Topics covered in this document:

Overview (Types of Investments)

Stocks

Bonds

Options

Futures

Risk and Diversification

Duration

Convexity

Overview (for more info, have a look at

http://www.investopedia.com/university/20_investments/ )
Investment objectives will almost always change for every investor throughout their
lives. Capital appreciation might be more important while you are young, meanwhile
entering your golden years might place a greater emphasis on providing income.
Whatever your objective, knowing what investment options are out there is extremely
important.

Furthermore, if there is one consistent idea is that diversification is king. A diversified

portfolio will not only reduce unwanted risk but also contributes to a winning portfolio. A
well-diversified portfolio doesn't necessarily mean just buying more than one stock.
Instead branching out into other areas of investment could be a viable alternative.
Without further ado, here are 20 Investments that we feel every investor should be aware
of:

20 Investments Investors Should Know

1. American Depository Receipt - ADR
2. Annuity
3. Closed-End Investment Fund
4. Collectibles
5. Common Stock
6. Convertible Securities
7. Corporate Bond
8. Futures Contract
9. Life Insurance
 10. Money Market Securities
11. Mortgage Backed Securities - MBS
12. Municipal Security - Munis
13. Mutual Fund
14. Options
15. Preferred Stock
16. Real Estate and Property
17. Real Estate Investment Trust - REIT
18. Treasuries (Government Securities)
19. Unit Investment Trust - UIT

20. Zero Coupon Securities

Stock Basics: What Are Stocks?

The Definition of a Stock

Plain and simple, stock is a share in the ownership of a company. Stock represents a
claim on the company's assets and earnings. As you acquire more stock, your ownership
stake in the company becomes greater. Whether you say shares, equity, or stock, it all
means the same thing.

The importance of being a shareholder is that you are entitled to a portion of the
company’s profits and have a claim on assets. Profits are sometimes paid out in the form
of dividends. The more shares you own, the larger the portion of the profits you get. Your
claim on assets is only relevant if a company goes bankrupt. In case of liquidation, you'll
receive what's left after all the creditors have been paid. This last point is worth repeating:
the importance of stock ownership is your claim on assets and earnings. Without
this, the stock wouldn't be worth the paper it's printed on.

Dividend: Distribution of a portion of a company's earnings, decided by the board of

directors, to a class of its shareholders. The amount of a dividend is quoted in the amount
each share receives or in other words dividends per share.

Liquidation
1. When a business or firm is terminated or bankrupt, its assets are sold and the proceeds
pay creditors. Any leftovers are distributed to shareholders.

2. Any transaction that offsets or closes out a long or short position.

Creditors liquidate assets to try and get as much of the money owed to them as possible.
They have first priority to whatever is sold off. After creditors are paid, the shareholders
get whatever is left with preferred shareholders having preference over common
shareholders.
Stock Basics: What Causes Prices To Change?
Stock prices change everyday by market forces. By this we mean that share prices change
because of supply and demand. If more people want to buy a stock (demand) than sell it
(supply), then the price moves up. Conversely, if more people wanted to sell a stock than
buy it, there would be greater supply than demand, and the price would fall.

That being said, the principal theory is that the price movement of a stock indicates what
investors feel a company is worth. Don't equate a company's value with the stock price.
The value of a company is its market capitalization, which is the stock price multiplied by
the number of shares outstanding.

The most important factor that affects the value of a company is its earnings. Earnings are
the profit a company makes, and in the long run no company can survive without them.

Stock Basics: How To Read a Stock Table/Quote

Any financial paper has stock quotes that will look something like the image below:

Columns 1 & 2: 52-Week Hi and Low - These are the highest and lowest prices at
which a stock has traded over the previous 52 weeks (one year). This typically does not
include the previous day's trading.

Column 3: Company Name & Type of Stock - This column lists the name of the
company. If there are no special symbols or letters following the name, it is common
stock. Different symbols imply different classes of shares. For example, "pf" means the
shares are preferred stock.

Column 4: Ticker Symbol - This is the unique alphabetic name which identifies the
stock. If you watch financial TV, you have seen the ticker tape move across the screen,
quoting the latest prices alongside this symbol. If you are looking for stock quotes online,
you always search for a company by the ticker symbol.
Column 5: Dividend Per Share - This indicates the annual dividend payment per share.
If this space is blank, the company does not currently pay out dividends.

Column 6: Dividend Yield - This states the percentage return on the dividend, calculated
as annual dividends per share divided by price per share.

Column 7: Price/Earnings Ratio - This is calculated by dividing the current stock price
by earnings per share from the last four quarters. For more detail on how to interpret this,
see our P/E Ratio tutorial.

Column 8: Trading Volume - This figure shows the total number of shares traded for
the day, listed in hundreds. To get the actual number traded, add "00" to the end of the
number listed.

Column 9 & 10: Day High & Low - This indicates the price range at which the stock
has traded at throughout the day. In other words, these are the maximum and the
minimum prices that people have paid for the stock.

Column 11: Close - The close is the last trading price recorded when the market closed
on the day. If the closing price is up or down more than 5% than the previous day's close,
the entire listing for that stock is bold-faced. Keep in mind, you are not guaranteed to get
this price if you buy the stock the next day because the price is constantly changing (even
after the exchange is closed for the day). The close is merely an indicator of past
performance and except in extreme circumstances serves as a ballpark of what you
should expect to pay.

Column 12: Net Change - This is the dollar value change in the stock price from the
previous day's closing price. When you hear about a stock being "up for the day," it
means the net change was positive

Summary

• Stock means ownership. As an owner, you have a claim on the assets and earnings
of a company as well as voting rights with your shares.

• Stock is equity, bonds are debt. Bondholders are guaranteed a return on their
investment and have a higher claim than shareholders. This is generally why
stocks are considered riskier investments and require a higher rate of return.

• You can lose all of your investment with stocks. The flip-side of this is you can
make a lot of money if you invest in the right company.

• The two main types of stock are common and preferred. It is also possible for a
company to create different classes of stock.

• Stock markets are places where buyers and sellers of stock meet to trade. The
NYSE and the Nasdaq are the most important exchanges in the United States.

• Stock prices change according to supply and demand. There are many factors
influencing prices, the most important being earnings.
 • There is no consensus as to why stock prices move the way they do.

• To buy stocks you can either use a brokerage or a dividend reinvestment plan
(DRIP).

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Bond Basics: What are Bonds?

A bond is nothing more than a loan of which you are the lender. The organization that
sells a bond is known as the issuer. You can think of it as an IOU given by a borrower
(the issuer) to a lender (the investor).

Of course, nobody would loan their hard-earned money for nothing. The issuer of a bond
must pay the investor something extra for the privilege of using his or her money. This
"extra" comes in the form of interest payments, which are made at a predetermined rate
and schedule. The interest rate is often referred to as the coupon. The date on which the
issuer has to repay the amount borrowed, known as face value, is called the maturity date.
Bonds are known as fixed-income securities because you know the exact amount of cash
you'll get back, provided you hold the security until maturity.

Coupon: The interest rate stated on a bond when it's issued. The coupon is typically paid
semiannually. This is also referred to as the "coupon rate".

Face value: The nominal or stated dollar amount of a security by the issuer. For stocks, it
is the original cost of the stock shown on the certificate. For bonds, it is the amount paid
to the holder at maturity (generally $1,000). Also known as "par value" or simply "par".

Fixed Income: An investment that provides a return in the form of fixed periodic
payments and eventual return of principle at maturity. Unlike a variable-income security
where payments change based on some underlying measure, such as short-term interest
rates, fixed-income securities payments are known in advance.

Bonds are debt whereas stocks are equity. This is the important distinction between the
two securities. By purchasing equity (stock) an investor becomes an owner in a
corporation. Ownership comes with voting rights and the right to share in any future
profits. By purchasing debt (bonds) an investor becomes a creditor to the corporation (or
government). The primary advantage of being a creditor is a higher claim on assets than
that of shareholders. That is, in the case of bankruptcy a bondholder will get paid before a
shareholder does. The bondholder, however, does not share in the profits if a company
does well--he or she is entitled only to the principal plus interest.

To sum it up, there is generally less risk in owning bonds compared to owning stocks, but
this comes at the cost of a lower return.

Issuer
The issuer is an extremely important factor as their stability is your main assurance of
getting paid back. For example, the U.S. Government is far more secure than any
corporation. Their default risk--the chance of the debt not being paid back--is extremely
small, so small that the U.S. government securities are known as risk free assets. The
reason behind this is that a government will always be able to bring in future revenue
through taxation. A company on the other hand must continue to make profits, which is
far from guaranteed. This means the corporations must offer a higher yield in order to
entice investors--this is the risk/return tradeoff in action.

The bond rating system helps investors distinguish a company's credit risk. Think of a
bond rating as the report card for a company's credit rating. Blue-chip firms, which are
safer investments, have a high rating while risky companies have a low rating. The chart
below illustrates the different bond rating scales from the major rating agencies in the
United States: Moody's, Standard and Poor's, and Fitch Ratings:

Bond Rating
Grade Risk
Moody's S&P/ Fitch
Aaa AAA Investment Highest Quality
Aa AA Investment High Quality
A A Investment Strong
Baa BBB Investment Medium Grade
Ba, B BB, B Junk Speculative
Caa/Ca/C CCC/CC/C Junk Highly Speculative
C D Junk In Default

Notice that if the company falls below a certain credit rating, its grade changes from
investment quality to junk status. Junk bonds are aptly named: they are the debt of
companies in some sort of financial difficulty. Because they are so risky they have to
offer much higher yields than any other debt. This brings up an important point: not all
bonds are inherently safer than stocks. Certain types of bonds can be just as risky, if not
more risky, than stocks.

Yield, Price, and Other Confusion

The price fluctuation of bonds is probably the most confusing part. In fact, many new
investors are surprised to learn that a bond's price, just like that of any other publicly-
traded security, changes on a daily basis! Here's the thing: so far we've talked about
bonds as if everybody held them to maturity. It's true that if you do this, you're
guaranteed to get your principal back; however, a bond does not have to be held to
maturity. At any time a bond can be sold in the open market, where the price can
fluctuate, sometimes dramatically. We'll get to how price changes in a bit. First we need
to introduce the concept of yield.

Measuring Return with Yield

Yield is a figure that shows the return you get on a bond. The simplest version of yield is
calculated by the following formula: yield = coupon amount/price. When you buy a bond
at par, yield is equal to the interest rate. When the price changes, so does the yield.

Yield to Maturity (YTM): The rate of return anticipated on a bond if it is held until the
maturity date. YTM is considered a long-term bond yield expressed as an annual rate.
The calculation of YTM takes into account the current market price, par value, coupon
interest rate and time to maturity. It is also assumed that all coupons are reinvested at the
same rate. Sometimes this is simply referred to as "yield" for short.

Putting It All Together: The Link Between Price and Yield

The yield's relationship with price can be summarized as follows: when price goes up,
yield goes down and vice versa. Technically you'd say the bond's prices and its yield are
inversely related.

Reading a Bond Table

Column 1: Issuer - This is the company, state (or province), or country that is issuing the
bond.

Column 2: Coupon - The coupon refers to the fixed interest rate that the issuer pays to
the lender.

Column 3: Maturity Date - This is the date on which the borrower will pay the investors
their principal back. Typically only the last two digits of the year are quoted, 25 means
2025, 04 is 2004, etc.
Column 4: Bid Price. This is the price someone is willing to pay for the bond. It is
quoted in relation to 100, no matter what the par value is. Think of the bid price as a
percentage: a bond with a bid of 93 means it is trading at 93% of its par value.

Column 5: Yield. The yield indicates annual return until the bond matures. Usually this
is the yield to maturity, not current yield. If the bond is callable it will have a "c--" where
the "--" is the year the bond can be called. For example c10 means the bond can be called
as early as 2010.

Callable bond: A bond that can be redeemed by the issuer prior to its maturity. Usually a
premium is paid to the bond owner when the bond is called. Also known as a
"redeemable bond".

Summary:

• Bonds are just like IOUs. Buying a bond means you are lending out your money.
• Bonds are also called fixed-income securities because the cash flow from them is
fixed.
• Stocks are equity; bonds are debt.
• The key reason for purchasing bonds is to diversify your portfolio.
• Issuers of bonds are governments and corporations.
• A bond is characterized by its face value, coupon rate, maturity, and issuer.
• Yield is the rate of return you get on a bond.
• When price goes up, yield goes down and vice versa.
• When interest rates rise, the price of bonds in the market falls and vice versa.
• Bills, notes, and bonds are all fixed-income securities classified by maturity.
• Government bonds are the safest, followed by municipal bonds, and then
corporate bonds.
• Bonds are not risk free. It's always possible--especially for corporate bonds--for
the borrower to default on the debt payments.
• High risk/high yield bonds are known as junk bonds.
• You can purchase most bonds through a brokerage or bank. If you are a U.S.
citizen you can buy through TreasuryDirect.
• Brokers often don't charge a commission to buy bonds but instead markup the
price.

Options Basics: Introduction

Nowadays, many investors' portfolios include investments such as mutual funds, stocks,
and bonds. But the variety of securities you have at your disposal does not end there. A
type of security called an option presents a world of opportunity to sophisticated
investors.

The power of options lies in their versatility. They enable you to adapt or adjust your
position according to any situation that arises. Options can be as speculative or as
conservative as you want. This means you can do everything from protecting a position
from a decline to outright betting on the movement of a market or index.

This versatility, however, does not come without its costs. Options are complex securities
and can be extremely risky. This is why, when trading options, you'll see a disclaimer
like the following:

Options involve risks and are not suitable for everyone. Option trading can be
speculative in nature and carry substantial risk of loss. Only invest with risk capital.

Options Basics: What are Options?

An option is a contract giving the buyer the right, but not the obligation, to buy or sell an
underlying asset at a specific price on or before a certain date. An option, just like a stock
or bond, is a security. It is also a binding contract with strictly defined terms and
properties.

Still confused? The idea behind an option is present in many everyday situations. Say for
example you discover a house that you'd love to purchase. Unfortunately, you won't have
the cash to buy it for another three months. You talk to the owner and negotiate a deal
that gives you an option to buy the house in three months for a price of $200,000. The
owner agrees, but for this option, you pay a price of $3,000.

This example demonstrates two very important points. First, when you buy an option,
you have a right but not the obligation to do something. You can always let the expiration
date go by, at which point the option is worthless. If this happens, you lose 100% of your
investment, which is the money you used to pay for the option. Second, an option is
merely a contract that deals with an underlying asset. For this reason, options are called
derivatives, which means an option derives its value from something else. In our
example, the house is the underlying asset. Most of the time, the underlying asset is a
stock or an index.

Underlying: 1. In derivatives, the security that must be delivered when a

derivative contract, such as a put or call option, is exercised.

2. In equities, the common stock that must be delivered when a warrant is exercised, or
when a convertible bond or convertible preferred share is converted to common stock.

Security: An instrument representing ownership (stocks), a debt agreement (bonds), or

the rights to ownership (derivatives).

Calls and Puts

The two types of options are calls and puts:

A call gives the holder the right to buy an asset at a certain price within a specific period
of time. Calls are similar to having a long position on a stock. Buyers of calls hope that
the stock will increase substantially before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific period
of time. Puts are very similar to having a short position on a stock. Buyers of puts hope
that the price of the stock will fall before the option expires.

Participants in the Options Market

There are four types of participants in options markets depending on the position they
take:

1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts

People who buy options are called holders and those who sell options are called writers;
furthermore, buyers are said to have long positions, and sellers are said to have short
positions.

Here is the important distinction between buyers and sellers:

-Call holders and put holders (buyers) are not obligated to buy or sell. They have the
choice to exercise their rights if they choose.
-Call writers and put writers (sellers) however are obligated to buy or sell. This means
that a seller may be required to make good on their promise to buy or sell.

Don't worry if this seems confusing--it is. For this reason we are going to look at options
from the point of view of the buyer. Selling options is more complicated and can thus be
even riskier. At this point it is sufficient to understand that there are two sides of an
options contract.

The Lingo
To trade options, you'll have to know the terminology associated with the options market.

The price at which an underlying stock can be purchased or sold is called the strike price.
This is the price a stock price must go above (for calls) or go below (for puts) before a
position can be exercised for a profit. All of this must occur before the expiration date.

An option that is traded on a national options exchange such as the CBOE is known as a
listed option. These have fixed strike prices and expiration dates. Each listed option
represents 100 shares of company stock (known as a contract).

For call options, the option is said to be in-the-money if the share price is above the strike
price. A put option is in-the-money when the share price is below the strike price. The
amount by which an option is in-the-money is referred to as intrinsic value.

The total cost (the price) of an option is called the premium. This price is determined by
factors including the stock price, strike price, time remaining until expiration (time
value), and volatility. Because of all these factors, determining the premium of an option
is complicated and beyond the scope of this tutorial.

Why use Options?

There are two main reasons why an investor would use options: to speculate and to
hedge.

Speculation
You can think of speculation as betting on the movement of a security. The advantage of
options is that you aren't limited to making a profit only when the market goes up.
Because of the versatility of options, you can also make money when the market goes
down or even sideways.

Hedging
The other function of options is hedging. Think of this as an insurance policy. Just as you
insure your house or car, options can be used to insure your investments against a
downturn. Critics of options say that if you are so unsure of your stock pick that you need
a hedge, you shouldn't make the investment. On the other hand, there is no doubt that
hedging strategies can be useful, especially for large institutions. Even the individual
investor can benefit. Imagine you wanted to take advantage of technology stocks and
their upside, but say you also wanted to limit any losses. By using options, you would
cost-effectively be able to restrict your downside while enjoying the full upside.

Types of Options
There are two main types of options:

• American options can be exercised at any time between the date of purchase and
the expiration date. The example about Cory's Tequila Co. is an example of the
use of an American option. Most exchange-traded options are of this type.
• European options are different from American options in that they can only be
exercised at the end of their life.

The distinction between American and European options has nothing to do with
geographic location.

How to Read an Options Table

Column 1: Strike Price - This is the stated price per share for which an underlying stock
may be purchased (for a call) or sold (for a put) upon the exercise of the option contract.
Option strike prices typically move by increments of $2.50 or $5.00 (even though in the
above example it moves in $2 increments).

Column 2: Expiry Date - This shows the termination date of an option contract.
Remember that
U.S.-listed options expire on the third Friday of the expiry month.

Column 3: Call or Put - This column refers to whether the option is a call (C) or put (P).

Column 4: Volume - This indicates the total number of options contracts traded for the
day. The total volume of all contracts is listed at the bottom of each table.

Column 5: Bid - This indicates the price someone is willing to pay for the options
contract.

Column 6: Ask - This indicates the price at which someone is willing to sell an options
contract.

Column 7: Open Interest - Open interest is the number of options contracts that are
open; these are contracts that have not expired nor been exercised.

Summary
Here's recap:

• An option is a contract giving the buyer the right but not the obligation to buy or
sell an underlying asset at a specific price on or before a certain date.
• Options are derivatives because they derive their value from an underlying asset.
• A call gives the holder the right to buy an asset at a certain price within a specific
period of time.
 • A put gives the holder the right to sell an asset at a certain price within a specific
period of time.
• There are four types of participants in options markets: buyers of calls, sellers of
calls, buyers of puts, and sellers of puts.
• Buyers are often referred to as holders and sellers are also referred to as writers.
• The price at which an underlying stock can be purchased or sold is called the
strike price.
• The total cost of an option is called the premium, which is determined by factors
including the stock price, strike price, and time remaining until expiration.
• A stock option contract represents 100 shares of the underlying stock.
• Investors use options both to speculate and hedge risk.
• Employee stock options are different from listed options because they are a
contract between the company and the holder. (Employee stock options do not
involve any third parties.)
• The two main classifications of options are American and European.
• Long term options are known as LEAPS.

Futures Fundamentals: A futures contract is a type of derivative instrument, or financial

contract, in which two parties agree to transact a set of financial instruments or physical
commodities for future delivery at a particular price. If you buy a futures contract, you
are basically agreeing to buy something, for a set price, that a seller has not yet produced.
But participating in the futures market does not necessarily mean that you will be
responsible for receiving or delivering large inventories of physical commodities—
remember, buyers and sellers in the futures market primarily enter into futures contracts
to hedge risk or speculate rather than exchange physical goods (which is the primary
activity of the cash/spot market). That is why futures are used as financial instruments by
not only producers and consumers but also speculators.

What Exactly Is a Futures Contract?

Let's say, for example, that you decide to subscribe to cable TV. As the buyer, you enter
into an agreement with the cable company to receive a specific number of cable channels
at a certain price every month for the next year. This contract made with the cable
company is similar to a futures contract, in that you have agreed to receive a product at a
future date, with the price and terms for delivery already set. You have secured your price
for now and the next year--even if the price of cable rises during that time. By entering
into this agreement with the cable company, you have reduced your risk of higher prices.

That's how the futures market works. Except instead of a cable TV provider, a producer
of wheat may be trying to secure a selling price for next season's crop, while a bread
maker may be trying to secure a buying price to determine how much bread can be made
and at what profit. So the farmer and the bread maker may enter into a futures contract
requiring the delivery of 5,000 bushels of grain to the buyer in June at a price of $4 per
bushel. By entering into this futures contract, the farmer and the bread maker secure a
price that both parties believe will be a fair price in June. It is this contract–-and not the
grain per se--that can then be bought and sold in the futures market.
So, a futures contract is an agreement between two parties: a short position, the party who
agrees to deliver a commodity, and a long position, the party who agrees to receive a
commodity. In the above scenario, the farmer would be the holder of the short position
(agreeing to sell) while the bread maker would be the holder of the long (agreeing to
buy). (We will talk more about the outlooks of the long and short positions in the section
on strategies, but for now it's important to know that every contract involves both
positions.)

In every futures contract, everything is specified: the quantity and quality of the
commodity, the specific price per unit, and the date and method of delivery. The “price”
of a futures contract is represented by the agreed-upon price of the underlying commodity
or financial instrument that will be delivered in the future. For example, in the above
scenario, the price of the contract is 5,000 bushels of grain at a price of $4 per bushel.

Summary on Futures:

• The futures market is a global marketplace, initially created as a place for farmers
and merchants to buy and sell commodities for either spot or future delivery. This
was done to lessen the risk of both waste and scarcity.
• Rather than trade in physical commodities, futures markets buy and sell futures
contracts, which state the price per unit, type, value, quality and quantity of the
commodity in question, as well as the month the contract expires.
• The players in the futures market are hedgers and speculators. A hedger tries to
minimize risk by buying or selling now in an effort to avoid rising or declining
prices. Conversely, the speculator will try to profit from the risks by buying or
selling now in anticipation of rising or declining prices.
• The CFTC and the NFA are the regulatory bodies governing and monitoring
futures markets in the U.S. It is important to know your rights.
• Futures accounts are credited or debited daily depending on profits or losses
incurred. The futures market is also characterized as being highly leveraged due
to its margins; although leverage works as a double-edged sword. It's important to
understand the arithmetic of leverage when calculating profit and loss, as well as
the minimum price movements and daily price limits at which contracts can trade.
• “Going long,” “going short,” and “spreads” are the most common strategies used
when trading on the futures market.

Once you make the decision to trade in commodities, there are several ways to participate
in the futures market. All of them involve risk, some more than others. You can trade
your own account, have a managed account or join a commodity pool.

Risk and Diversification:

What is Risk?
Whether it is investing, driving, or just walking down the street, everyone exposes
themselves to risk. Your personality and lifestyle play a big deal on how much risk you
are comfortably able to take on. If you invest in stocks and have trouble sleeping at nights
because of your investments you are probably taking on too much risk.

The Different Types of Risk

Lets take a look at the two basic types of risk:

• Systematic Risk - A risk that influences a large number of assets. An example is

political events. It is virtually impossible to protect yourself against this type of
risk.

• Unsystematic Risk - Sometimes referred to as "specific risk". It's risk that affects
a very small number of assets. An example is news that affects a specific stock
such as a sudden strike by employees.

Diversification is the only way to protect yourself from unsystematic risk. (We will
discuss diversification later in this tutorial).

Now that we've determined the fundamental types of risk lets look at more specific types
of risk, particularly when we talk about stocks and bonds:

• Credit or Default Risk - This is the risk that a company or individual will be
unable to pay the contractual interest or principal on its debt obligations. This
type of risk is of particular concern to investors who hold bond's within their
portfolio. Government bonds, especially those issued by the Federal
government, have the least amount of default risk and least amount of
returns while corporate bonds tend to have the highest amount of default risk
but also the higher interest rates. Bonds with lower chances of default are
considered to be “investment grade,” and bonds with higher chances are
considered to be junk bonds. Bond rating services, such as Moody's, allows
investors to determine which bonds are investment-grade, and which bonds
are “junk”.

• Country Risk – This refers to the risk that a country won't be able to honor
its financial commitments. When a country defaults it can harm the
performance of all other financial instruments in that country as well as other
countries it has relations with. Country risk applies to stocks, bonds, mutual
funds, options and futures that are issued within a particular country. This
type of risk is most often seen in emerging markets or countries that have a
severe deficit.

• Foreign Exchange Risk – When investing in foreign countries you must

consider the fact that currency exchange rates can change the price of the
asset as well. Foreign exchange risk applies to all financial instruments that
are in a currency other than your domestic currency. As an example, if you
are a resident of America and invest in some Canadian stock in Canadian
dollars, even if the share value appreciates, you may lose money if the
Canadian dollar depreciates in relation to the American dollar.

• Interest Rate Risk - A rise in interest rates during the term of your debt
securities hurts the performance of stocks and bonds.
 • Political Risk - This represents the financial risk that a country's government
will suddenly change its policies. This is a major reason that second and third
world countries lack foreign investment.
• Market Risk - This is the most familiar of all risks. It's the day to day
fluctuations in a stocks price. Also referred to as volatility.Market risk applies
mainly to stocks and options. As a whole, stocks tend to perform well during a
bull market and poorly during a bear market—volatility is not so much a
cause but an effect of certain market forces. Volatility is a measure of risk
because it refers to the behavior, or “temperament,” of your investment
rather than the reason for this behavior. Because market movement is the
reason why people can make money from stocks, volatility is essential for
returns, and the more unstable the investment the more chance it can go
dramatically either way.

Diversification

With the stock markets bouncing up and down 5% every week there needs to be a
safety net for individual investors. Diversification is the answer.

Diversifying your portfolio may not be the sexiest of investment topics. Still, most
investment professionals agree that while it does not guarantee against a loss,
diversification is the most important component to helping you reach your long-
range financial goals while minimizing your risk. But, remember that no matter how
much diversification you do, it can never reduce risk down to zero.

What do you need to have a well diversified portfolio? There are 3 main aspects you
should have to ensure the best diversification:

1. Your portfolio should be spread among many different investment vehicles

such as cash, stocks, bonds, mutual funds, and perhaps even some real
estate.

2. Your securities vary in risk. You're not restricted to picking only blue chip
stocks. In fact, the opposite is true. Picking different investments with
different rates of return will ensure that large gains offset losses in other
areas. Keep in mind that this doesn't mean invest in penny stocks!

Your securities should vary by industry, minimizing unsystematic risk to small groups
of companies.

Another question people always ask is how many stocks they should buy to reduce
the risk of their portfolio. The portfolio theory tells us that after 10-12 diversified
stocks you are very close to optimal diversification. This doesn't mean buying 12
internet or tech stocks will give you optimal diversification, instead you need to buy
stocks of different sizes and from various industries.
Advanced Bond Concepts: Duration
(http://www.investopedia.com/university/advancedbond/advancedbond6.
asp )

The term “duration,” having a special meaning in the context of bonds, is a

measurement of how long in years it takes for the price of a bond to be repaid by its
internal cash flows. It is an important measure for investors to consider, as bonds
with higher durations are more risky and have higher price volatility than bonds with
lower durations.

For each of the two basic types of bonds the duration is the following:

1. Zero-coupon bond – Duration is equal to its time to maturity.

2. Vanilla bond - Duration will always be less than its time to

maturity.

Let's first work through some visual models that demonstrate the properties of
duration for a zero-coupon bond and a vanilla bond.

Duration of a Zero Coupon Bond

The red lever above represents the four-year time period it takes for a zero coupon
to mature. The money bag balancing on the far right represents the future value of
the bond, the amount that will be paid to the bondholder at maturity. The fulcrum, or
the point holding the lever, represents duration, which must be positioned where the
red lever is balanced. The fulcrum balances the red lever at the point on the time line
when the amount paid for the bond and the cash flow received from the bond are
equal. Since the entire cash flow of a zero-coupon bond occurs at maturity, the
fulcrum is located directly below this one payment.

Duration of a Vanilla or Straight Bond

Consider a vanilla bond that pays coupons annually and matures in five years. Its
cash flows consist of five annual coupon payments and the last payment includes the
face value of the bond.
The moneybags represent the cash flows you will receive over the five-year period.
To balance the red lever (at the point where total cash flows equal the amount paid
for the bond), the fulcrum must be further to the left, at a point before maturity.
Unlike the zero-coupon bond, the straight bond pays coupon payments throughout
its life and therefore repays the full amount paid for the bond sooner.

Factors Affecting Duration

It is important to note, however, that duration changes as the coupons are paid to
the bondholder. As the bondholder receives a coupon payment, the amount of the
cash flow is no longer on the timeline, which means it is no longer counted as a
future cash flow that goes towards repaying the bondholder. Our model of the
fulcrum demonstrates this: as the first coupon payment is removed from the red
lever (paid to the bondholder), the lever is no longer in balance (because the coupon
payment is no longer counted as a future cash flow).

The fulcrum must now move to the right in order to balance the lever again:
Duration increases immediately on the day a coupon is paid, but throughout the life
of the bond, the duration is continually decreasing as time to the bond's maturity
decreases. The movement of time is represented above as the shortening of the red
lever: notice how the first diagram had five payment periods and the above diagram
has only four. This shortening of the timeline, however, occurs gradually, and as it
does, duration continually decreases. So, in summary, duration is decreasing as time
moves closer to maturity, but duration also increases momentarily on the day a
coupon is paid and removed from the series of future cash flows—all this occurs until
duration, as it does for a zero-coupon bond, eventually converges with the bond's
maturity.

Duration: Other factors

Besides the movement of time and the payment of coupons, there are other factors
that affect a bond's duration: the coupon rate and its yield. Bonds with high coupon
rates and in turn high yields will tend to have lower durations than bonds that pay
low coupon rates, or offer a low yield. This makes empirical sense, since when a
bond pays a higher coupon rate, or has a high yield, the holder of the security
receives repayment for the security at a faster rate. The diagram below summarizes
how duration changes with coupon rate and yield.

Types of Duration
There are four main types of duration calculations, each of which differ in the way
they account for factors such as interest rate changes and the bond's embedded
options or redemption features. The four types of durations are Macaulay duration,
modified duration, effective duration, and key-rate duration.

Macaulay Duration
The formula usually used to calculate a bond's basic duration is the Macaulay
duration, which was created by Frederick Macaulay in 1938 but not commonly used
until the 1970s.

Macaulay duration is calculated by adding the results of multiplying the present value
of each cash flow by the time it is received, and dividing by the total price of the
security. The formula for Macaulay duration is as follows:

n = number of cash flows

t = time to maturity
C = cash flow
i = required yield
M = maturity (par) value
P = bond price

Remember that bond price equals .

So the following is an expanded version of Macaulay duration:

Let's go through an example:

Betty holds a five-year bond with a par value of $1000 and coupon rate of 5%. For
simplicity, let's assume that the coupon is paid annually and that interest rates are
5%. What is the Macaulay duration of the bond?
= 4.55 years

Fortunately, if you are seeking the Macaulay duration of a zero-coupon bond, the
duration would be equal to the bond's maturity, so there is no calculation required.

Modified Duration
Modified duration is a modified version of the Macaulay model that accounts for
changing interest rates. Because they affect yield, fluctuating interest rates will
affect duration, so this modified formula shows how much the duration changes for
each percentage change in yield. For bonds without any embedded features, bond
price and interest rate move in opposite directions, so there is an inverse relationship
between modified duration and an approximate one-percentage change in yield.
Because the modified duration formula shows how a bond's duration changes in
relation to interest rate movements, the formula is appropriate for investors wishing
to measure the volatility of a particular bond. Modified duration is calculated as the
following:

OR

Let's continue analyzing Betty's bond and run through the calculation of her modified
duration. Currently her bond is selling at $1000, or par, which translates to a yield to
maturity of 5%. Remember that we calculated a Macaulay duration of 4.55.
= 4.33 years

Our example shows that if the bond's yield changed from 5% to 6%, the duration of
the bond will have declined to 4.33 years. Because it calculates how duration will
change when interest increases by 100 basis points, the modified duration will
always be lesser than Macaulay duration.

Effective Duration
As the modified duration formula discussed above assumes that the expected cash
flows will remain constant, even if prevailing interest rates change, it is accurate for
option-free fixed-income securities. On the other hand, cash flows from securities
with embedded options or redemption features will change when interest rates
change. For calculating the duration of these types of bonds, effective duration is the
most appropriate.

Effective duration requires the use of binomial trees to calculate the option-adjusted
spread (OAS). There are entire courses built around just those two topics, so the
calculations involved for effective duration is beyond the scope of this tutorial. There
are, however, many programs available to investors wishing to calculate effective
duration.

Key-Rate Duration
The final duration calculation to learn is key-rate duration, which calculates the spot
durations of each of the 11 “key” maturities along a spot rate curve. (To refresh your
knowledge of this curve, see the section of this tutorial on the term structure of
interest rates.) These 11 key maturities are at the 3-month and 1, 2, 3, 5, 7, 10, 15,
20, 25, and 30-year portions of the curve.

In essence, key-rate duration, while holding the yield for all other maturities
constant, allows the duration of a portfolio to be calculated for a one-basis-point
change in interest rates. The key-rate method is most often used for portfolios such
as the bond-ladder, which consists of fixed-income securities with differing
maturities. Here is the formula for key-rate duration:

The sum of the key-rate durations along the curve is equal to the effective duration.

Duration and Bond Price Volatility

More than once throughout this tutorial, we have already established that when
interest rates rise, bond prices fall, and vice versa. But how does one determine the
degree of a price change when interest rates change? Generally, bonds with a high
duration will have a higher price fluctuation than bonds with a low duration. But it is
important to know that there are also three other factors that determine how
sensitive a bond's price is to changes in interest rates. These factors are term to
maturity, coupon rate, and yield to maturity. Knowing what affects a bond's volatility
is important to investors who use duration-based immunization strategies (which we
discuss below) in their portfolios.

Factors 1 and 2: Coupon rate and Term to Maturity

If term to maturity and a bond's initial price remain constant, the higher the coupon,
the lower the volatility, and the lower the coupon, the higher the volatility. If the
coupon rate and the bond's initial price are constant, the bond with a longer term to
maturity will display higher price volatility, and a bond with a shorter term to
maturity will display lower price volatility.

Therefore, if you would like to invest in a bond with minimal interest rate risk, a
bond with high coupon payments and a short term to maturity would be optimal. An
investor who predicts that interest rates will decline would best potentially capitalize
on a bond with low coupon payments and a long term to maturity, since these
factors would magnify a bond's price increase.

Factor 3: Yield to Maturity (YTM)

The sensitivity of a bond's price to changes in interest rates also depends on its yield
to maturity. A bond with a high yield to maturity will display lower price volatility
than a bond with a lower yield to maturity (but similar coupon rate and term to
maturity). Yield to maturity is affected by the bond's credit rating, so bonds with
poor credit ratings will have higher yields than bonds with excellent credit ratings.
Therefore, bonds with poor credit ratings typically display lower price volatility than
bonds with excellent credit ratings.

All three factors affect the degree to which bond price will change in the face of a
change in prevailing interest rates. These factors work together and against each
other. Consider the chart below:

So, if a bond has both a short term to maturity and a low coupon rate, its
characteristics have opposite effects on its volatility: the low coupon raises volatility
and the short term to maturity lowers volatility. The bond's volatility would then be
an average of these two opposite effects.
Immunization
As we mentioned in the above section, the interrelated factors of duration, coupon
rate, term to maturity, and price volatility are important for those investors
employing duration-based immunization strategies. These strategies aim to match
the durations of assets and liabilities within a portfolio for the purpose of minimizing
the impact of interest rates on the net worth. To create these strategies, portfolio
managers use Macaulay duration.

For example, say a bond has a two-year term with four coupons of $50 and a par
value of $1000. If the investor did not reinvest his or her proceeds at some interest
rate, he or she would have received a total of $1200 at the end of two years.
However, if the investor were to reinvest each of the bond cash flows until maturity,
he or she would have more than $1200 in two years. Therefore, the extra interest
accumulated on the reinvested coupons would allow the bondholder to satisfy a
future $1200 obligation in less time than the maturity of the bond.

Understanding what duration is, how it is used, and what factors affect it will help
you determine a bond's price volatility. Volatility is an important factor in
determining your strategy for capitalizing on interest rate movements. Furthermore,
duration will also help you determine how you can protect your portfolio from
interest rate risk.

For any given bond, a graph of the relationship between price and yield is convex.
This means that the graph is curved rather than a straight-line (linear). The degree
to which the graph is curved shows how much a bond's yield changes in response to
a change in price. In this section we take a look at what affects convexity and how
investors can use it to compare bonds.

Convexity and Duration

If we graph a tangent at a particular price of the bond (touching a point on the
curved price-yield curve), the linear tangent is the bond's duration, which is shown in
red on the graph below. The exact point where the two lines touch represents
Macaulay duration. Modified duration, as we saw in the preceding section of this
tutorial, must be used to measure how duration is affected by changes in interest
rates. But modified duration does not account for large changes in price. If we were
to use duration to estimate the price resulting from a significant change in yield, the
estimation would be inaccurate. The yellow portions of the graph show the ranges in
which using duration for estimating price would be inappropriate.
Furthermore, as yield moves further from Y*, the yellow space between the actual
bond price and the prices estimated by duration (tangent line) increases.

The convexity calculation, therefore, accounts for the inaccuracies of the linear
duration line. This calculation that plots the curved line uses a Taylor series (a
calculus theory), which is very complicated and something we won't be describing
here. The main thing for you to remember about convexity is that it shows how
much a bond's yield changes in response to changes in price.

Convexity
Properties of Convexity

Convexity is useful also for comparing bonds. If two bonds offer the same duration
and yield but one exhibits greater convexity, changes in interest rates will affect
each bond differently. A bond with greater convexity is less affected by
interest rates than a bond with less convexity. Also, bonds with greater
convexity will have a higher price than a bond with lower convexity,
regardless of whether interest rates rise or fall. This relationship is illustrated in
the following diagram:
As you can see Bond A has greater convexity than Bond B, but they both have the
same price and convexity when price equals *P and yield equals *Y. If interest rates
changed from this point by a very small amount, then regardless of the convexity,
both bonds would have approximately the same price. When yield increases by a
large amount, however, the prices of both Bond A and Bond B decrease, but Bond
B's price decreases more than Bond A's. Notice how at **Y the price of Bond A
remains higher, demonstrating that investors will have to pay more money (accept a
lower yield to maturity) for a bond with greater convexity.

What Factors Affect Convexity?

Here is a summary of the different kinds of convexities produced by different types
of bonds:

1) The graph of the price-yield relationship for a plain vanilla bond

exhibits positive convexity. The price-yield curve will increase as yield
decreases, and vice versa. Therefore, as market yields decrease, the
duration increases (and vice versa).

2) In general, the higher the coupon rate, the lower the convexity of a
bond. Zero-coupon bonds have the highest convexity.

3) Callable bonds will exhibit negative convexity at certain price-yield

combinations. Negative convexity means that as market yields
decrease, duration decreases as well. See the chart below for an
example of a convexity diagram of callable bonds.
Remember that for callable bonds, which we discuss in our section detailing types of
bonds, modified duration can be used for an accurate estimate of bond price when
there is no chance that the bond will be called. In the chart above, the callable bond
will behave like an option-free bond at any point to the right of *Y. This portion of
the graph has positive convexity because, at yields greater than *Y, a company
would not call its bond issue: doing so would mean the company would have to
reissue new bonds at a higher interest rate. (Remember that as bond yields increase,
bond prices are decreasing and thus interest rates are increasing.) A bond issuer
would find it most optimal, or cost-effective, to call the bond when prevailing interest
rates have declined below the callable bond's interest (coupon) rate. For decreases in
yields below *Y, the graph has negative convexity as there is a higher risk that the
bond issuer will call the bond. As such, at yields below *Y, the price of a callable
bond won't rise as much as the price of a plain vanilla bond.

Convexity is the final major concept (after bond pricing, yield, term structure, and
duration) you need to know for gaining insight into the more technical aspects of the
bond market. Understanding even the most basic characteristics of convexity allows
the investor to better comprehend the way in which duration is best measured, and
how changes in interest rates affect the prices of both plain vanilla and callable
bonds.