Chapter 14
Investment Alternatives and Trading
• Fixed-Income Securities
 You are a LENDER to the issuer of the security
 Your return is a fixed amount of income over a
fixed amount of time (interest payments on
bonds)
– Motivation for buying is INCOME
– All mature to a fixed amount
– Lenders have rights if borrower defaults
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Investment Alternatives and Trading
• All fixed-income securities eventually
mature for fixed amount
– The maturity amount is called the par
value or face value
– This amount is fixed regardless of what
the security sold for prior to maturity
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Investment Alternatives and Trading
• Types of Fixed-Income Securities
Money market instruments -- Mature within a
year
Bonds -- Mature anywhere from two to twenty
years or even longer
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Investment Alternatives and Trading
• Money Market Instruments
– A discount security sold for less than its face
value
– When security matures, lender receives full
face value
– Lender’s return based on the difference
between the price paid and the face value
– Little or no default risk
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Investment Alternatives and Trading
• Bonds
A fixed-income security with maturity date
when issued greater than one year
– Bonds are NOT discounted securities
– Most bonds pay regular, fixed amount of interest
twice a year
– Interest is calculated as a percentage of the face
value called the coupon rate (simple interest)
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Investment Alternatives and Trading
• Bonds--Callable Feature
Most bonds are “callable”
– This means issuer can buy back the bonds
from investors
– Bonds are re-purchased prior to maturity
date and at pre-specified prices
– Likely to be recalled when interest rates are
low or falling
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Investment Alternatives and Trading
• Differences Between Bonds and Money
Market Instruments
Length of Maturity
How Returns Are Earned
Callable Feature
Safety (Ratings)
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Investment Alternatives and Trading
• Treasury Notes and Bonds
– Issued by the U.S. Treasury
– Both have fixed coupon rates
– Both have face values of $1,000 to $5,000
• T-Notes have much shorter maturities
than T-Bonds
• T-Bonds are callable starting five years
from date of maturity; T-Notes aren’t
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Investment Alternatives and Trading
• Municipal Bonds
Issued by state and local governmental units:
Two types:
 General obligation
• Backed by full faith and credit of issuing state
• General tax revenues can be used to pay
bondholders
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Investment Alternatives and Trading
• Municipal Bonds
 Revenue
• Issued to pay for a project like a new road
• Only revenues generated from the project are
used to repay bondholder
 Tax status
– Exempt from federal income tax
– NOT exempt from state income tax
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Investment Alternatives and Trading
• Bond Ratings
Ratings range from AAA (best) to D (in
default)
Bond with rating of B or above considered
investment grade (fairly low risk of default)
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Investment Alternatives and Trading
• Corporate Bonds
Issued by U.S. and foreign corporations to
• Finance expansions
• Finance acquisitions
Interest is subject to federal, state taxes
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Investment Alternatives and Trading
• Bond Pricing
Depending on the interest rate used to
discount future cash payments, a bond may
sell for
• Face value
• Less than face value
The interest rate used is called the bond’s
“yield to maturity”
Chapter 14
Investment Alternatives and Trading
• Stock Investing
– People invest in stock
• In the hope that the price of the stock will
increase with company profit growth
• For the quarterly cash payments (dividends)
which they may receive
– Return on stock based on both price
appreciation and income (dividends)
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Investment Alternatives and Trading
• Types of Stocks
–
–
–
–
–
–
Blue Chip
Income
Growth
Speculative
Cyclical
Defensive
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Investment Alternatives and Trading
• Valuing Common Stock
Two common questions which investors ask:
How much am I willing to pay for this
stock?
At what price should I sell?
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Investment Alternatives and Trading
• Criteria in Valuing Common Stock
Current level of earnings
Current level of dividends
Expected growth rate of earnings and
dividends
Uncertainty about the growth rate in
earnings and dividends
Level of interest rates
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Investment Alternatives and Trading
• Finding Information About Stocks
Investor advisory services (like Standard & Poor’s)
given in-depth analysis of stock.
Their reports cover:
•
•
•
•
Summary of company’s business
Financial performance (for prior 5-10 yrs.)
Prospects for the future (general business forecasts)
Assessment of the stock
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Investment Alternatives and Trading
• Measures of Financial Strength
Return on Equity
Earnings per Share
Price/Earnings Ratio
Beta
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Investment Alternatives and Trading
• Real Estate
– Home ownership may not be as good an
investment as it has been in the past
– Returns from real estate have lagged behind
stocks and bonds on occasion (not this year)
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Investment Alternatives and Trading
• Exotic Investments: Options
Gives owner the right to buy or sell stock at
a fixed price over a fixed period of time
Depending on what happens to stock, an
option can go up or down in value
Investor does NOT have to exercise the
option, but will still be charged a fee
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Investment Alternatives and Trading
• Options Example
– If investor owns option to purchase a certain
stock at $40/share:
• Option is VALUABLE if the price rises to
$55/share
• Option has LITTLE VALUE if price falls to
$35/share
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Investment Alternatives and Trading
• Exotic Investments: Futures
– A real contract between two parties that calls
for future delivery of some asset at a set
price
– Contracts can be on:
•
•
•
•
Agricultural commodities
Precious metals
Petroleum products
Currencies
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Investment Alternatives and Trading
• Exotic Investments: Real assets and collectibles
– Includes gold, silver, diamonds, great works
of art
– All of returns come from price appreciation
– Considerably more risky than investing in
stocks, bonds, or real estate
Chapter 14
Investment Alternatives and Trading
• Characteristics of Efficient Markets
Sufficient information determining
underlying supply and demand
• Is available to all participants
• Is available at about the same time
Trading takes place in full view of all
market participants
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Investment Alternatives and Trading
• Characteristics of Efficient Markets
One can buy or sell
• At a price close to that of the most recent, similar
trade, assuming there is no new information
Transactions costs as a percentage of the
security being bought or sold are low
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Investment Alternatives and Trading
• Characteristics of Efficient Markets
All participants have equal access to market
• No investor can execute buy or sell orders faster
than any other investor (No Arbitrage Opport.)
Prices adjust quickly to new public information.
• This information is available
– To all participants
– At about the same time
Chapter 14
Investment Alternatives and Trading
• Types of Financial Markets
 Primary market
• A market where investors buy newly issued
securities
• The issuer ( perhaps a corporation) receives the
proceeds from the security sale
– Example: Someone buys a T-bill from the
U.S. Treasury or Shares of a Corporation in
an IPO from the company.
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Investment Alternatives and Trading
• Types of Financial Markets
 Secondary financial market
• A market where trading between investors
involves previously issued securities
• The original issuer is not directly affected by
these transactions
– Example: The New York Stock Exchange
Chapter 14
Investment Alternatives and Trading
• New York Stock Exchange
The oldest stock market in the U.S.
More than 2,500 stocks traded
• Represent most of the largest, best-known
corporations in America
Stocks traded have a total market value over $5
trillion
Companies must apply for listing to trade on NYSE
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Investment Alternatives and Trading
• The NASDAQ Stock Market
Largest, best-organized over-the-counter
market for stocks in the U.S.
More than 5,000 stock issues trade on this
market
Companies tend to be smaller and less wellknown than those in the NYSE
Chapter 14
Investment Alternatives and Trading
• The NASDAQ Stock Market
– Trading takes place through the network;
Buyers and sellers never see each other
– Buy and sell orders executed electronically
– Maintains at least two market makers
• Similar to specialists in NYSE
• Buy and sell from their inventories to maintain
orderly market
Chapter 14
Investment Alternatives and Trading
• Selecting a Brokerage Firm
– You must determine if you want a
• Full-service firm
• Discount firm
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Investment Alternatives and Trading
• Full-Service Firms
Offer investment advice and
recommendations
Have access to reports written by analysts
within the firm
Have lists of recommended securities
Assign specific brokers who are paid on
commission to each client
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Investment Alternatives and Trading
• Discount Firms
Provide mainly execution order and recordkeeping services
Also provide investment information from
independent sources
Many brokers may deal with one client
Brokers work on salary instead of
commission
Chapter 14
Investment Alternatives and Trading
• Types of Orders: Market
The most common type of order
Instructs broker to obtain the best possible
price for you
Highest if you are selling
Lowest if you are buying
Most market orders are filled within one to
two minutes
Chapter 14
Investment Alternatives and Trading
• Types of Orders: Limit
Establishes a limit to the price at which you
will buy or sell
 A ceiling if you are buying
 A floor if you are selling
Can be valid for one day, one week, one
month, or until it is canceled
Chapter 14
Investment Alternatives and Trading
• Reasons for Good Investment Record Keeping
– Tax Purposes
– Performance Tracking