Chapter 2
Asset Classes and Instruments
Classifying Securities
Basic Types Major Subtypes
Interest-bearing Money market instruments
(Debt Obligations) Fixed-income securities
Common stock
Equities
Preferred stock
Derivatives Futures
Options
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 or
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.
Treasury Yields at [Link]
Equities
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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. Some Cos pay dividends.
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.
Issued by large cos: banks, utilities, insurance
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. E.g.
Stock Quote Example:
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Preferred Stock
Example: Citigroup preferred stock.
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.
Construction of Indices
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How are stocks weighted?
- Price weighted (DJIA)
- Market-value weighted (S&P500, Nasdaq100)
- Equally weighted (Value Line Index, “VL”)
How are VL returns averaged (cross-sectionally)?
- Arithmetic (VLA)
- Geometric (VLG)
Derivatives
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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
and its value rises or falls based on the price movement of the primary
asset/(basket of assets), but may not be in the same directions and amount.
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.
Futures contract: An agreement made today regarding the terms of a trade that
will take place later.
Option Contracts
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.
Example of a Call Option
Call option:
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An April 30 Call Option on Coca-Cola with a $73 strike price and 3 months to
maturity is selling at a premium of $0.50 per option.
You buy 10 options for $5
If on March 15, Coca Cola stocks are selling @ $75/ shr
U can buy 10 stocks of Coca-Cola @ $730
U can immediately sell them back @ $750
Payoff $20
Gain $20 - $5 = $15
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.
Potential gains and losses from CALL options:
Buyers:
Best case, theoretically unlimited profits.
Worst case, the call buyer loses the entire premium.
Sellers:
Best case, the call seller collects the entire premium.
Worst case, theoretically unlimited losses.
Note: for buyers, losses are limited, but gains are not.
Potential gains and losses from PUT options:
Buyers:
Best case, market price (for the underlying) is zero.
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Worst case, the “put” buyer loses the entire premium.
Sellers:
Best case, the “put” seller collects the entire premium.
Worst case, market price (for the underlying) is zero.
Note: for buyers and sellers, gains and losses are limited.
Quotes:
Futures Contracts
Examples: Financial futures (i.e., S&P 500, T-bonds, foreign currencies futures);
Commodity futures (on wheat, crude oil, cattle, soybean, etc).
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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.
Large amount of gains and losses are possible.
Example of a futures contract
It’s June 2011
Agree with dealer to buy gold in Dec 31 @ $400/ounce
One contract = 100 ounces
You agreed to receive 100 oz of gold in Dec 31 @ $40,000
What do you pay today for this contract today ?
If in Dec 31 gold is selling @ $500/ounce
You take delivery & sell your 100 ozs in open mkt @ $50,000
Your gain $10,000
If actual Dec 31 price is $350/oz, your loss $5,000
If you do not want to wait until Dec and sell the futures
contract to someone else in Aug for $450/ounce, gain $5,000
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.
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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Example of a futures contract
It’s June 2011
Consider a T-bond contract w/ September 2011 closing
Settled at (=last price) 110-02 = $110.0625 per $100 face value
Each contract is standardized at $100,000 face value
If you agreed to buy 1 contract, in Sept you will pay 1000x110.0625 = 110,062.50
and take delivery of one contract.
What do you pay today for this contract today?
In one month it is selling at 115-02
If you sell, you make $5 per 100 of face value or $5,000 per contract
For 15 contracts, you gain 15x$5,000 = $75,000
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