Chapter 2
Charles P. Jones, Investments: Analysis and Management,
12th Edition, John Wiley & Sons
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Commonly owned by individuals
Represent personal transactions between the
owner and the issuer
Owner must open the account, maintain it, close
it
In contrast to marketable securities, which trade
in impersonal markets
Usually very liquid or easy to convert to cash
without loss of value
Examples: Savings accounts and bonds, CDs
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Negotiable or salable in the marketplace
Short-term, highly liquid, relatively-low risk
debt instrumentsrates tend to move together
Issued by governments and private firms
Examples: T-Bills, Commercial paper
T-bill is most prominent money market security
Safest asset available
Serves as a benchmark asset
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Marketable debt with maturity greater than
one year and equity securities, which have
no maturity date
Riskier than money market securities
Fixed-income securities have a specified
payment schedule
Dates and amount of interest and principal
payments known in advance
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Bonds are long-term debt instruments/IOUs
Buyer of a newly issued coupon bond lends
money to issuer, issuer agrees to pay
interest and re-pay principal on maturity
date
Bonds are fixed-income securities
Buyer knows future cash flows
Known interest and principal payments
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If sold before maturity, price depends on
current interest rates
Considered safer than stocks or derivatives
Prices quoted as a % of par value, which is
usually $1,000
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Bond will be worth exactly face value at
maturity
Until maturity, price changes depending on
interest rates
Interest rates and bond prices move inversely
Bond buyer in secondary market must pay
the price of the bond plus accrued interest
Prices quoted without accrued interest
Premium: amount above par value
Discount: amount below par value
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Callable Bonds
Provision gives the issuer the right to call in,
(i.e., buy back) the bonds from investors
This option is attractive to issuers when
market interest rates drop sufficiently below
coupon rate
Issuer can save money by replacing higher interestcost bonds with new, lower interest-cost bonds
Wise investor note the bond issues provisions re:
call
Most Treasury bonds cannot be called
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U.S. government/Treasury securities
Government agency securities
Federal agencies, such as GNMA
Government Sponsored Enterprises (GSEs)
Mortgage-backed Securities (MBSs)
Municipal securities
Two basic types: General Obligation and Revenue
Generally exempt from federal taxes
Corporate bonds
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Usually unsecured and callable
Receive payment priority if bankruptcy or
liquidation
Convertible bonds may be exchanged for
another asset at the owners discretion
Risk that issuer may default on payments
New Types: DANs, inflation-protected notes
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Rate relative, not absolute, probability of
default
Rating organizations
Standard and Poors Corporation (S&P)
Moodys Investors Service Inc.
Rating firms perform the credit analysis for
the investor, may disagree on ratings
Bond ratings and coupon rates inversely
related
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Investment grade securities
Rated AAA, AA, A, BBB
Typically, institutional investors only buy these
Speculative securities
Rated BB, B, CCC, CC
Significant uncertainties
Junk bonds
Rated BB or lower
High-risk, high-yield bonds
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Transformation of illiquid, risky individual
loans into more liquid, less risky assetbacked securities (ABSs)
ABS is a securitized interest in a pool of nonmortgage assets
Marketable securities backed by auto loans,
credit-card receivables, small-business loans,
leases
ABSs can be structured in tranches with different
prices, credit ratings, average maturities
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Denote an ownership interest in a
corporation
Denote control over management, at least
in principle
Voting rights important
Denote limited liability
Investor cannot lose more than their investment
should the corporation fail
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Hybrid security: features of both debt and
equity
Preferred stockholders paid after
bondholders but before common
stockholders
Dividend known, fixed in advance
May be cumulative if dividend omitted
Often convertible into common stock
May carry variable dividend rate
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Common stockholders are residual
claimants on income and assets
Par value is face value of a share
Book value is accounting value of a share
Book value per share can play a role in
investment decisions
Market value is current market price of a
share
Aggregate market value is market price per
share times number of shares outstanding
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Dividends are cash payments to
shareholders
Common stockholder has no specific promises to
receive any cash from the corporation
Lack of promise plus price volatility make
common stocks risky
Dividend yield is income component of return
=D/P
Payout Ratio is ratio of dividends to earnings
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Stock dividend is payment to owners in stock
Stock split is the issuance of additional shares
in proportion to the shares outstanding
The book and par values are changed
Additional shares not additional value for
investor
P/E ratio is the ratio of current market price of
equity to the firms most recent 12-month
earnings
Shows how much the market is willing to pay for $1
of earnings
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May provide higher returns, lower risk
Changes in value of the US Dollar can
increase interest in owning foreign
securities
Investors can buy individual foreign
securities or use investment companies
American Depository Receipts (ADRs)
represent indirect ownership of shares of a
foreign firm
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Securities whose value is derived from
another security
Futures and options contracts are
standardized and performance is guaranteed
by a third party
Risk management tools
Futures contract is an obligation to buy or sell
Options contract is the right to do so, not an
obligation
Warrants are long-term options on common
stock of issuing firm
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Options are created by investors, not
corporations
Call (Put): Buyer pays premium for the right
(not the obligation) to purchase (sell) 100
shares from (to) the seller at a fixed price
before a certain date
Seller can re-sell option in secondary market
Call (put) buyers betting the price of underlying
stock will rise (fall)
Allow investors to speculate on short-term
movements of certain common stocks
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Futures contract: 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
Long (short) position: commitment to purchase
(deliver) the asset
Used to hedge the risk of price changes
Small margin size can result in large profits
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