Chapter 4---Investment Instruments.docx

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Department
Commerce 
Course
COMM 101
Professor
Leanne Hagarty
Semester
Fall

Description
Chapter 4 --- Investment Instruments Types of investments: Bonds • It represents debt for issuing corporation or government • Principle plus stated rate of interest must be paid back at some stated future date • When interest rates go up, bond prices go down. • Characteristics of Bonds • Legal, binding agreement Low risk Bonds are a legal obligation, yet they allow you to remain in control • Fixed rate of return The interest rate is called as "coupon rate" The interest rate is the percentage of the face value ($1000) The return is called as "coupon payment" Often paid semi-annually • Fixed term Principal repaid at maturity Knowing how much it will worth after the fixed term • Priority over stockholder o First task Types of Bonds 1) Secured vs. Unsecured • Secured bond: it is backed up by the financial assets. Hv promise • Unsecured bond: it also called as debentures / unsecured blinding agreement. No promise. Most Canada bonds are unsecured. 2) Registered vs. Bearer • Registered bond: The ownership of the bond is the one who register the names of bondholders are registered with the company, which means people can track who owns the bond. Most doing it on electrically. • Bearer bond: The ownership of the bond belong to whoever holding it. the bond is unregistered, which means no one can track who owns the bond, and no records for the transaction of ownership of the bond. Features of Bonds • Callable • The issuer of callable bond (to call back all the bonds and reissue some day. Ex: the interest rate change, so they recalling all bonds back) has the right at almost any time to call the bonds in and pay them off at a price stipulated in the bond indenture. • It happens when the prevailing interest rate is lower than the rate being paid. • The call price (the price that the issuer must pay to call in the bond) is usually higher than its face value. • Serial • The firms retires portions of the bond issue at different predetermined dates • Convertible • The feature just for you, they allow you change the bond into common stock • Convertible bonds can be converted to common stock, depends on the option of the bondholder. o It also means that the company does not need to pay back the bond. • Since this option gives bondholders a chance of capital gains, the company can offer a lower interest rates when issuing the bonds. Factors that Determine the Value of the Bond 1) What impacts the coupon rate at bond issue? • Prevailing Interest Rates (国际通行利率) o When interest rates rise, the bond becomes more attractive. o When interest rates fall, the bond becomes less attractive. o Example: You own a bond paying 3% interest. When interest rates are low – say 1%, your interest rate is higher than the going rate. This makes your bond attractive to other investors. But if interest rates rise to 5%, your bond is less attractive. • Credit rating of issuer http://www.moodys.com/ o A credit rating can provide the information about an issuer's ability to make interest payment and repay the principal on a bond. o Higher rating means the investment is safe and profitable in the long run. 2) What impacts bond price when traded? • The relationship between the prevailing interest rate and the coupon rate • Changes in credit rating( if the rating goes down, the bond is riskier, so need to make less risk to get bond) • Inflation o In general, when the inflation rate increases (lower the value of the dollar), the bond price falls Because rising inflation decreases the value of your investment. In other words, when your bond matures, the return you have earned on your investment will be worth less in today's dollars. EX: Wal-Mart put the product that hard to sell on sale. o Economic/Market Risk o When the economy is bad, less high-risk bonds are in the market. Concept of Yield (产量,收益,%) • Yield is the percentage return on any investment. • It helps us to compare investment • Face Value is the specific amount of principal to be repaid at maturity date by the issuer. (always use $1000 as face value for bonds) • Formula for calculating yield: Interest= coupon rate x face value Capital gain= face value – purchase price PS: Assumes you will hold the bond until maturity. Need to calculate ‘what you made’ on an annual basis. Example: You buy a 6% bond for $850 with 10 years to maturity. Calculate the Approximate Yield to Maturity on this bond. Step 1: Identify key information 6%=coupon rate. Purchase price or price paid=850. face value=1000 Step 2: Calculate components: Annual bond interest=face value x coupon= 1000x0.06=$60 Annual capital gain= (face value-price paid)/ time to maturity= (1000-850)/10=$15 Step 3: Plug components into formula (60+15)/850=8.8% Notice: Here, our yield is higher than the coupon rate.. (why?) because your bond is less than 1000, is on discount Bond Pricing Three scenarios to consider: 1) You pay less than face value ($1000) for the bond ==Priced “At a Premium” 3) You pay face value (=$1000) for the bond ==Priced “At Par” Scenario 1: Pay at a “Discount” PS: Capital gain when they get less than 1000 back. You have a low coupon rate, drop the price When the yield greater you need more capital gain to hold that yield Scenario 2: Pay at “a Premium” PS: You want to sale it as a Premium because you have a higher yield They will have higher interest rate and may want to get less capital gain (even loss) Scenario 3: Pay “At Par” PS: You pay at Par because 1000=1000 You hv no reason to make a discount, capital gain=1000, got nothing Bond Pricing Summary • Bond prices vary inversely with interest rate • Remember, coupon rate is fix • If coupon rate is less than Expect yield (other economics element), price goes down • If coupon rate is higher than expect yield in the economics, Premium the price (go up), your bond is better • If coupon rate is equal to expect yield, no body is better, you sell at par, 1000 Reading bond quotations: PS: Price is calculate as percentage of face value $996.03 Types of Investments: Stocks • Stock represents equity/capital for issuing company • Characteristics of Stocks o Voting rights o No fixed term o Variable return o Discretionary payment (Dividends) o No legal obligation o Dividends only give out when the business is doing good. o Risk o Higher risk, higher return. Types of Stocks:  More share mean large market  Common stock right, is about if they issue more share, value is less,  After common holder pay the share holder get more money Common Stocks • Individuals and companies buy a firm’s common stock, hoping that the stock will increase in value (a capital gain) and/or will provide dividend income. • Stock value is expressed in three ways: 1) Par Value o The face value of a share of the stock is set by the issuing company’s board of directors and stated on stock certificates o Each company must preserve money in the amount of its stock's par value in its retained earnings, and cannot distribute it as dividends. 2) Market Value o Market value is the real value of a stock. o The current price of one share of a stock in the secondary securities market. The price of a stock is influenced by: a) Objective factors (e.g. company profits) b) Subjective factors (e.g. rumors, investor relations, stockbroker recommendations) 3) Book Value Value of a common stock expressed as total stockholder’s equity divided by the number of shares of stock Stockholders' equity is the sum of a company's common stock par value, retained earnings, and additional paid-in capital. Preferred Stock • Usually issued with a stated par value
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