INVESTMENTS:

AnalysisandManagement
ThirdCanadianEdition

W. Sean Cleary
Charles P. Jones
Prepared by
Khalil Torabzadeh
University of Lethbridge

Chapter 2
Investment
Alternatives

Learning Objectives
Describe the major types of financial assets and
how they are organized.
Explain what non-marketable financial assets are.
Describe the important features of money market
and capital market securities.
Distinguish among preferred stock, income trusts,
and common stock.
Understand the basics of options and futures.
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Figure 2-1 Major Types of Financial

Assets

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Non-Marketable Financial Assets

Examples: Savings deposits, Canada Savings
Bonds (CSBs), Guaranteed Investment
Certificates (GICs)
Commonly owned by individuals
Represent direct exchange of claims between
issuer and investor
Usually safe investments which are easy to
convert to cash without loss of value
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Marketable Financial Assets

Major types include:
Money Market Securities
Capital Market Securities
Derivative Securities

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Money Market Securities

Examples: Treasury bills, commercial paper,
Eurodollars, repurchase agreements, bankers
acceptances (B/As)
Marketable: claims are negotiable or saleable in
the marketplace
Short-term, liquid, relatively low-risk debt
instruments
Issued by governments and private firms
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Treasury Bills (T-bills)

Treasury Bills:
Short-term promissory notes issued by
governments
T-bills accounted for about one-half of all
outstanding money market securities.
Sold at a discount from face value in
denominations of $5,000, $25,000, 100,000, and
$1 million
Typical maturities are 91, 182, and 364 days
although shorter maturities are also offered

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Treasury Bills (T-bills)

Treasury Bills:
Due to government backing, there is a very low
risk of default
Widely distributed and actively traded high
liquidity
In subsequent chapters we will use government Tbill rates as a measure of the riskless rate
available to investors, commonly referred to as the
risk-free rate

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Commercial Paper
Commercial Paper:
Short-term unsecured promissory notes
issued by large, well-known, and financially
strong corporations (including finance
companies)
Denominations start at $100,000 with
maturities of 30 to 365 days, and it is sold
either directly by the issuer or indirectly
through a dealer, with rates slightly above Tbill rates.

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Eurodollars
Eurodollars:
Dollar-denominated deposits held in foreign
banks or in offices of Canadian banks located
abroad
Although this market originally developed in
Europe, dollar-denominated deposits can now
be made in many countries, such as those of
Asia
Consist of both time deposits and certificates of
deposit (CDs), with the latter constituting the
largest component of the Eurodollar markets
Maturities are mostly short-term, often less than
six months

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Repurchase Agreements
Repurchase Agreements (RPs):
agreements between a borrower and lender
(typically institutions) to sell and repurchase
money market securities
borrower initiates an RP by contracting to sell
securities to a lender and agreeing to
repurchase these securities at a pre-specified
(higher) price on a stated future date
maturity is generally very short, from 3 to 14
days, and sometimes overnight
minimum denomination is typically $100,000

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Bankers Acceptances
Bankers Acceptances (B/As):

Time drafts drawn on a bank by a customer,

whereby the bank agrees to guarantee
payment of a particular amount at a specified
future date
Differ from commercial paper because the
associated payments are guaranteed by a
bank, and thus possess the credit risk
associated with that bank
Issued in minimum denominations of $100,000
Typical maturities range from 30 to 180 days,
with 90 days being the most common
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Capital Market Securities

Major types include:
Fixed-Income Securities
Equity Securities

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Fixed-Income Securities
Marketable debt with maturity greater than
one year
More risky than money market securities
Fixed-income securities have a specified
payment schedule

Dates and amount of interest and principal

payments known in advance

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Fixed-Income Securities
Bonds long-term debt instruments
Major bond types:

Government of Canada bonds

U.S. Treasury bonds
Provincial bonds
Provincially-guaranteed bonds Ontario Hydro
U.S. federal agency securities GNMAs
(Ginnie Maes), FNMAs (Fannie Maes)

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Fixed-Income Securities
Major bond types (contd):

Corporate bonds

Usually pay semi-annual interest, are callable,

carry a sinking fund provision, and have a par
value of $1,000
Convertible bonds may be exchanged for
another asset
Risk that issuer may default on payments

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Bond Characteristics
Callable bonds give the issuer the option to
call or repurchase outstanding bonds at
predetermined call prices (generally at a
premium over par) at specified times
This feature is detrimental to the bondholders
who are willing to pay less for them (i.e., they
demand a higher return) than for similar noncallable bonds.
Generally, the issuer agrees to give 30 or more
days notice that the issue will be redeemed
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Bond Characteristics
Extendible Bonds: gives the investor an
option to extend the maturity date
Retractable Bonds: gives the investor an
option to redeem the bond at par prior to
maturity
Issuers are able to sell bonds with these
features at higher prices than straight issues
When bond prices rise (yields fall):

they are attractive long-term investments

When bond prices fall (yields rise):

they can trade as short-term debt

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Bond Characteristics

Convertible Bonds may be converted into

common shares at predetermined prices.
This feature makes the issue more saleable and
lowers the interest rate that must be offered
Permits the holding of a two-way security:

The safety of a bond

The capital gains potential of a share

If the common shares of the company are split,

the convertible debt provides protection against
dilution by adjusting the conversion privilege
Convertibles are normally callable
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Bond Characteristics
Convertible Bonds (contd)
The market price of convertible debt depends
on the value of the underlying common stock
When the stock is selling well below the
conversion price, the convertible debt is more
like straight debt
When the stock approaches conversion price, a
premium appears
When the stock rises above the conversion
price, the debt will rise accordingly, and will
then be selling off the stock

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Asset-Backed Securities
Asset-backed securities are securitized assets
E.g. mortgage-backed securities
Investors assume little default risk as most
mortgages are guaranteed by a federal
government agency

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Equity Securities
Represent an ownership interest
Preferred stock

Preferred shareholders are paid after

bondholders but before common
shareholders
Dividend known, fixed in advance
May be cumulative if dividend omitted

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Equity Securities
Income trusts

Pay out a portion of cash flows generated from

underlying assets
E.g. royalty trusts and real estate investment
trusts (REITs)

Common stock

Common shareholders are residual claimants

on income and assets
Common shareholders can elect board of
directors and vote on important issues
Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Derivative Securities
Securities whose value is derived from some
underlying security
Futures and options contracts are
standardized and performance is guaranteed
by a third party

Risk management tools

Warrants are options issued by firms

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Options
Exchange-traded options are created by
investors, not corporations
Call (Put) gives the buyer the right but not the
obligation to purchase (sell) a fixed quantity of
shares at a a fixed price up to a certain date
Options are being traded in the secondary
market at a price called premium
Increases return possibilities

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Forward and Futures Contracts

Forward Contract: A customized agreement between
a buyer and seller to make future delivery of a fixed
asset at a fixed price. These contracts are sold
through the over-the-counter market.
Futures contract: A standardized agreement between
a buyer and seller to make future delivery of a fixed
asset at a fixed price
A good faith deposit called margin, is required of
both the buyer and seller to reduce default risk
Used to hedge the risk of price changes

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

Appendix 2A
Taxation of Investment Income in Canada
Interest income from debt securities is taxable
at the full marginal rate
Dividends and capital gains afford investors a
tax break
Dividends received from Canadian
corporations are taxable for all provinces
except Quebec
Capital gain: only 50% is taxable

Cleary Jones/Investments: Analysis and Management, 3rd Canadian Edition, Chapter 2

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