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Chapter 2

Investment Alternatives

3 Options for Household Savings with regard to financial assets


1. Hold with the financial intermediaries such as bank, insurance companies, thrifts (??) 2. Direct Investing: Buying and Selling securities directly with the help of broker or investment banks such shares, bonds 3. Indirect Investing: Hold securities indirectly while leaving investment decisions to others such a mutual funds or pension fund [Exhibit 2.1 on page 22, P. Jones]

Indirect Investing
In Indirect Investment, investors handed-over their investment to third party; thus losing their direct control of the securities. There are three types of investment companies. 1. Closed-End investment companies (Managed Firm) 2. Mutual Funds (Managed Firm) 3. Exchange-Traded Funds (ETFs) [Un-Managed Firm]

Direct Investing
Non-Marketable Investments Marketable Investments
Money Market Capital Market
Fixed-Income Equity Securities

Derivatives Market

Non-Marketable Securities
1. 2. 3. 4. Savings Accounts Non-Negotiable Certificates of deposit Money market deposits accounts US saving bonds

Savings Accounts savings accounts in commercial banks and thrift (savings and loan institutions and credit unions) Non-Negotiable Certificates of deposit (CDs) commercial bank and other institutions offer a variety of savings certificates known as certificate of deposit (CDs)
Rate is directly proportional to maturity of CDs. It is a buy-and-hold certificate

Money Market Securities (MMS)


The market for short-term, highly liquid, lowrisk assets such as treasury bills and negotiable CDs. The assets are sold by government, financial institutions and corporations. The maturities of money market instruments range from 1 day to 1 year; usually 90 days

Forms of MMS
Treasury Bills Negotiable Certificate of Deposit (CDs) Commercial Papers Repurchases Agreement (RPs) Bankers Acceptance

Forms of MMS....Treasury Bills


Short-term money market instrument sold at discount and redeem at face value issued by the Government Sold at auction Its a benchmark assets Risk-Free financial asset (Rf) Treasury Notes: 2-10 years maturity Treasury Bonds: more than 10 years obligations

Forms of MMS...Treasury Bills


Return (Investment yield) on T-Bills
( Face.value Purchase Pr ice) 365 Yield X Purchase . price Maturiy in Days

Forms of MMS
Commercial Paper its like T-Bills; however, the issuer is a corporation not government
It is also an unsecured promissory note.

Negotiable Certificate of Deposit


The investor deposit money in a bank; in return, the bank issued a certificate which is negotiable. The holder of the CD will receive the depoisted money alongwith interest.

Forms of MMS
Repurchase Agreement ( RPs or Repo)
the short-term sell of government securities to corporations with an intention to repurchase the securities at higher price. Interest rate is related with T-Bills mostly Maturity runs from overnight to only a few day How is different from T-Bills
T-bills are only issued at discount; however, it is not in the case of Repo.

Forms of MMS
Bankers Acceptance
Short-term promissory note drawn on a bank by a firm to assist in foreign or domestic trade. Once it is accepted by a bank, it becomes BA The drawer can negotiate the instrument in the secondary market at discount price. The bank is supposed to pay the amount on maturity to the holder of the BA

Example of BA
Importer (Pakistani Firm) and Exporter (England Firm) a deal of Rs. 10,000 Both companies agree to settle the deal in 90 days draft Pakistani firm get a letter of credit from HBL; so HBL will honor the draft presented on behalf of Pakistani firm England firm (drawer) order its bank (e.g., RBS) to draw a draft of Rs. 10,000 on HBL Once HBL (drawee) accepts it; it becomes BA Now the england firm can trade the BA in secondary market if it can not wait for 90 days. On maturity, the holder (may be England firm or any other party) will receive the money from HBL.

Capital Market
The market for long-term securities. Marketability is poor Risk is higher due to long maturity time... Include both debt and equity securities...
Fixed-Income Securities Equity Securities

Fixed-Income Securities
The amount and date of each Payment is known in advance Treasury bonds Agency bonds Municipal bonds Corporate bonds Asset-backed securities Mortgage-related bonds Non-Zero Coupon Bonds Zero Coupon Bonds Callable Bonds Debenture

Bonds
Long-term debt instruments representing the issuers contractual obligation Fixed-Income security As interest (coupon rate) and principle payment is specified in advance The buyer can sell the bonds before maturity; the price depends upon interest rates at that time.. Default of the payment may lead to bankruptcy

Characteristics
Face value Usually have maturity date... Have coupon the periodic interest payment by the issuer to the holder of the bonds May be issued at discounts or premium Credit Rating plays an important role in deciding interest rate.

Corporate Bonds
Long-term debt securities of various types sold by corporations Senior Securities: Debt securities have preference over shares in case of payments or in case of liquidation. Debenture unsecured bonds; backed by the issuers overall financial soundness

Non-Zero Coupon Bonds


having finite maturity In such bonds, the investor receives interest (I) in the form of annuity and terminal value (principal amount)

The Zero Coupon Bond


A bond issued at discount and redeem at its face value... Having no interest (coupon) rate... The difference between discount and redeemable value is rate of return

Callable Bonds
The issuer of the bond has the right to call the bond and retire it by paying off the obligation... The call option is attractive when the market interest rate is lower then the coupon rate. Costs are incurred on callable bonds such as call premium and administrative expenses. Call premium is usually equals to one year interest rate if the bond is called within a year; after the first year, it usually decline at constant rate. Callable bonds can be re-issued at lower coupon rate but non-refundable bonds can be re-issued.

Treasury Securities
Like T-Bills Treasury-Notes: 2-10 years maturity Treasury-Bonds: more than 10 years maturity TIPS (Treasury Inflation-Indexed Securities) protect the investors against the inflation losses....TIPS pay a fixed rate of interest but this rate is applied to the inflation-adjusted principal.

Federal Agency Securities


US government established federal agencies to help certain sector either by providing direct loans or guarantee of private loan. The securities issued by federal credit agencies (fully guaranteed) or by government sponsored agencies (not guaranteed). Mortgage-Backed Securities: securities whose value depends on some set of mortgages.

Municipal Securities
Securities issued by political entities other than the federal government and its agencies such as cities, states, counties.
1. General Obligation Bonds backed by full faith and credit 2. Revenue Bonds which are repaid from the revenues generated by the project in which the bonds are issued

Junk Bond
High risky and high yield bond Usually issued by the firm as a last option

Equity Securities
Preferred Stock Hybrid security as it resembles both equity and fixed-income securities Like equity: having ownership position, infinite life and dividend receipt. Like debt: fixed amount of dividend is received. Having intermediate claim between bondholders and equity holders on a firms assets and earnings. Having no voting power in annual general meeting usually Having prior claim on the assets on liquidation May be cumulative or non-comulative regarding dividend payment My be convertible preferred stock to common stock

Equity Securities
Common Stock
Having voting power having control over management Having second/last claim on the assets and earnings Receive dividend (cash and stock)

Derivatives
The securities that derive their values by having claim on the some underlying securities.

Options
Rights to buy or sell a stated number of shares of a security at a specified price; it may be:
Puts an option to sell a specified number... Calls an option to buy a specified number...

Options only give a right to put and call; not an obligation to sell (purchase) shares.

Future Contracts
Agreement providing for the future exchange of a particular assets at a currently determined market price. The assets may be commodities (corn, wheat) or financial assets (shares, bonds, T-Bills etc.) The buyer pays the money upon delivery of assets by seller. Used by both hedgers and speculators. Hedgers purchase future contracts to reduce price uncertainty; while Speculators purchase future contracts to exploit the uncertainty to earn profit.

In Conclusion, Direct Investment......

Non-Marketable Financial assets


Saving deposits Certificate of deposit Money market deposits accounts US saving bonds Money Market securities T-bills Negotiable certificates of deposits Commercial papers Repurchase agreements Bankers acceptance

Direct investing

Direct investing
Capital market securities
A. Fixed income securities Treasury or government bonds Corporate bonds B. Equity securities Preferred stock Common stocks

Derivative Securitas
Options Futures