Chapter 2

Investment Alternatives

3 Options for Household Savings with regard to financial assets

1. Hold with the financial intermediaries such as bank, insurance companies, thrifts (??)

2. Direct Investing: Buying and Selling securities directly with the help of broker or investment banks such shares, bonds

3. Indirect Investing: Hold securities indirectly while leaving investment decisions to others such a mutual funds or pension fund

[Exhibit 2.1 on page 22, P. Jones]

Indirect Investing

• In Indirect Investment, investors handed-over their investment to third party; thus losing their direct control of the securities.

• There are three types of investment companies.1. Closed-End investment companies (Managed

Firm)2. Mutual Funds (Managed Firm)3. Exchange-Traded Funds (ETFs) [Un-Managed

Firm]

Direct Investing

• Non-Marketable Investments• Marketable Investments– Money Market– Capital Market• Fixed-Income• Equity Securities

– Derivatives Market

Non-Marketable Securities

1. Savings Accounts2. Non-Negotiable Certificates of deposit3. Money Market Deposit Accounts (MMDAs)4. US government Savings Bonds

• Savings Accounts – savings accounts in commercial banks and thrift (savings and loan institutions and credit unions)

• Non-Negotiable Certificates of deposit (CDs) – commercial bank and other institutions offer a variety of savings certificates known as certificate of deposit (CDs)– Rate is directly proportional to maturity of CDs. – It is a buy-and-hold certificate

Money Market Securities (MMS)

• The market for short-term, highly liquid, low-risk assets such as treasury bills and negotiable CDs.

• The assets are sold by government, financial institutions and corporations.

• The maturities of money market instruments range from 1 day to 1 year; usually 90 days

Forms of MMS

• Treasury Bills• Negotiable Certificate of Deposit (CDs)• Commercial Papers• Repurchases Agreement (RPs)• Banker’s Acceptance

Forms of MMS....Treasury Bills

• Short-term money market instrument sold at discount and redeem at face value issued by the Government

• Sold at auction• Its a benchmark assets• Risk-Free financial asset (Rf)• Treasury Notes: 2-10 years maturity• Treasury Bonds: more than 10 years obligations

Forms of MMS...Treasury Bills

• Return (Investment yield) on T-Bills

Daysin 365

.)Pr.(

MaturiyX

pricePurchaseicePurchasevalueFaceYield

Forms of MMS

• Commercial Paper – its like T-Bills; however, the issuer is a corporation not government– It is also an unsecured promissory note.

• Negotiable Certificate of Deposit – The investor deposit money in a bank; in return,

the bank issued a certificate which is negotiable.– The holder of the CD will receive the depoisted

money alongwith interest.

Forms of MMS

• Repurchase Agreement ( RPs or Repo) – – the short-term sell of government securities to

corporations with an attention to repurchase the securities at higher price.

– Interest rate is related with T-Bills mostly– Maturity runs from overnight to only a few day– How is different from T-Bills• T-bills are only issued at discount; however, it is not in

the case of Repo.

Forms of MMS

• Bankers’ Acceptance – – Short-term promissory note drawn on a bank by a

firm to assist in foreign or domestic trade.– Once it is accepted by a bank, it becomes ‘BA’– The drawer can negotiate the instrument in the

secondary market at discount price.– The bank is supposed to pay the amount on

maturity to the holder of the BA

Example of BA• Importer (Pakistani Firm) and Exporter (England Firm) a deal of Rs.

10,000• Both companies agree to settle the deal in 90 days draft• Pakistani firm get a letter of credit from HBL; so HBL will honor the

draft presented on behalf of Pakistani firm• England firm (drawer) order its bank (e.g., RBS) to draw a draft of Rs.

10,000 on HBL• Once HBL (drawee) accepts it; it becomes BA• Now the england firm can trade the BA in secondary market if it can

not wait for 90 days.• On maturity, the holder (may be England firm or any other party)

will receive the money from HBL.

Capital Market

• The market for long-term securities.• Marketability is poor• Risk is higher due to long maturity time...• Include both debt and equity securities...– Fixed-Income Securities– Equity Securities

Fixed-Income Securities

• The amount and date of each Payment is known in advance– Treasury bonds– Agency bonds– Municipal bonds– Corporate bonds – Asset-backed securities– Mortgage-related bonds– Money market securities

Bonds

• Long-term debt instruments representing the issuer’s contractual obligation

• Fixed-Income security• As interest (coupon rate) and principle payment is

specified in advance• The buyer can sell the bonds before maturity; the

price depends upon interest rates at that time..• Default of the payment may lead to bankruptcy

Characteristics

• Face value• Usually have maturity date...• Have coupon – the periodic interest payment

by the issuer to the holder of the bonds• May be issued at discounts or premium• Credit Rating plays an important role in

deciding interest rate.

Callable Bonds• The issuer of the bond has the right to call the bond and

retire it by paying off the obligation...• The call option is attractive when the ‘market interest rate’ is

lower then the coupon rate.• Costs are incurred on callable bonds such as ‘call premium’

and ‘administrative expenses’.• Call premium is usually equals to one’ year interest rate if

the bond is called within a year; after the first year, it usually decline at constant rate.

• Callable bonds can be re-issued at lower coupon rate but non-refundable bonds can be re-issued.

The Zero Coupon Bond

• A bond issued at discount and redeem at its face value...

• Having no interest (coupon) rate...• The difference between discount and

redeemable value is rate of return

Types of Bonds

1. Treasury securities 2. Federal agency3. Municipal 4. Corporate bonds

1. Treasury Securities

• Like T-Bills• Treasury-Notes: 2-10 years maturity• Treasury-Bonds: more than 10 years maturity• TIPS (Treasury Inflation-Indexed Securities) –

protect the investors against the inflation losses....TIPS pay a fixed rate of interest but this rate is applied to the inflation-adjusted principal.

2. Federal Agency Securities

• US government established federal agencies to help certain sector either by providing direct loans or guarantee of private loan.

• The securities issued by federal credit agencies (fully guaranteed) or by government sponsored agencies (not guaranteed).

• Mortgage-Backed Securities: securities whose value depends on some set of mortgages.

3. Municipal Securities

• Securities issued by political entities other than the federal government and its agencies such as cities, states, counties.1. General Obligation Bonds – backed by full faith

and credit2. Revenue Bonds – which are repaid from the

revenues generated by the project in which the bonds are issued

4. Corporate Bonds

• Long-term debt securities of various types sold by corporations

• Senior Securities: Debt securities have preference over shares in case of payments or in case of liquidation.

• Debenture – unsecured bonds; backed by the issuer’s overall financial soundness

5. Junk Bond

• High risky and high yield bond• Usually issued by the firm as a last option

Equity Securities• Preferred Stock

– Hybrid security as it resembles both equity and fixed-income securities

– Like equity: having ownership position, infinite life and dividend receipt.

– Like debt: fixed amount of dividend is received.– Having intermediate claim between bondholders and equity

holders on a firm’s assets and earnings.– Having no voting power in annual general meeting usually– Having prior claim on the assets on liquidation– May be cumulative or non-comulative regarding dividend payment– My be convertible preferred stock to common stock

Equity Securities

• Common Stock– Having voting power having control over

management– Having second/last claim on the assets and

earnings– Receive dividend (cash and stock)

Derivatives

• The securities that derive their values by having claim on the some underlying securities.

Options –

• Rights to buy or sell a stated number of shares of a security at a specified price; it may be:– Puts – an option to sell a specified number...– Calls – an option to buy a specified number...

• Options only give a right to put and call; not an obligation to sell (purchase) shares.

Future Options• Agreement providing for the future exchange of a particular

assets at a currently determined market price.• The assets may be commodities (corn, wheat) or financial

assets (shares, bonds, T-Bills etc.)• The buyer pays the money upon delivery of assets by seller.• Used by both hedgers and speculators.– Hedgers purchase future contracts to reduce price

uncertainty; while– Speculators purchase future contracts to exploit the

uncertainty to earn profit.

In Conclusion, Direct Investment......

Direct investing• Non-Marketable Financial assets– Saving deposits– Certificate of deposit– Money market deposits accounts– US saving bondsMoney Market securities– T-bills– Negotiable certificates of deposits– Commercial papers– Repurchase agreements– Banker’s acceptance

Direct investing

• Capital market securitiesA. Fixed income securities– Treasury or government bonds– Corporate bondsB. Equity securities– Preferred stock– Common stocksDerivative Securitas– Options– Futures