Chapter 2

Charles P. Jones, Investments: Analysis and Management,

12th Edition, John Wiley & Sons

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Commonly owned by individuals

Represent personal transactions between the
owner and the issuer
Owner must open the account, maintain it, close
it
In contrast to marketable securities, which trade
in impersonal markets

Usually very liquid or easy to convert to cash

without loss of value
Examples: Savings accounts and bonds, CDs

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Negotiable or salable in the marketplace

Short-term, highly liquid, relatively-low risk
debt instrumentsrates tend to move together
Issued by governments and private firms
Examples: T-Bills, Commercial paper
T-bill is most prominent money market security
Safest asset available
Serves as a benchmark asset

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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

Dates and amount of interest and principal

payments known in advance

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Bonds are long-term debt instruments/IOUs

Buyer of a newly issued coupon bond lends
money to issuer, issuer agrees to pay
interest and re-pay principal on maturity
date
Bonds are fixed-income securities

Buyer knows future cash flows

Known interest and principal payments

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If sold before maturity, price depends on

current interest rates
Considered safer than stocks or derivatives
Prices quoted as a % of par value, which is
usually $1,000

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Bond will be worth exactly face value at

maturity
Until maturity, price changes depending 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
Prices quoted without accrued interest

Premium: amount above par value

Discount: amount below par value

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Callable Bonds
Provision gives the issuer the right to call in,
(i.e., buy back) the bonds from investors
This option is attractive to issuers when
market interest rates drop sufficiently below
coupon rate

Issuer can save money by replacing higher interestcost bonds with new, lower interest-cost bonds
Wise investor note the bond issues provisions re:
call

Most Treasury bonds cannot be called

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U.S. government/Treasury securities

Government agency securities

Federal agencies, such as GNMA

Government Sponsored Enterprises (GSEs)
Mortgage-backed Securities (MBSs)

Municipal securities
Two basic types: General Obligation and Revenue
Generally exempt from federal taxes

Corporate bonds

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Usually unsecured and callable

Receive payment priority if bankruptcy or
liquidation
Convertible bonds may be exchanged for
another asset at the owners discretion
Risk that issuer may default on payments
New Types: DANs, inflation-protected notes

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Rate relative, not absolute, probability of

default
Rating organizations

Standard and Poors Corporation (S&P)

Moodys Investors Service Inc.

Rating firms perform the credit analysis for

the investor, may disagree on ratings
Bond ratings and coupon rates inversely
related

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Investment grade securities

Rated AAA, AA, A, BBB
Typically, institutional investors only buy these

Speculative securities
Rated BB, B, CCC, CC
Significant uncertainties

Junk bonds
Rated BB or lower
High-risk, high-yield bonds

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Transformation of illiquid, risky individual

loans into more liquid, less risky assetbacked securities (ABSs)
ABS is a securitized interest in a pool of nonmortgage assets
Marketable securities backed by auto loans,
credit-card receivables, small-business loans,
leases
ABSs can be structured in tranches with different
prices, credit ratings, average maturities

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Denote an ownership interest in a

corporation
Denote control over management, at least
in principle

Voting rights important

Denote limited liability

Investor cannot lose more than their investment
should the corporation fail

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Hybrid security: features of both debt and

equity
Preferred stockholders paid after
bondholders but before common
stockholders

Dividend known, fixed in advance

May be cumulative if dividend omitted

Often convertible into common stock

May carry variable dividend rate

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Common stockholders are residual

claimants on income and assets
Par value is face value of a share
Book value is accounting value of a share

Book value per share can play a role in

investment decisions

Market value is current market price of a

share
Aggregate market value is market price per
share times number of shares outstanding

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Dividends are cash payments to

shareholders
Common stockholder has no specific promises to
receive any cash from the corporation
Lack of promise plus price volatility make
common stocks risky
Dividend yield is income component of return
=D/P
Payout Ratio is ratio of dividends to earnings

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Stock dividend is payment to owners in stock

Stock split is the issuance of additional shares
in proportion to the shares outstanding

The book and par values are changed

Additional shares not additional value for

investor
P/E ratio is the ratio of current market price of
equity to the firms most recent 12-month
earnings

Shows how much the market is willing to pay for $1

of earnings
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May provide higher returns, lower risk

Changes in value of the US Dollar can
increase interest in owning foreign
securities
Investors can buy individual foreign
securities or use investment companies
American Depository Receipts (ADRs)
represent indirect ownership of shares of a
foreign firm

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Securities whose value is derived from

another security
Futures and options contracts are
standardized and performance is guaranteed
by a third party
Risk management tools
Futures contract is an obligation to buy or sell
Options contract is the right to do so, not an
obligation

Warrants are long-term options on common

stock of issuing firm
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Options are created by investors, not

corporations
Call (Put): Buyer pays premium for the right
(not the obligation) to purchase (sell) 100
shares from (to) the seller at a fixed price
before a certain date
Seller can re-sell option in secondary market
Call (put) buyers betting the price of underlying
stock will rise (fall)

Allow investors to speculate on short-term

movements of certain common stocks
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Futures contract: 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
Long (short) position: commitment to purchase
(deliver) the asset
Used to hedge the risk of price changes
Small margin size can result in large profits

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