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Chapter 4

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Administrative Studies
ADMS 3531
Dale Domian

Chapter #4 – Overview of Security Types 4.1 - Classifying Securities • Financial assets ac be grouped into three broad categories and subdivided into few major subtypes • Securities are often called financial ‘instruments’ • Financial assets are hard to classify because they are hybrids, meaning that they are a combination of the basic types 4.2 - Interest-Bearing Assets • Interest bearing assets pay interest implicitly and explicitly • The value of these assets depends, on interest rates o Because these assets begin as a loan of some sort which becomes a debt obligation of some issuer Money Market Instruments • Money market instruments are short-term debt obligations of large corporations and governments (with an original maturity of less than one year) • Money market instruments usually have two properties o They are essentially IOUs sold by large corporations or gov’ts to borrow money o They mature in less than one year from the time they are sold, meaning that the loan must be repaid within one year • Money instruments trade in very large denominations – most are liquid (not all) • Most common money market instrument – T-Bills o Sold on a discount basis – which means they are sold at a price that is less than their stated face value o T-Bills are bought at one price and then when the bill matures, the investor receives the full face value o T-bills are the most liquid type of money market instrument – that is, the type with the largest and most active market o T-bills are risk free • Money market instruments are relatively low in risk and buying from money market is fixed because the owner is promised a fixed future payment o Most important risk is the risk of default which is the possibility that the borrower will not repay the loan as promised • However, prices for different money market instrument are quoted in the financial press in differ ways o Interest rates are quoted, not prices, so some calculation is necessary to convert rates top prices • Examples: U.S. Treasury bills (T-bills), bank certificates of deposit (CDs), corporate and municipal money market instruments. • Potential gains/losses: o A known future payment, except when the borrower defaults (i.e., does not pay). Fixed-Income Securities • Fixed-income securities are longer-term debt obligations of corporations and governments, that promise to make fixed payments according to a preset schedule o One characteristic – begins like a loan of some sort like money market o They are debt obligations • When they are issued, their lives exceed one year. • Terms like ‘bond’ or ‘note’ are fixed –income securities • Examples: U.S. Treasury notes, corporate bonds, car loans, student loans. o You buy 1 million in face amount of a 6%, 2-year bond. The 6% is called the coupon rate, and it tells you that you will receive 6% of the 1 million face value each year, or $60000, in two $30000 semiannual ‘coupon’ payments. In 2 years, in addition to your final $30000 coupon payment, you will receive the 1 million face value. The price you would pay for this bond depends on market conditions • Current yield - is the annual coupon rate divided by the current bond price • Most bonds 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, among other things, what type of security is being priced • With money market instruments, there are various details that are very important • Potential gains/losses: o Fixed coupon payments and final payment at maturity, except when the borrower defaults. o Possibility of gain (loss) from fall (rise) in interest rates o Significant risk – the issuer will not make the promised payments  This risk depends on the issuer o Depending on the debt issue, illiquidity can be a problem.  Illiquidity means that you might not be able to sell securities quickly for their current market value 4.3 - Equities Common Stock • Represents ownership in a corporation • A part owner receives a pro rated share of whatever is left over after all obligations have been met in the event of liquidation  Examples: IBM shares, Microsoft shares, Intel shares, Dell shares, etc.  Potential gains/losses:  Many companies pay cash dividends to their shareholders. However, neither the timing nor the amount of any dividend is guaranteed.  The stock value may rise or fall depending on the prospects for the company and market-wide circumstances. Preferred Stock • The dividend is usually fixed and must be paid before any dividends for the common shareholders • In the event of liquidation, preferred shares have a particular face value • Unlike a debt obligation, preferred dividends can be omitted  Information is a bit harder to find for preferred stock versus common stock.  Preferred stock resembles a fixed-income security – have a fixed payment and fixed liquidation value (but no fixed maturity date)  Not a debt obligation  Potential gains/losses:  Dividends are “promised.” However, there is no legal requirement that the dividends be paid, as long as no common dividends are distributed.  The stock value may rise or fall depending on the prospects for the company and market-wide circumstances. 4.4 - Derivatives  Primary asset: Security originally sold by a business or government to raise money.  Can claim on the assets of the issuer  Thus, stocks and bonds are primary financial assets  Derivative asset: A financial asset that is derived from an existing traded asset, rather than issued by a business or government to raise capital. More generally, any financial asset that is not a primary asset.  Difficult to g
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