Chapter 2
Investment
Alternatives
Learning Objectives
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Describe the major types of financial assets and
how they are organized.
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Explain what non-marketable financial assets are.
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Describe the important features of money market
and capital market securities.
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Distinguish among preferred stock, income trusts,
and common stock.
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Understand the basics of options and futures.
Non-Marketable Financial Assets
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Savings deposits
Canada Savings Bonds (CSBs)
http://www.csb.gc.ca/eng/bonds.asp
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
Money Market Securities
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Examples: Treasury bills, commercial paper,
Eurodollars, repurchase agreements,
banker’s 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
Treasury Bills (T-bills)
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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
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Treasury Bills (T-bills)
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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
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Commercial Paper
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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 T-bill
rates.
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Eurodollars
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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
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Repurchase Agreements
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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
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Bankers Acceptances
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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
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Fixed-Income Securities
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Marketable debt with maturity greater than
one year
More risky than money market securities
Fixed-income securities have a specified
payment schedule
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Dates and amount of interest and principal
payments known in advance
Fixed-Income Securities
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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)
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Fixed-Income Securities
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Major bond types (cont’d):
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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
Bond Characteristics
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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
Bond Characteristics
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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):
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they are attractive long-term investments
When bond prices fall (yields rise):
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they can trade as short-term debt
Bond Characteristics
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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:
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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
Bond Characteristics
Convertible Bonds (cont’d)
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The market price of convertible debt depends
on the value of the underlying common stock
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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
Asset-Backed Securities
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Asset-backed securities are “securitized” assets
E.g. mortgage-backed securities
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Investors assume little default risk as most
mortgages are guaranteed by a federal
government agency
Equity Securities
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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
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Equity Securities
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Income trusts
Pay out a portion of cash flows generated from
underlying assets
 E.g. royalty trusts and real estate investment
trusts (REITs)
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Common stock
Common shareholders are residual claimants on
income and assets
 Common shareholders can elect board of
directors and vote on important issues
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Derivative Securities
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Securities whose value is derived from some
underlying security
Futures and options contracts are
standardized and performance is guaranteed
by a third party
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Risk management tools
Warrants are options issued by firms
Options
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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 before a certain date
Options can be sold in the market at a price
Increases return possibilities
Futures
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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
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Appendix 2-A
Taxation of Investment Income in
Canada
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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
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