Chapter 11 Investments

Fixed interest government bonds

Cashflows
Government/government body may raise money by floating a loan on a stock
exchange.
Terms of issue set out by borrower, investors may be invited to subscribe to
the loan at the issue price.
Issue may be by tender instead investors invited to nominate the price they
are prepared to pay. Loan issued to highest bidders, subject to certain rules of
allocation.
Advantages of fixed bond price
Government will know price investors will pay at outset will know cost of
borrowing money.
Administratively less difficult
Disadvantages of fixed bond price
Investors may be willing to pay more for the bond than the set price
Money could be borrowed more cheaply via tender
However:
Insufficient investors may be prepared to pay for the set price -> only part
of offer sold, and government may not meet finance requirements
Variations
Some have variable redemption dates -> may be chosen by borrower/lender
as any interest date within a certain period or any interest date on or after a
given date -> undated.
Security, marketability, return
Developed economies -> bonds issued by the government form the largest,
most important and most liquid part of the bond market. Investors can deal in
large quantities with little (or no) impact on the price.
Bonds issued in their domestic current are the most secure long-term
investment available.
Security + low volatility of return -> low expected return, compensated by
low dealing costs.
Relative to inflation, income stream may be volatile
Index-linked bonds generally based on time lag (publication of index figure,
calculate coupon amounts in advance). Effectively no inflation protection
during the lag period.
Why rate of return for fixed interested government bond not known at outset?
Coupons reinvested on unknown terms
Sale price before redemption unknown at outset
Real return not known (inflation unknown)
Tax rates/systems may change
Summary Fixed interest government bonds
- Issued at a price or by tender
- Investors receive coupons (usually half yearly) + redemption payment
(usually at par)
- Some redemption dates variable, some stocks undated
- Very secure, liquid and marketable (in developed countries)
- Low expected return
- Low dealing costs
- Real returns are uncertain unless index linked.

Government bills
Short dated securities, funds governments short term spending
requirements.
Issued at discount and redeemed at par with no coupon. Yield typically
quoted as simple rate of discount.
Mostly in domestic currency.
Absolutely secure and highly marketable. Often used as benchmark risk free
short-term investment

Corporate bonds
Debt issued by company, not government
Usually less secure than government bonds (depends on type of bond,
company, term)
Usually less marketable than govnt bonds sizes of issues much smaller.
Higher yield than government bonds.

Loans may be secured on some/all of the assets of the issuing company -> if the
company fails to make one of the coupon payments/redemption payment,
stockholders may take possession of the asset.
Unsecured no specific security. If company defaults, stockholders must sue the
company rank equally with other creditors, after holders of secured loan stock.
Yields higher than comparable loan issued by same company (reflect higher
default risk).

Debentures
Part of loan capital of companies -> long term borrowings.
Payments -> regular coupons and final redemption payment
Issuing company provides some form of security to holders of the debenture,
e.g. fixed or floating charge on assets

Eurobonds
Medium/long term borrowing
Unsecured
Regular annual coupon payments, generally repayable at par
Generally issued by large companies and on behalf of governments
Generally innovative market design to attract investors
Issued and traded internationally (normally by syndicate of banks)
Can be issued in any currency (not necessarily domestic currency of
borrower).
Yields typically slightly lower than conventional unsecured loan stocks of the
same issuer.
Certificates of deposit
Certificate stating some money has Interest payable on maturity,
been deposited. Security/marketability depends on
Issued by banks, building societies. bank.
Terms to maturity -> 28 days to 6 Active secondary market.
months.
Yield margin depends on:
a) Security of bond (based on quality of company)
b) Marketability (based largely on size of issue)

Ordinary shares
Also called equities securities issued by commercial undertakings
Entitles holders to receive all the net profits of the company after interested
on loans and fixed interest stocks have been paid.
Dividends paid out -> paid at the discretion of directors.
Remaining profits retained as reserves/finance companys activities.
Investors -> high potential returns for high risks, especially capital losses.
Lowest ranking form of finance.
Initial running yield is low but dividends should increase with inflation, real
growth in company earnings.
Expected overall future return higher than most other classes of security ->
greater risk of default, variability of returns
Return => dividends, increase in market price of shares
Marketability varies according to size of company, better than loan capital if:
- Bulk of companys capital in ordinary shares
- Loan capital fragmented into several different issues
- Investors buy/sell ordinary shares more frequently than trade in loan capital.
Voting rights in proportion to number of shares held.

Preference shares
Less common than ordinary shares.
Fixed stream of investment income limited to a set amount, almost always
paid.
Rank about ordinary SHs.
Only get voting rights if dividends unpaid or there is a matter directly
affecting their rights.
Only paid at directors discretion no ordinary dividend can be paid if
outstanding preference dividends.
Most cases cumulative unpaid dividends carried forward.
Expected return likely to be lower than ordinary shares.
Marketability similar to loan capital (worse than ordinary shares, a lot worse
than fixed interest government bonds)

Convertibles
 Unsecured loan stocks/preference shares that convert into ordinary shares of
the issuing company.
Stated, annual interest payment.
Date of conversion -> single date, or at the option of the holder, one of a
series of specified dates.
Period prior to conversion -> cross between fixed interest stock and ordinary
shares.
As date of conversion gets nearer becomes clearer whether it will stay as
loan stock or become ordinary shares. Behaviour becomes closer to security
into which it converts.
Higher income than ordinary shares, lower income than conventional loan
stock/preference shares.
Less volatility in price of convertible than in share price of underlying equity.
Combine lower risk of debt security with potential for large gains of an equity
-> lower running yield than loan stock/preference share.
Option to convert has time value reflected in price of stock.
Why do convertibles have lower income than conventional loan stock?
- Option to convert.
- Investor expecting to receive a higher income from dividends after conversion
than the stock is currently paying.
- Value of expected future income makes stock more attractive than
conventional stock
- Company can pay lower income now.
Income/return on ordinary shares vs preference shares vs convertibles
Ordinary shares income
- Dividend income can sometimes be quite low
- Sometimes dividends grow as company becomes more successful
- Overall return -> regular dividend payments + capital gain when sold
- Likely to be greater than the return on any other financial asset holder takes
greatest risk.
Preference shares vs ordinary shares vs convertible
- Preference shares give steady income; doesnt offer high rewards.
- Convertible gives steady income + potential high rewards of ordinary share
-> more attractive than preference share -> lower income.
- Ordinary share might offer low/volatile income now but potentially high
income/capital growth -> riskier.
- If ordinary share were providing higher, more stable payments than a
convertible, there would be no point in buying convertible -> would buy
ordinary share.

Property
Return -> rental income, capital gains realised on sale.
Rents/capital values expected to income broadly with inflation in long term
similar returns to ordinary shares.
Can be considerable fluctuations.
Rents reviewed at specific intervals, e.g. 3-5 years generally in line with
market rent on similar properties.
Characteristics
 Large unit sizes -> less flexibility than investment in shares
Each property is unique -> difficult to value and valuation is expensive
Actual value obtainable on sale uncertain.
Buying/selling expenses are higher than shares/bonds.
Net rental income may be reduced by maintenance expenses
May be periods where property unoccupied.

Poor marketability each property is unique, buying/selling incur high costs.

Running yield normally higher than ordinary shares, lower than fixed interest
bonds.
Dividends increase annually, rents reviewed less often
Property much less marketable
Expenses associated with property investment much higher
Large, indivisible units of property much less flexible
On average, dividends rise more rapidly than rents dividends benefit
from returns arising from retention of profits and their reinvestment in
the company.

Lease an agreement that allows one party (leaseholder) the use of a specified
portion of a property for a specified period of time in return for some payment.

Derivatives
A financial instrument with a value dependent on the value of some other,
underlying asset.

Futures
A futures contract is a standardised, exchange tradeable contract between two
parties to trade a specific asset on a set date in the future at a specified price.
Financial futures are based on an underlying financial instrument:
1. Bond futures
Physical delivery of bond (deliverer chooses the stock which is
cheapest to deliver)
Price paid by receiving party adjusted to allow for the fact that
the coupon may not be equal to that of the notional bond which
underlies the contract settlement price
2. Short interest rate futures
Based on benchmark interest rate, settled for cash.
As interest rates fall, the price rises, vice versa.
Contract based on interest paid on a notional deposit for a
specified period from the expiry of the future.
On expiry, purchaser made profit/loss related to the difference
between final settlement price and original dealing price.
3. Stock index futures
Contract provides for a notional transfer of assets underlying a
stock index at a specified price on a specified date.
Cash amount on settlement -> difference between future price
and index value.
4. Currency futures
 Delivery of a set amount of a given currency on the specified
date.

Margin
Once a contract is matched, the clearing house becomes the party to every
trade.
No need to rely on financial soundness/integrity of original counterparty.
Each party must deposit a sum of money with the clearing house.
Margin payments act as a cushion against potential losses which the parties
may suffer from future adverse price movements.
Initial margin is deposited at the start. Additional payments of variation
margin are made daily to ensure clearing houses exposure to credit risk is
controlled.

Options
An option gives an investor the right but not the obligation or buy or sell a
specified asset on a specified future date.

Call option right, but not the obligation to buy a specified asset on a set date
in the future for a specified price
Put option right, but not the obligation to sell a specified asset on a set date
in the future for a specified price

Buying a put vs selling a call

- Difference between right and obligation
- Buying a put -> costs you money, allows you to choose whether or not to sell
the underlying asset.
- Selling a call -> receive money, must sell underlying asset if and only if, the
holder of the option wants to.
- If you buy a put likely to sell if market price < exercise price
- If you sell a call forced to sell if market price > exercise price

When you write (sell) an option, you collect a premium for giving the holder the
right to exercise (or not) the option.

American style option can be exercised on any date before its expiry
European style option can be exercised only at expiry

e.g. Writer of American style put option, exercise price of 20p, October expiry
date
- Given another person the right but not the obligation to sell the underlying
asset to him at a price of 20p at any time up to a date in the following
October.
- In return the writer has a received a premium.
Call writers liability can be unlimited, put option writers liability can be very
large => margin required from writers of options. Not required from holders of
options (max loss is premium).
Swaps
A swap is a contract between two parties under which they agree to exchange a
series of payments according to a prearranged formula.
- Normally two different types of interest payments or two different currencies.

Interest rate swaps

One party agrees to pay the other a regular series of fixed amounts for a
certain term.
In exchange, the second party agrees to pay a series of variable amounts
based on the level of a short-term interest rate.
Both sets of payments in same currency.

Currency swap
Agreement to exchange a fixed series of interest payments and a capital sum
in one currency for a fixed series of interest payments and capital sum in
another.

Swap will be priced so that the PV of the cashflows is slightly negative for
investor, positive for issuing organisation.
Difference price that investor is prepared to pay for the advantages brought by
the swap and issuers expected profit margin.

Risks
a) Market risk
o Risk that market conditions will change so PV of net outgo under
agreement increases.
o Market maker will often attempt to hedge market risk by entering
into offsetting agreement.
b) Credit risk
o Risk that other party will default on payments.
o Will only occur if swap has a negative value to the defaulting party.