Chapter 2

Charles P. Jones, Investments: Principles and Concepts,

12th Edition, John Wiley & Sons

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 Continuing our scenario from Chapter 1 wherein you inherit
$1 million dollars from a relative, with the stipulation that
you must invest it under the general supervision of a
trustee, let’s consider our investing opportunities. You
know generally about stocks and bonds, but you are not
really sure about the specific details of each. For example,
you do not know what a BBB rating on a bond indicates.
 Furthermore, you are unaware of zero-coupon bonds, you
have never heard the term securitization, and when your
broker suggests that you consider ADRs for international
exposure, you are really at a loss. For sure, you are not
ready to explain to your trustee why you might consider
derivative securities for your portfolio.

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 It is clear that an investor in today’s world should be
prepared to deal with these issues, because they, and
similar issues, will come up as soon as you undertake any
type of investing program.

 Fortunately, you can learn to evaluate your investing

opportunities, both current and prospective, by learning
some basics about the fundamental types of securities as
outlined in this chapter.

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 Identify money market and capital market securities and
understand the important features of these securities.

 Recognize important terms such as asset-backed securities,

stock splits, bond ratings, and ADRs.

 Understand the basics of two derivative securities, options

and futures, and how they fit into the investor’s choice set.

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 In this chapter the emphasis is on financial assets, which
are financial claims on the issuers of the securities. These
claims are marketable securities that are saleable in the
various marketplaces.
 Basically, households have three choices with regard to
savings options:
◦ Hold the liabilities of traditional intermediaries (such as banks,
thrifts, and insurance companies).
◦ Hold securities directly, such as stocks and bonds.
◦ Hold securities indirectly, through mutual funds and pension
funds.

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 Indirect Investing
◦ The buying and selling of the shares of investment
companies which, in turn, hold portfolios of securities

 Direct Investing
• Investors buy and sell securities themselves,
typically through brokerage accounts

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 A distinguishing characteristic of these assets is that they
represent personal transactions between the owner and the
issuer, In contrast to the marketable securities which is
traded on in impersonal markets
 E.g., As the owner of a savings account at a credit union (or
Bank) must open the account personally, and you must
deal with the credit union in maintaining the account or in
closing it.
 These are “safe” investments, occurring at (typically)
insured financial institutions or issued by the government,
 Some of these assets offer the ultimate in liquidity,

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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

◦ Money markets include short-term, highly liquid, relatively low-

risk debt instruments sold by governments, financial institutions,
and corporations to investors with temporary excess funds to
invest.
◦ Debt instruments—rates 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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 Capital markets encompass fixed-income and equity
securities with maturities greater than one year. Risk is
generally much higher than in the money market because
of the Marketable debt time to maturity and the very
nature of the securities sold in the capital markets.
Marketability is poorer in some cases.

 Equity securities, which have no maturity date

 Fixed-income securities have a specified payment

schedule where, dates and amount of interest and principal
payments known in advance

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 Bonds Long-term debt instruments representing the
issuer’s contractual obligation/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. If bond is paying more than the market the bond will
be sold at premium and vice versa.

 Considered safer than stocks or derivatives due to its fixed

return and the right on the assets of the issuer in case of
default.

 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 interest-cost
bonds with new, lower interest-cost bonds
◦ Wise investor note the bond issue’s 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 owner’s 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 Poor’s Corporation (S&P)

◦ Moody’s 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 asset-
backed securities (ABSs)
◦ ABS is a securitized interest in a pool of non-
mortgage 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 firm’s 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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