Investment Alternatives

Investment
Alternatives
 Describe the major types of financial assets
and how they are organized.
 Explain what non-marketable financial assets
are.
 Describe the important features of money
market and capital market securities.
 Distinguish among preferred stock, income
trusts, and common stock.
 Understand the basics of options and futures.
 Examples: Savings deposits, Guaranteed
Investment Certificates (GICs)
 Commonly owned by individuals
 Represent direct exchange of claims
between issuer and investor

 Usually “safe” investments which are easy to
convert to cash without loss of value

 Examples: Treasury bills, commercial
paper, Eurodollars, repurchase
agreements, banker’s acceptances (B/As)
 Marketable: claims are negotiable or
saleable in the marketplace

 Short-term, liquid, relatively low-risk debt
instruments
 Issued by governments and private firms
 Treasury Bills:
◦ Short-term promissory notes issued by governments
◦ T-bills accounted for about one-half of all
outstanding money market securities.
◦ Sold at a discount from face value in denominations
of $5,000, $25,000, 100,000, and $1 million
◦ Typical maturities are 91, 182, and 364 days
although shorter maturities are also offered
 Treasury Bills:
◦ Due to government backing, there is a very low risk
of default
◦ Widely distributed and actively traded – high
liquidity
◦ Government T-bill rates as a measure of the
“riskless rate” available to investors, commonly
referred to as the risk-free rate
 Commercial Paper:
◦ Short-term unsecured promissory notes issued
by large, well-known, and financially strong
corporations (including finance companies)
◦ Denominations start at $100,000 with maturities
of 30 to 365 days, and it is sold either directly
by the issuer or indirectly through a dealer, with
rates slightly above T-bill rates.
 Eurodollars:
◦ Dollar-denominated deposits held in foreign
banks or in offices of Canadian banks located
abroad
◦ Although this market originally developed in
Europe, dollar-denominated deposits can now be
made in many countries, such as those of Asia
◦ Consist of both time deposits and certificates of
deposit (CDs), with the latter constituting the
largest component of the Eurodollar markets
◦ Maturities are mostly short-term, often less than
six months
 Repurchase Agreements (RPs):
◦ agreements between a borrower and lender
(typically institutions) to sell and repurchase
money market securities
◦ borrower initiates an RP by contracting to sell
securities to a lender and agreeing to
repurchase these securities at a pre-specified
(higher) price on a stated future date
◦ maturity is generally very short, from 3 to 14
days, and sometimes overnight
◦ minimum denomination is typically $100,000
 Bankers Acceptances (B/As):
◦ Time drafts drawn on a bank by a customer,
whereby the bank agrees to guarantee payment
of a particular amount at a specified future date
◦ Differ from commercial paper because the
associated payments are guaranteed by a bank,
and thus possess the credit risk associated with
that bank
◦ Issued in minimum denominations of $100,000
◦ Typical maturities range from 30 to 180 days,
with 90 days being the most common
 Marketable debt with maturity greater than
one year
 More risky than money market securities
 Fixed-income securities have a specified
payment schedule
◦ Dates and amount of interest and principal
payments known in advance
 Bonds – long-term debt secured instruments
 Major bond types:
◦ Government of Canada bonds
◦ U.S. Treasury bonds
◦ Provincial bonds
◦ Provincially-guaranteed bonds – Ontario Hydro
◦ U.S. federal agency securities – GNMAs (Ginnie
Maes), FNMAs (Fannie Maes)
 Major bond types (cont’d):
◦ Corporate bonds
 Usually pay semi-annual interest, are callable, carry
a sinking fund provision, and have a par value of
$1,000
 Convertible bonds may be exchanged for another
asset
 Risk that issuer may default on payments
Bond Characteristics
 Callable bonds give the issuer the option to
“call” or repurchase outstanding bonds at
predetermined “call” prices (generally at a
premium over par) at specified times
 This feature is detrimental to the
bondholders who are willing to pay less for
them (i.e., they demand a higher return) than
for similar non-callable bonds.
 Generally, the issuer agrees to give 30 or
more days notice that the issue will be
redeemed
 Extendible Bonds: gives the investor an
option to extend the maturity date
 Retractable Bonds: gives the investor an
option to redeem the bond at par prior to
maturity
 Issuers are able to sell bonds with these
features at higher prices than straight
issues
 When bond prices rise (yields fall):
◦ they are attractive long-term investments
 When bond prices fall (yields rise):
◦ they can trade as short-term debt
 Convertible Bonds may be converted into
common shares at predetermined prices.
 This feature makes the issue more saleable
and lowers the interest rate that must be
offered
 Permits the holding of a two-way security:
◦ The safety of a bond
◦ The capital gains potential of a share
 If the common shares of the company are
split, the convertible debt provides
protection against dilution by adjusting the
conversion privilege
 Convertibles are normally callable
Convertible Bonds (cont’d)
 The market price of convertible debt
depends on the value of the underlying
common stock
◦ When the stock is selling well below the
conversion price, the convertible debt is more
like straight debt
◦ When the stock approaches conversion price, a
premium appears
◦ When the stock rises above the conversion price,
the debt will rise accordingly, and will then be
selling off the stock
 Asset-backed securities are “securitized”
assets
 E.g. mortgage-backed securities
◦ Investors assume little default risk as most

mortgages are guaranteed by a federal
government agency
 Represent an ownership interest
 Preferred stock
◦ Preferred shareholders are paid after
bondholders but before common shareholders
◦ Dividend known, fixed in advance
◦ May be cumulative if dividend omitted
 Income trusts
◦ Pay out a portion of cash flows generated from
underlying assets
◦ E.g. royalty trusts and real estate investment
trusts (REITs)
 Common stock
◦ Common shareholders are residual claimants on
income and assets
◦ Common shareholders can elect board of
directors and vote on important issues
 Securities whose value is derived from
some underlying security
 Futures and options contracts are
standardized and performance is

guaranteed by a third party
◦ Risk management tools
 Warrants are options issued by firms
 Exchange-traded options are created by
investors, not corporations
 Call (Put) gives the buyer the right but not the
obligation to purchase (sell) a fixed quantity

of shares at a a fixed price before a certain
date
 Options can be sold in the market at a price
 Increases return possibilities
 Futures contract: A standardized
agreement between a buyer and seller to
make future delivery of a fixed asset at a
fixed price
◦ A “good faith deposit” called margin, is required
of both the buyer and seller to reduce default
risk
◦ Used to hedge the risk of price changes

Investment Alternatives

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Investment Alternatives

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Investment

between issuer and investor

convert to cash without loss of value

saleable in the marketplace

◦ Investors assume little default risk as most

standardized and performance is

obligation to purchase (sell) a fixed quantity

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