treasury securities
 Government agency securities
◦ Federal agencies, GSEs, MBSs
 Municipal securities
◦ General Obligation and Revenue
◦ Exempt from federal taxes and potentially
state and local
 Corporate bonds

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 Obligations of the federal government
 Notes have less than 10 years to original
maturity, bonds have 10 or more years
 Income from T-notes and T-bonds is
exempt from state and local taxes
 Treasury strips: claims to a portion of
either the interest or principal payments
 Government Agency Bonds - obligations of
agencies of the federal government
◦ Most were established to finance housing;
farming and student loans also exist
◦ Either federally related or govt. sponsored
◦ Many agencies issue debt with income that is
exempt from state and local taxes
◦ Example agencies include: Fannie Mae, Freddie
Mac, Ginnie Mae
 Bond is worth exactly face value at maturity
◦ Price changes depend on interest rates
◦ Interest rates and bond prices move inversely
 Bond buyer in secondary market must pay the
price of the bond plus accrued interest
◦ Prices quoted without accrued interest
◦ Premium: amount above par value
◦ Discount: amount below par value

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Callable Bonds
 Provision gives the issuer the right to “call in”
the bonds from investors

 Option is attractive to issuer when market rate

drops sufficiently below coupon rate
◦ Issuer saves by replacing higher interest-cost
bonds with new, lower rate bonds
◦ Wise investors note the bond’s call provision

 Most Treasury bonds cannot be called

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 Usually unsecured and often callable
 Receive payment priority in bankruptcy or
liquidation
 Convertible bonds may be exchanged for
another asset at the owner’s discretion
 Risk that issuer may default on payments
 New Types: DANs, inflation-protected notes

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 Reflect probability of default, relative rating

 Rating organizations

◦ Standard and Poor’s, Moody’s, Fitch Ratings

 Rating firms perform credit analysis for

investors, may disagree on ratings

 Bond ratings and coupon rates are inversely

related

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 Investment grade securities
◦ Rated AAA, AA, A, BBB
◦ Many institutional investors buy only these
 Speculative securities
◦ Rated BB, B, CCC, CC
◦ Significant uncertainties
 Junk bonds
◦ Rated BB or lower
◦ High-risk, high-yield bonds

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 Packaging illiquid, risky individual loans into
more liquid, less risky asset-backed securities
(ABSs)
◦ ABS is a securitized interest in a pool of non-
mortgage assets
◦ Alternative assets include: auto loans, credit-
card receivables, small-business loans, leases
◦ ABSs can be structured in tranches with
different prices, credit ratings, maturities

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 Municipal Bonds - obligations of state and
local governments
◦ Interest income is exempt from federal taxation
and possibly state and local taxation
 Returns on municipal bonds:
RTEY = Rm / (1 - t)
* Where: RTEY = taxable equivalent yield; Rm = yield on
tax exempt security; t = marginal tax rate
 Denote an ownership interest in a
corporation
 Denote control over management, at least
in principle
◦ Voting rights important
 Denote limited liability
◦ Investor cannot lose more than their
investment should the corporation fail

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 Hybrid security: features of both debt and
equity
 Preferred stockholders paid after bondholders
but before common stockholders
◦ Dividend known, fixed in advance
◦ May be cumulative if dividend omitted
 Often convertible into common stock
 May carry variable dividend rate

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 Common stockholders are residual claimants
on income and assets

 Book value is accounting value of a share

 Market value is current market price of a share

 Aggregate market value is market price per

share times number of shares outstanding
◦ Referenced as market cap

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 Dividends are cash payments to shareholders
◦ Common stockholder has no specific promise to
receive cash from the corporation
◦ Lack of promise plus price volatility make
common stocks risky
◦ Dividend yield is income component of return
◦ Payout Ratio is ratio of dividends to earnings

Declaration Date Ex-Dividend Date Holder-of-Record Payment Date

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 Stock dividend is payment to owners in stock

 Stock split is the issuance of additional shares

in proportion to the shares outstanding

 Additional shares, not additional value

 P/E ratio is the ratio of current price of equity to

the firm’s most recent 12-month earnings
◦ Shows how much market pays for $1 of earnings

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 May provide higher returns, lower risk
 Changes in value of US dollar can increase
interest in owning foreign securities
 Investors can buy individual foreign
securities or use investment companies
 American Depository Receipts (ADRs)
represent ownership of foreign firm stock

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Major Classifications
 Buyouts – buyer acquires a controlling equity
stake
 Venture Capital – capital extended to a new firm
◦ Seed stage, start-up stage, expansion stage,
replacement capital

* Private equity investors: pension funds,

endowments, insurance companies and high
net-worth investors
 Generally organized as a limited partnership

 General partner is the managing partner

 Two phases: raising funds and managing

equity investments

 Initial success is important for subsequent

funding

 Duration of 10-12 years, extendable 2-3

years
 Securities whose value is derived from another
security
 Futures and options are standardized and
performance is guaranteed by a third party
◦ Risk management tools
◦ Futures contract is an “obligation” to buy or sell
◦ Options contract is the “right” to do so
 Warrants are long-term options issued by a
firm

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 Options are created by investors, not firms

 Call (Put): Buyer pays premium for the right to

purchase (sell) shares at a fixed price
◦ Seller can re-sell option in secondary market
◦ Call (put) buyers betting the price of underlying
stock will rise (fall)

 Allow investors to speculate on short-term

movements in stock price

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 Futures contract: standardized agreement
between parties for delivery of an asset at a
fixed price
◦ A “good faith deposit,” called margin, is required
of both buyer and seller to reduce default risk
◦ Long (short) position: commitment to purchase
(deliver) the asset
◦ Used to hedge the risk of price changes
◦ Small margin size can result in large profits

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