Chapter 2

Charles P. Jones, Investments: Principles and Concepts,

11th Edition, John Wiley & Sons

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 Investment Alternatives
1-Nonmarketable Securities Direct Investing
 Saving deposits, Fixed deposits
 Non Negotiable Certificates of deposits
 MMDA
 U.S. saving bonds
2a- Money Market Securities  T-bills- a benchmark financial asset
 Negotiable certificate of deposit
 Commercial paper
 Eurodollars
 Repurchase agreement
2b- Capital Market Securities  Fixed Income
Treasuries (bills, notes, bonds, TIPS)
Agencies
Municipals
Corporates
 Equities
Preferred stock
Common stock
2c- Derivative Market Securities  Options
 Futures, Swaps, Warrants, CDOs, CDS
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Indirect Investment
 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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 Commonly owned by individuals
 Represent direct exchange of claims between

issuer and investor

 Cannot be resold
 Examples: Savings accounts, Fixed accounts/ Time

Deposit, Euro Dollar account, certificates of

deposit (CDs), money market deposit accounts

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 Savings deposits bear interest (normally, they carry the
lowest rate paid on bank deposits) but may be withdrawn
at will (though a bank usually will reserve the right to
require advance notice of a planned withdrawal).

 Time/Fixed deposits carry a fixed maturity and the bank

may impose a penalty if the customer withdraws funds
before the maturity date is reached. The interest rate
posted on time deposits may be either fixed or floating.

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 A certificate of deposit is a promissory note issued by a bank.

 It is a “time deposit” (with different maturities) that restricts

holders from withdrawing funds on demand.

 It is a “buy and hold” investment strategy.

 Although it is still possible to withdraw the money, this action

will often incur a penalty.

 The term can range from one month to 5 years (higher rates
are offered as maturities increase).
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 A money market deposit account (MMDA) is a financial account that
pays interest based on current interest rates (no interest rate ceilings) in the
money markets.
 Money is insured by FDIC up to $250,000 per bank per account.

 Many money market accounts place restrictions on the amount of

transactions you can make in a month (such as six or less), up to three of
which can be by checks.

 No limitations on withdrawal if made in person or through ATMs.

 No limitations on number of deposits.

 Furthermore, you usually have to maintain a certain balance in the account

to receive the higher rate of interest. Some banks require at least $500,
others require a much higher balance.
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 In Pakistan, the protected deposit coverage is
set at Rs250,000/- per depositor per bank.

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 A US dollar that has been deposited outside
the US, especially in Europe.
 Eurodollar deposits consist of both time

deposit and CD.

 Maturities are mostly short term (less than 6

months).

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 Marketable: claims are negotiable or saleable in
the marketplace
 Short-term, liquid, relatively low risk debt

instruments
 Issued by governments and/or private firms
 Examples: REPO (private firms), Money market

mutual funds (private firms), T-Bills (Govt.),

Commercial paper (private firms)

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 A repurchase agreement, also known as a repo, is
the sale of securities(usually government
securities) together with an agreement for the
seller to buy back the securities at a later date at a
higher price.
 The repurchase price should be greater than the

original sale price, the difference effectively

representing interest, sometimes called the repo
rate.
 The maturity lies from 3-14 days and sometimes

overnight..
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 Marketable debt with maturity greater than one
year and ownership shares
 More risky than money market securities
 Fixed-income securities (debt securities/ bonds)

have a specified payment schedule

◦ Dates and amount of interest and principal payments
known in advance

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 Traditional Bond: A bond in which the entire principal
can be withdrawn at a single time after the bond’s
maturity date is over is called a Traditional Bond.
 Callable Bond: When the issuer of the bond calls out his
right to redeem the bond even before it reaches its
maturity is called a Callable Bond. Through this type of
bonds, the issuer can convert a high debt bond into a
low debt bond.
 Fixed-Rate Bonds: When the coupon rate remains the
same through the course of the investment, it is called
Fixed-rate bonds.

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 Floating Rate Bonds: When the coupon rate keeps
fluctuating during the course of an investment, it is called
a floating rate bond.
 Puttable Bond: When the investor decides to sell their bond
and get their money back before the maturity date, such
type of bond is called a Puttable bond.
 Mortgage Bond: The bonds which are backed up by the real
estate companies and equipment are called mortgage
bonds.
 Zero-Coupon Bond: When the coupon rate is zero and the
issuer is only applicable to repay the principal amount to
the investor, such type of bonds are called zero-coupon
bonds.
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 Serial Bond: When the issuer continues to pay back the loan amount to the
investor every year in small instalments to reduce the final debt, such type of
bond is called a Serial Bond.
 Extendable Bonds: The bonds which allow the Investor to extend the maturity
period of the bond are called Extendable Bonds.
 Climate Bonds: Climate Bonds are issued by any government to raise funds when
the country concerned faces any adverse changes in climatic conditions.
 War Bonds: War Bonds are issued by any government to raise funds in cases of
war.
 Inflation-Linked Bonds: Bonds linked to inflation are called inflation linked bonds.
The interest rate of Inflation linked bonds is generally lower than fixed rate bonds

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 Buyer of a newly issued coupon bond is lending
money to the issuer who agrees to repay principal
and interest.(YTM)
 Usually carry call provision. (YTC)
 Bonds are fixed-income securities

◦ Buyer knows future cash flows

◦ Known interest and principal payments
 If sold before maturity, price will depend on
interest rates at that time.

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 A bond that is trading above its par value in the
secondary market is a premium bond. A bond will
trade at a premium when it offers a coupon
(interest) rate that is higher than the current
prevailing interest rates being offered for new
bonds.
 A bond currently trading for less than its par

value in the secondary market is a discount bond.

A bond will trade at a discount when it offers a
coupon rate that is lower than prevailing interest
rates.
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 Zero-coupon bond
◦ Sold at a discount and redeemed for face value at
maturity
◦ Locks in a fixed rate of return, reducing reinvestment
rate risk
◦ May have call feature
◦ Not popular with taxable investors
 Although no coupon payments are made on zero coupon
bonds until maturity, investors may still have to pay
federal, state, and local income taxes on the imputed
interest that accrues each year.

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 To illustrate, assume a $1,000 U.S. TIPS was purchased with a 3%
coupon; also assume inflation during the first year was 10%. If this were
the case, the face value of the TIPS would adjust upward by 10%, to
$1,100.

 Furthermore, the coupon payment (3%), which is also based on face

value, would be $33 (payments adjust and are paid semi-annually). The
end result is that not only are interest payments protected against
inflation, but so is the bond's face value, which is returned to the investor
at maturity. Traditional nominal bonds offer neither of these protections.

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 Federal government securities (eg., T-bonds)
 Federal agency securities (eg., GNMAs;

mortgage-backed securities )
 Federally sponsored credit agency securities

(eg., FNMAs;Federal National Mortgage

Association)

https://www.youtube.com/watch?
v=wDyNoQrWhVk&t=292s

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 Municipal securities: General obligation
bonds, Revenue bonds
◦ Tax implications: Income from investing in
municipal bonds is generally exempt from Federal
and state taxes for residents of the issuing state.
While the interest income is tax-exempt, any
capital gains distributed are taxable to the investor.

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 Usually unsecured debt maturing in 20-40
years, paying semi-annual interest, callable,
with par value of $1,000
◦ Callable bonds gives the issuer the right to repay
the debt prior to maturity
◦ Convertible bonds may be exchanged for another
asset at the owner’s discretion
◦ Risk that issuer may default on payments

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 Rate relative probability of default
 Rating organizations

◦ Standard and Poors Corporation (S&P)

◦ Moody’s Investors Service Inc
◦ Fitch
◦ PACRA
◦ JCR
 Rating firms perform the credit analysis for the
investor
 Emphasis on the issuer’s relative probability of

default
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 Investment grade securities
◦ Rated AAA, AA+, AA, A+, A
◦ Typically, institutional investors are confined to
bonds in these four categories
 Speculative/ Junk securities
◦ Rated BBB, B, CCC, C
◦ Significant uncertainties
◦ C rated bonds are not paying interest

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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 because features of both debt and
equity
 Preferred stockholders paid after debt 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
 Book value is accounting value of a share
 Market value is current market price of a

share

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 Dividends are cash payments to shareholders
◦ Dividend yield is income component of return =D/P

◦ Payout Ratio is ratio of dividends to earnings =

DPS/EPS

◦ Dividends / NI

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 Suppose Coca-Cola BODs meet on May 24
and declares a quarterly dividend, payable on
July 2. May 24 is called the declaration date.
The board will declare a holder-of-record
date, say June 7. the books close on this date,
but coke goes ex-dividend on June 5. to
receive this dividend, an investor must
purchase the stock by June 4. the dividend
will be mailed to the stockholders of record
on the payment date, July 2.

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 Direct investing
◦ US stockbrokers can buy and sell securities on
foreign stock exchanges
◦ Foreign firms may list their securities on a US
exchange or on Nasdaq
◦ Purchase American Depositary Receipts (ADR’s)
 Issued by depositories having physical possession of
foreign securities
 Investors isolated from currency fluctuations

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 To offer ADRs, a U.S. depository bank will purchase shares on a foreign
exchange. The bank will hold the stock as inventory and issue an ADR for
domestic trading. ADRs list on either the New York Stock Exchange (NYSE),
American Stock Exchange (AMEX), or the Nasdaq, but they are also sold
over-the-counter (OTC).

 U.S. banks require that foreign companies provide them with detailed
financial information. This requirement makes it easier for American
investors to assess a company's financial health.

 KEY TAKEAWAYS
 An ADR is a certificate issued by a U.S. bank that represents shares in
foreign stock.
 ADRs trade on American stock exchanges.
 ADRs and their dividends are priced in U.S. dollars.
 ADRs represent an easy, liquid way for U.S. investors to own foreign stocks.
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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
 Warrants are options issued by firms

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 Securitization is a process of converting of an
(illiquid) asset (with periodic cash flows) into
marketable securities (e.g. CDO).
 Transformation of illiquid, risky individual loans

into asset-backed securities (ABS)

 CDO is an Asset Backed Security

◦ Marketable securities backed by auto loans, credit-card

receivables, small-business loans, leases

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 Exchange-traded options are created by
investors, not corporations
 Call (Put): Buyer has the right but not the

obligation to purchase (sell) a fixed quantity

from (to) the seller at a fixed price before a
certain date
◦ Right is sold in the market at a price
 Increases return possibilities

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  When the exercise price exceeds the current
stock price, a call option is said to be out-of-
the-money.
 
 When the exercise price is below the current
stock price, the option is in-the-money.

 https://www.youtube.com/watch?v=AKQ-
X2kEKHc

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 Futures contract: A standardized agreement
(exchange traded) 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
◦ Used to hedge the risk of price changes
Forwards contract: unstandardized agreements hence
more risky. OTC

Manager with farmer

15rs/Kg-----1000 tons
If the market price is 5Rs/kg 2-
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 Taxable equivalent yield=tax exempt municipal yield/1- marginal tax
rate

 Effective state rate= Marginal state rate x (1 – marginal federal rate)

 Combined rate = effective state rate + federal rate

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