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Chapter 4

Chapter 4 Overview of Security Types.docx

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FIN 501
Edward Blinder

FIN501 investment analysis I CHAPTER 4 OVERVIEW OF SECURITY TYPES CLASSIFYING SECURITIES  Financial assets can be grouped into three broad categories, and each can be subdivided into few major subtypes  Distinctions can become blurred because some financial instruments are hybrids, meaning they are combinations of the basic types BASIC TYPES MAJOR SUBTYPES Interest-bearing Money market instruments Fixed-income securities Equities Common stock Preferred stock Derivatives Options Futures INTEREST-BEARING ASSETS  Some interest-bearing assets pay interest implicitly and some pay explicitly, but the common denominator is that the value of these assets depends on interest rates o They pay interest because they all begin life as a loan so they are all debt obligations of some issuer  Types of interest-bearing assets: 1. Money market instruments: debt obligations of large corporations and governments with an original maturity of one year or less  EX. Bank of Canada sells T-bills on a discount basis bi-weekly; other instruments include bank certificates of deposit (CDs) and corporate, provincial and municipal money market instruments  Potential gain from money market instrument is fixed because the owner is promised a fixed future payment and has relatively low risk  Risk of default is the possibility that the borrower will not repay the loan as promised 2. Fixed-income securities: longer-term debt obligations, often of corporations and governments, that promise to make fixed payments according to a preset schedule  Live exceeds 12 months at the time they are issued  Current yield: annual coupon divided by the current bond price  Prices for fixed-income securities are quoted in different ways, depending on, among other things, what type of security is being priced  Potential gain from owning a fixed-income security comes in two forms: i. There are fixed payments promised and final payment at maturity ii. Prices of most fixed-income securities rise when interest falls, so there is possibility of a gain from a favourable movement in rates EX. Suppose you buy $1 million face amount of a 6%, two-year bond. Receive $60,000 each year in “coupon” payments. In two years in addition to your final $60,000 coupon payment, you will receive $1 million FV. Price you pay for the bond depends on market conditions. EQUITIES  Two forms of equities: 1. Common stock: represents ownership in a corporation  As a part owner, you are entitled to your pro rata share of anything paid out by the company and you the right to vote on important matters regarding the company  If it were to be sold or liquidated, you would receive your share of whatever was left over after all of the company’s debts and other obligations (such as wages) are paid  Potential benefits from owning stock: i. Cash dividends, which are paid strictly at the discretion of a company’s board of directors, which is elected by shareholders, and can, at any time, increase, decrease, or omitted all together ii. The value of your stock may rise because share values in general increase or because the future prospects for your particular company improve  Downside is reversed: shares may lose value if either economy or particular company falters FIN501 investment analysis I 2. Preferred stock: company must pay fixed dividends on its preferred stock before any dividends can be paid to common shareholders  Company must pay fixed dividends on its preferred stock before any dividends can be paid to common
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