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FIN 501 (31)
Chapter 4

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Ryerson University
FIN 501
Edward Blinder

Chapter 4: Overview of Security Types  4.1 Classifying Securities:  Classification scheme for different securities  Financial assets, such as bonds and stocks, are often called securities and financial “instruments” as well  4.2 Interest-Bearing Assets:  Interest-bearing assets pay interest  Some pay interest implicitly and some pay it explicitly, but the common denominator is that the value of these assets depends, at least for the most part, on interest rates  The reason that these assets pay interest is that they all begin life as a loan of some sort, so they are all debt obligations of some issuer  Table 4.1: Classification of Financial Assets (Major Types of Financial Assets) Classification of Financial Assets Basic Types Major Subtypes Interest- bearing Money market instruments Fixed- income securities Equities Common stock Preferred stock Derivatives Options Futures  Money Market Instruments: debt obligations of large corporations and governments with an original maturity of one year or less - Simplest form of interest-bearing asset - Money market instruments generally have the following two properties: 1. They are essentially IOUs sold by large corporations or governments to borrow money. 2. They mature in less than one year from the time they are sold, meaning that the loan must be repaid within one year. - Most money market instruments trade in very large denominations, and most, but not all, are quite liquid - The most familiar example is a Treasury bill (T-bill) - The Bank of Canada borrows billions of dollars by selling T-bills to the public bi-weekly - T-bills are sold on a discount basis- means T-bills are sold at a price that is less than their stated face value - An investor buys T-bills at one price and later, when the bill matures, receives the full face value- the difference is interest earned - Treasury bills are the most liquid type of money market instrument- that is, the type with the largest and most active market - Other types of money market instruments traded in active markets include bank certificates of deposit (or CDs) and corporate, provincial, and municipal money market instruments - The potential gain from buying a money market instrument is fixed because the owner is promised a fixed future payment - The most important risk is the risk of default, which is the possibility that the borrower will not repay the loan as promised - With T-bill, there is no possibility of default (essentially risk-free) - Most money market instruments have relatively low risk, but there are exceptions, and a few spectacular defaults have occurred in the past - Usually interest rates are quoted, not prices, so some calculation is necessary to convert rates to prices  Fixed-Income Securities: longer-term debt obligations, often of corporations and governments, that promise to make fixed payments according to a preset schedule - It begins life as a loan of some sort making them a debt obligation - Typically issued by corporations and governments - Unlike money market instruments, fixed-income securities have lives that exceed 12 months at the time they are issued - The words “note” and “bond” are generic terms for fixed-income securities, but “fixed income” is more accurate - Examples of Fixed-Income Securities: page 104/105 - Coupon rate: the rate you receive from the face value - Current Yield: annual coupon divided by the current bond price - For most bonds, the coupon rate never changes but the current yield fluctuates with the price of the bond - Fixed-Income Price Quotes: prices for fixed-income securities are quoted in different ways, depending on, what type of security is being priced (Figure 4.1 page 106) - Bid Price: is the dealer’s buying price - Ask Price: is the dealer’s selling price - Bond Prices: are quoted as percentages of bond face value - Yield Change: represents the change in ask yield from the previous close - The potential gains from owning a fixed-income security comes in two forms: 1. The fixed payments promised 2. The final payment at maturity - The prices of most fixed- income securities rise when interest rates fall, so there is the possibility of a gain from a favourable movement in rates - An unfavorable change in interest rates will produce a loss - Another significant risk for many fixed-income securities is the possibility that the issuer will not make the promised payments (risk depends on issuer- doesn’t exist in Canadian government bonds but for many other issuers the possibility is very real) - Unlike most money market instruments, fixed-income securities are often quite illiquid, again depending on the issuer and the specific type  4.3 Equities:  Equities are the most familiar type of security which comes in 2 forms: 1. Common Stock (more important) 2. Preferred Stock  Common Stock: represents ownership in a corporation - As part of an owner, you are entitled to your pro rata share of anything paid out and you have the right to vote on important matters - If the company 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 - The potential benefits from owning common stock come in 2 forms: 1. Many companies (but not all) pay cash dividends to their shareholders. However, neither the timing nor the amount of any dividend is guaranteed. At any time, it can be increased, decreased, or omitted altogether. Dividends are strictly at the discretion of a company’s board of directors, which is elected by shareholders. 2. The value of your stock may rise because share values in general increase or because the future prospects for your particular company improve (or both). The downside is just the reverse: your shares may lose value if either the economy or your particular company falters.  Preferred Stock: - Dividend is usually fixed at some amount and never changed - In the event of liquidation, preferred shares have a particular face value - The reason preferred stock is called “preferred” is that a company must pay the fixed dividend on its preferred stock before any dividends can be paid to common shareholders (preferred shareholders must be paid first) - The dividend on a preferred stock can be omitted at the discretion of the board of directors, so, unlike a debt obligation, there is no legal requirement that the dividend be paid (as long as the common dividend is also skipped) - However, some preferred stock is cumulative: meaning that any and all skipped dividends must be paid in full (although without interest) before common shareholders can receive a dividend
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