978-1259720697 Chapter 3 Lecture Note

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Chapter 3

Overview of Security Types

Slides

3-1 Chapter 3

3-2 Overview Of Security Types

3-3 Learning Objectives

3-4 Security Types

3-5 Classifying Securities

3-6 Interest-Bearing Assets

3-7 Money Market Instruments

3-8 Fixed-Income Securities

3-9 Quote Example: Fixed-Income Securities

3-10 Equities

3-11 Common Stock

3-12 Common Stock Price Quotes

3-13 Common Stock Price Quotes Online: http://finance.yahoo.com

3-14 Some Investors Want High Dividend Yields www.wsj.com

3-15 Derivatives, I.

3-16 Derivatives, II.

3-17 Futures Contracts

3-18 Futures Contracts: Online Price Quotes

3-19 Futures Price Quotes Online Source: www.cmegroup.com

3-20 Option Contracts, I.

3-21 Option Contracts, II.

3-22 Option Contracts, III.

3-23 Option Contracts, IV.

3-24 Option Contracts: Online Price Quotes for Nike (NKE) Call and Put Options

3-25 The New Method to Decode Option Symbols

3-26 Investing in Stocks versus Options, I.

3-27 Investing in Stocks versus Options, II.

3-28 Useful Internet Sites

3-29 Chapter Review, I.

3-30 Chapter Review, II.

Chapter Organization

3.1 Classifying Securities

3.2 Interest-Bearing Assets

A. Money Market Instruments

B. Fixed-Income Securities

3.3 Equities

A. Common Stock

B. Preferred Stock

C. Common Stock Price Quotes

3.4 Derivatives

A. Futures Contracts

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Overview of Security Types 3-2

B. Futures Price Quotes

C. Gains and Losses on Futures Contracts

3.5 Option Contracts

A. Option Terminology

B. Options versus Futures

C. Option Price Quotes

D. Gains and Losses on Option Contracts

E. Investing in Stocks versus Options

3.6 Summary and Conclusions

Selected Web Sites

finra-markets.morningstar.com/BondCenter (reference for current corporate

bond prices)

www.investinginbonds.com (reference for bond basics)

www.finra.org (learn more about TRACE)

www.wsj.com (various quotes)

www.fool.com (reference to see whether you are a “Foolish investor”)

www.stocktickercompany.com (reference for reproduction stock tickers)

www.cmegroup.com (CME Group)

www.cboe.com (Chicago Board Options Exchange)

finance.yahoo.com (reference for option prices)

Annotated Chapter Outline

3.1 Classifying Securities

This chapter provides an introduction to the different types of securities. In

general, three questions are asked:

What are the security’s basic nature and its distinguishing characteristics?

What are the potential gains and losses?

How are prices quoted?

The three basic types of financial assets are: interest-bearing, equities, and

derivatives. Some securities are hybrids—they are combinations of the basic

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Overview of Security Types 3-3

types of securities. Financial assets are also referred to as securities and

financial instruments.

3.2 Interest-Bearing Assets

Interest bearing assets: value of the asset depends on interest rates.

The values of all of these assets depend on interest rates; they are a type of

loan, and they are all debt obligations. There are many types of interest-bearing

assets, and they range from the simple to the very complex.

A. Money Market Instruments

Money market instruments: short-term obligations of corporations and

governments that mature in one year or less.

Treasury bills (or T-bills): money market security sold by the U.S.

Treasury, on a discount basis, with no possibility of default (risk-free).

Money market instruments are the simplest form of interest-bearing asset. They

are IOUs sold by large corporations or governments, and they mature in less

than one year. They are usually sold in large denominations and are very liquid.

Treasury bills are the most familiar type of money market instruments. The U.S.

Treasury borrows billions of dollars by selling T–bills to the public. They are sold

on a discount basis, i.e., sold at a price less than their stated face value. When

they mature, the investor receives the full face value, and the difference is the

interest earned. The risk of default is very low, so T-bills are essentially risk-free.

While money market instruments are typically pure discount securities, times of

financial panic can induce investors to pay above face value, effectively resulting

in a negative yield – the price of security.

B. Fixed-Income Securities

Fixed income securities: These are longer-term debt obligations (over

12 months) of corporations and governments. These securities make

fixed payments according to a preset schedule.

Fixed income securities are issued by corporations and governments: promise to

make fixed payments, are debt obligations, and have maturities that are 12

months or longer. They also are known by the terms “note” or “bond.”

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Example:

Suppose you purchase a $10,000 face value four-year Treasury note with a 5

percent coupon. The notes pay interest semiannually, so you will receive $500

per year or $250 in two semiannual coupon payments for each of the next four

years. At the end of year four you will receive both the last $250 interest payment

and the $10,000 face value.

Lecture Tip: When discussing bond quotations it is important to stress the

difference between the coupon rate and the current yield. Students really tend to

confuse the two. Stress that for the vast majority of bonds the coupon rate does

not change. The major use of the coupon rate is to calculate the coupon interest

payment. It is also important to emphasize that bond prices are quoted as a

percentage of face value.

3.3 Equities

Equities consist of common stock and preferred stock.

A. Common Stock

Common stock: This security represents ownership in a corporation.

Benefits include cash dividends and potential capital gain in the value of

the shares. Neither benefit is guaranteed.

Common stock represents ownership in a corporation. As an owner, you are

entitled to a share of any profits paid out by the corporation, and you have the

right to vote on important corporate issues. Although, any influence is minimal

given the large number of shares outstanding. Also, dual class structures may

further reduce the power of minority shareholders.

Shareholders receive two benefits from owning common stock: dividends and

capital gains. They receive the cash dividends paid by the corporation, although

the amount and timing of the dividends are not guaranteed. The dividends are

determined by the company’s board of directors, elected by the shareholders.

The capital gains accrue from the price of the shares increasing or decreasing in

value. Neither of the benefits is guaranteed.

B. Preferred Stock

Preferred stock: This security is a hybrid security. The dividends and

fixed liquidation value are similar to a fixed income security. The gain or

loss from the change in value resembles equity. For tax purposes,

preferred is treated as equity.

Preferred stock differs from common in that the dividend is usually fixed (and

never changes), preferred shares have a set value upon liquidation of the firm,

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and companies must pay the preferred dividend before common dividends can

be paid. Most preferred is cumulative—skipped dividends must be paid before

common stockholders receive a dividend. Potential gains include dividends and

gains from price increases. Preferred stock issues are less frequent than

common stock and are usually issued by large corporations, banks and public

utilities.

Preferred stock is an example of a hybrid security. It is similar to a fixed income

security because of its fixed payment and fixed liquidation value. It is similar to

equity because of the potential gain or loss in value from price changes related to

firm value.

Lecture Tip: It is important to stress that preferred stock is a hybrid security, that

is, it has features of both equity and debt. Therefore, it is not for every investor.

The preferred stock usually has fixed dividend payments and preference during

liquidation, similar to debt. But preferred stock is treated as equity for tax and

accounting purposes, and it changes in value relative to changes in firm value, so

it shares in capital gains.

C. Common Stock Price Quotes

Lecture Tip: Several fine points should be stressed when discussing stock

quotes:

The 52 week Hi and Lo are for the past 52 weeks, not since the beginning of

the year.

The dividend is the annual dividend, based upon the most recent quarterly

dividend.

Explain how the dividend yield (annual dividend / closing price) is different

than the current yield on a bond (coupon payment / bond price).

The P/E ratio is based upon the current closing price divided by the most

recent earnings per share.

The trading volume is based upon trading round lots of 100 shares, so the

volume quote in the journal is multiplied times 100.

The Explanatory Notes are very important in determining what the special

symbols mean.

Note 1: finance.yahoo.com allows you to access a variety of stock quotes—

including intraday. The “Work the Web” using Nordstrom stock is quite a

handy way to illustrate stock quotes to students.

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Note 2: There are a variety of stock tickers available online. Students have

almost surely seen one on TV, so it is an interesting way to connect stock

quotes to the students.

3.4 Derivatives

Primary asset: security sold by a business or government to raise money.

Derivative asset: an asset that is derived from an existing traded asset,

rather than issued by a business or government. Any asset that is not a

primary asset is a derivative asset (also called derivative security).

A primary asset is a security originally sold by a business or government to raise

money, and it represents claims on the assets of the issuers. A derivative asset is

derived from an existing traded asset and represents claims on other financial

assets, or on the future price of a real asset. Any financial asset that is not a

primary asset is a derivative asset.

A. Futures Contracts

Futures contract: an agreement made today regarding the terms of a

trade that will take place later.

A futures contract is an agreement made today regarding the terms of a trade

that will take place later. The commodity, price, and time are specified in the

contract. Futures contracts are standardized; specify a specific quantity, and

specify in detail what the underlying asset is and where it is to be delivered. Most

futures contracts don’t result in delivery. When an investor wants out of the

contract, the contract can be sold to someone else at a profit or loss. Two broad

categories of futures contracts include financial futures and commodity futures.

B. Futures Price Quotes

This is a confusing area for students, as the financial press (e.g., the Wall Street

Journal) strives to save space by shortening the price quotes. Fortunately, the

websites of the CME Group and NYMEX provide more information to help the

students understand how option prices are quoted.

For example, corn, wheat, and soybeans are quoted in cents per bushel; live

cattle are quoted in cents per hundred weight; T-notes and bonds are quoted in

points and 32nd of 100%; gold and crude oil are quoted in dollars (per ounce and

barrel, respectively); and heating oil and gasoline are quoted in cents per gallon.

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C. Gains and Losses on Futures Contracts

Once one knows how the price of the futures contract is quoted, all that is

needed to calculate gains and losses is the size of the futures contract. For

example, the size of a gold contract is 100 ounces. If a trader buys one gold

contract, and the gold price subsequently increases by $4 per ounce, the trader

makes $400. If gold prices subsequently decrease by $4 per ounce, the trader

loses $400.

A shortcut for T-notes and T-bonds is to see that each 32nd is worth $31.25

(=1000 divided by 32). In the textbook example, the T-bond contract price

increased by approximately 5 full points. Obviously, each full point is comprised

of 32 32nd.This means the profit is 5 times 32 times $31.25, which is $5,000 per

contract. If, instead, the price increases from 128 17.5/32 to 128 22.5/32, you

make 5 times $31.25, or $156.25.

3.5 Option Contracts

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. Option contracts traded on exchanges are standardized.

A. Option Terminology

Call option: an option that gives the owner the right, but not the obligation

to buy an asset.

Put option: an option that gives the owner the right, but not the obligation

to sell an asset.

Option premium: the price paid to buy an option.

Strike price: the price specified in an option contract at which the

underlying asset can be bought (call option) or sold (put option). It is also

known as the striking price or exercise price.

Expiration date: the last day on which an option can be exercised.

There are two basic types of options: calls and puts. The owner of a call option

has the right, but not the obligation, to buy the underlying asset at a prespecified

price for a specified period of time. The owner of a put option has the right, but

not the obligation, to sell the underlying asset at a prespecified price for a

specified period of time. The price you pay for the option is the option premium.

The last day an option can be exercised is the expiration date, and the price

specified at which the underlying asset can be bought (call) or sold (put) is the

strike or exercise price. An American option can be exercised at any time up to

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the expiration date, but a European option can be exercised only on the

expiration date. There are weekly and monthly options. Monthly options expire

the third Friday of the month, while weekly options expire on Friday of the given

week.

B. Options versus Futures

Two differences exist between options and futures: the purchaser (seller) of a

futures contract is obligated to buy (sell), where the owner of a call (put) option is

not obligated to buy (sell). When you buy (sell) a futures contract, you pay

(receive) no money. When you buy (sell) an option contract, you pay (receive)

the premium.

C. Option Price Quotes

Lecture Tip: Several fine points should be stressed when discussing option price

quotes.

The strike prices come in standard increments. Stocks that have different

strike prices have had stock splits.

The volume for option contracts is based upon actual option contracts traded.

Because stock is traded in 100 share round lots (or 10 for mini options), each

option contract controls 100 shares of stock. Therefore, the dollar price that

option buyers pay is equal to 100 times the quoted option premium (also

called the option price).

Note: The finance.yahoo.com website allows you to view option chains, i.e.,

prices of a collection of options. An in-class example like the one in Figure 3.5 is

a highly effective teaching aid when it comes to the vagaries of options.

D. Gains and Losses on Option Contracts

Example: Options provide an investor an opportunity to leverage his/her

investment. Suppose you, an investor, want the right to control 500 shares of

Intel stock. Because each option contract is for 100 shares, and you want the

right to buy 500 shares, you need five contracts.

The contract you decide to purchase is the Intel September 40 call option.

Suppose the option premium for the contract with a $40 strike and a September

expiration is $0.95, so one contract would cost $0.95 × 100 = $95. The cost for

five contracts would therefore be 5 × $95 = $475.

Suppose you hold on to your contracts until September rolls around, and they are

just about to expire. What are your gains (or losses) if Intel shares are selling for

$55 per share? $30 per share?

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If Intel is selling for $55 per share, you will profit handsomely. You have the right

to buy 500 shares at a price of $40 per share. Because the stock is worth $55,

your options are worth $15 per share, or $7,500 in all. So you invested $475 and

ended up with more than 15 times that. Not bad.

If the stock ends up at $30 per share, however, the result is not so pretty. You

have the right to buy the stock for $40 when it is selling for $30, so your call

options expire worthless. You lose the entire $475 that was originally invested. In

fact, if the stock price is anything less than $40, then you lose $475 (plus

applicable commissions and exchange fees).

E. Investing in Stocks versus Options

To get a better idea of the potential gains and losses from investing in stocks

compared to investing in options, let’s suppose you have $15,000 to invest.

You’re looking at Monster Beverage, which is currently selling for $150 per share.

You also notice that a call option with a $150 strike price and three months to

maturity is available. The premium is $10. Monster pays no dividends. You’re

considering investing all $15,000 either in the stock or in the call options. What

is your return from these two investments, if, in three months, Monster is selling

for $165 per share? What about $135 per share?

First, if you buy the stock, your $15,000 will purchase one round lot, meaning 100

shares. A call contract costs $1,000 (why?), so you can buy 15 of them. Notice

that your 15 contracts give you the right to buy 1,500 shares at $150 per share.

If, in three months, Monster is selling for $165, your stock will be worth 100

shares × $165 = $16,500.Your dollar gain will be $16,500 less the $15,000 you

invested, or $1,500. Because you invested $15,000, your return for the three-

month period is $1,500 / $15,000 = 10%. If Monster is selling for $135 per share,

then you lose $1,500, and your return is -10 percent.

If Monster is selling for $165, your call options are worth $165 – $150 = $15 each,

but now you control 1,500 shares, so your options are worth 1,500 shares × $15

= $22,500 total. You invested $15,000, so your dollar return is $22,500 – $15,000

= $7,500, and your percentage return is $7,500/$15,000 = 50%, compared to 10

percent on the stock investment. However, if Monster is selling for $135 when

your options mature, then you lose everything, and your return is -100%.

3.6 Summary and Conclusions

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