FNCE 625 – Investment Analysis and Management

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Investments: Analysis and Management

Fourteenth Edition

Gerald R. Jensen and Charles P. Jones

Chapter 2

Investment Alternatives

Nonmarketable Financial Assets

Commonly owned by individuals

Personal transactions between owner and issuer

Owner opens, closes, and maintains account

In contrast, marketable securities trade in impersonal markets

Usually very liquid or easy to convert to cash without loss of value

Examples: Savings accounts, M M D As, and C Ds

Marketable Financial Assets

Fixed-income: payment specified by a contract

Money market securities and bonds (fixed & floating rate)

Equity: represents ownership share in a firm

Common and preferred stock

Derivative securities: value is derived based on the prices of other assets

Options, futures, forwards, swaps

Types of Securities

Money Market Securities - securities with an original maturity of 1 year or less

Include: T-bills, commercial paper, banker’s acceptances, certificates of deposit (C Ds), repurchase agreements, etc.

Capital Market Securities - securities with more than 1 year in original maturity

Include: Common & preferred stock and bonds

Money Market Securities

Negotiable or salable in the marketplace

Short-term, highly liquid, relatively-low risk debt instruments—rates tend to move together

Issued by governments and private firms

Generally trade in large denominations

Generally sell on a discount basis

Generally are low risk securities

Treasury Bills (T-bills)

Obligations of the federal government

Commonly referred to as the risk-free security

Income earned on T-bills is exempt from state and local taxes

Auctioned regularly by the Treasury

Bids can be competitive or non-competitive

Sell in minimum denominations of $10,000

Certificates of Deposit (C Ds)

Sell on an add-on interest basis

Insured to $250,000 by the F D I C

For the larger banks the insurance level is assumed to be much larger

C Ds with denominations of $100,000 or more are negotiable

Commercial Paper (C P)

Basically a short-term, unsecured note (bond)

Maturities of 270 days or less are exempt from S E C registration requirements

Less liquid than other money market securities

Frequently C P is directly placed

Bankers Acceptances

A time draft drawn on and accepted by a commercial bank

Generally created by a transaction between exporters and importers in different countries

Maximum maturity is legally established at 180 days

The Market for Overnight Money

Federal Funds - short-term lending between banks generally to maintain required reserves

Other financial inst. have entered this market

Repurchase Agreements (Repos) - Sale of a security with the agreement to repurchase the security at a higher price in the near future

Eliminates price risk for the lender

Pricing Money Market Securities

Pricing formula for money market securities that trade on a discount basis e.g. T-bills

Where F is the security’s face value,

is its quoted

bank discount rate, and n is its days to maturity

Returns on Money Market Securities

Two principle return measures are: bond equivalent yield

and effective annual yield

Capital Market Securities

Marketable debt with maturity greater than one year and equity securities, which have no maturity date

Riskier than money market securities

Fixed-income securities have a specified payment schedule

Bond Characteristics 1

Bonds are long-term debt instruments/I O Us

Buyer of a newly issued coupon bond lends money to issuer, issuer agrees to pay interest and re-pay principal at maturity

Bonds are fixed-income securities

Buyer knows future cash flows - interest and principal payments

Major Bond Types

U.S. government/Treasury securities

Government agency securities

Federal agencies, G S Es, M B Ss

Municipal securities

General Obligation and Revenue

Exempt from federal taxes and potentially state and local

Corporate bonds

Treasury Notes & Bonds

Obligations of the federal government

Notes have less than 10 years to original maturity, bonds have 10 or more years

Income from T-notes and T-bonds is exempt from state and local taxes

Treasury strips: claims to a portion of either the interest or principal payments

Other Federal Government Bonds

Government Agency Bonds - obligations of agencies of the federal government

Most were established to finance housing; farming and student loans also exist

Either federally related or govt. sponsored

Many agencies issue debt with income that is exempt from state and local taxes

Example agencies include: Fannie Mae, Freddie Mac, Ginnie Mae

Bond Characteristics 2

Bond is worth exactly face value at maturity

Price changes depend on interest rates

Interest rates and bond prices move inversely

Bond buyer in secondary market must pay the price of the bond plus accrued interest

Price is quoted without accrued interest

Premium: amount above par value

Discount: amount below par value

Callable Bonds

Allow issuer to “call in” the bonds from investors

Option is attractive to issuer when market rate drops sufficiently below coupon rate

Issuer saves by replacing higher interest-cost bonds with new, lower rate bonds

Wise investors note the bond’s call provision

Most Treasury bonds cannot be called

Corporate Bonds

Usually unsecured and often callable

Receive payment priority in bankruptcy or liquidation

Convertible bonds may be exchanged for another asset at the owner’s discretion

Risk that issuer may default on payments

New Type: Inflation-protected securities

Bond Ratings 1

Reflect probability of default, relative rating

Rating organizations

Standard and Poor’s, Moody’s, Fitch

Rating firms perform credit analysis for investors, may disagree on ratings

Bond ratings and coupon rates are inversely related

Bond Ratings 2

Investment grade securities

Rated A A A, A A, A, B B B

Many institutional investors buy only these

Speculative securities

Rated B B, B, C C C, C C

Significant uncertainties

Junk bonds

Rated B B or lower

High-risk, high-yield bonds

Securitization

Packaging illiquid, risky individual loans into more liquid, less risky asset-backed securities (A B Ss)

A B S is a securitized interest in a pool of non-mortgage assets

Alternative assets include: auto loans, credit-card receivables, small-business loans, leases

A B Ss can be structured in tranches with different prices, credit ratings, maturities

State & Local Government Bonds

Municipal Bonds - obligations of state and local governments

Interest income is exempt from federal taxation and possibly state and local taxation

Returns on municipal bonds:

Where: RTEY = taxable equivalent yield; Rm = yield on tax exempt security; t = marginal tax rate