Chapter 3

Overview of Security Types

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 Overview of Security Types

“An investment operation is one which upon thorough analysis

promises safety of principal and an adequate return. Operations
not meeting these requirements are speculative.”

–Benjamin Graham

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 Learning Objectives

Price quotes for all types of investments are easy to find, but
what do they mean? Learn the answers for:

1. Various types of interest-bearing assets.

2. Equity securities.

3. Futures contracts.

4. Option contracts.

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 Investing Overview

• Fundamental Question: Why invest at all?

― We invest today to have more tomorrow.
― Investment is simply deferred consumption.
― We choose to wait because we want more to spend later.

• Investors have their own investment objectives and

strategies

• The Investment Policy Statement (IPS)

― Designed to reflect your objectives and strategies
― Two parts: 1) Objectives, 2) Constraints
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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
― How its prices are quoted in the financial press.

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Classifying Securities

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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 and 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 calculate prices from the

quoted rates.

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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.

If you might not be able to sell securities quickly for their

current market value, the market is said to be illiquid.

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 Quote Example: Fixed-Income Securities
• Price Quotations from www.wsj.com—the online version of
The Wall Street Journal (some columns are self-explanatory):

The price (per $100 face) of the

bond when it last traded.
You will receive 5.75% of the bond’s face
value each year in 2 semi-annual payments.

The Yield to Maturity (YTM) of the bond.

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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

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Common Stock Price Quotes Online
at http://finance.yahoo.com

First, enter symbol.

Resulting
Screen

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 Preferred Stock
• Information is a bit harder to find for preferred stock versus
common stock.

• Example: Bank of America (BAC) preferred stock

― Find all the BAC preferred stock issues via a Google search—one source is:
quantumonline.com.
― One issue has a ticker of: BAC-J (BAC-PJ is its symbol at Yahoo!)

• 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 will 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.

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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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 Futures Contracts

• Examples: financial futures (i.e., 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.

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Futures Contracts: Online Price Quotes

Source: Markets Data Center at www.wsj.com.

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 Futures Price Quotes Online

Source: www.cmegroup.com
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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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 Option Contracts, II.

• 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.

• 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.

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 Option Contracts, III.

• Potential gains and losses from call options:

―Buyers:
o Profit when the market price minus the strike price is greater than the option premium.
o Best case, theoretically unlimited profits.
o Worst case, the call buyer loses the entire premium.

―Sellers:
o Profit when the market price minus the strike price is less than the option
premium.
o Best case, the call seller collects the entire premium.
o Worst case, theoretically unlimited losses.

―For buyers, option losses are limited, but gains are not.

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 Option Contracts, IV.

• Potential gains and losses from put options:

―Buyers:
o Profit when the strike price minus the market price is greater than the option premium.
o Best case, market price (for the underlying) is zero.
o Worst case, the put buyer loses the entire premium.

―Sellers:
o Profit when the strike price minus the market price is less than the option premium.
o Best case, the put seller collects the entire premium.
o Worst case, market price (for the underlying) is zero.

―For buyers and sellers, gains and losses are limited.

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 Option Contracts: Online Price Quotes
for Nike (NKE) options

Source: www.finance.yahoo.com
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The New Method to Decode Option Symbols

In 2010, a new option symbol system was introduced.

―The symbols expand from 5 letters to 20 letters and numbers.

―The stated goal is to reduce confusion by explicitly stating:

o the underlying stock symbol

o option expiration date
o whether the option is a call or a put
o the dollar part of the strike price
o the decimal part of the strike price

―We do not know whether quadrupling the size of the ticker will
reduce confusion.
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 Investing in Stocks versus Options, I.
Stocks (we assume no dividends):

• Suppose you have $10,000 for investments. Monster Beverage

Corporation is selling at $50 per share.

• Number of shares bought = $10,000 / $50 = 200

• If Monster is selling for $55 per share 3 months later, gain = ($55
 200) - $10,000 = $1,000 (10% gain)

• If Monster is selling for $45 per share 3 months later, gain = ($45
 200) - $10,000 = -$1,000 (10% loss)
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 Investing in Stocks versus Options, II.
Call 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.

― One call contract costs $4  100 = $400
― number of contracts bought = $10,000 / $400 = 25
(controlling 25  100 = 2,500 shares)

• If Monster is selling for $55 per share 3 months later, gain = {($55 – $50)
 2,500} - $10,000 = $2,500 (25% gain)

• If Monster is selling for $45 per share 3 months later, loss = ($0  2,500)
– $10,000 = -$10,000 (100% loss)
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 Useful Internet Sites

• www.investinginbonds.com (a reference for bond basics)

• www.finra.com (learn more about TRACE)
• www.fool.com (Are you a “Foolish investor”?)
• www.cmegroup.com (CME Group)
• www.cboe.com (Chicago Board Options Exchange)
• jmdinvestments.blogspot.com (reference for recent financial information)

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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 Contracts
― Futures Price Quotes
― Gains and Losses on Futures Contracts

• Option Contracts
― Option Terminology
― Options versus Futures
― Option Price Quotes
― Gains and Losses on Option Contracts
― Investing in Stocks versus Options

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