INVESTMENT ALTERNATIVES &

INVESMENT COMPANIES

2-1
NONMARKETABLE FINANCIAL ASSETS

 Commonly owned by individuals

 Represent direct exchange of claims between issuer and
investor
 Usually very liquid or easy to convert to cash without loss
of value
 Examples: Savings accounts and bonds, certificates of
deposit, money market deposit accounts

2-2
MONEY MARKET SECURITIES

 Marketable: claims are negotiable or salable in the

marketplace
 Short-term, liquid, relatively low risk debt instruments
 Issued by governments and private firms
 Examples: Money market mutual funds,
T-Bills, Commercial paper

2-3
CAPITAL MARKET SECURITIES
 Marketable debt with maturity greater than one year and ownership
shares
 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

2-4
BOND CHARACTERISTICS

 Buyer of a newly issued coupon bond is lending money to

the issuer who agrees to repay principal and interest
 Bonds are fixed-income securities
 Buyer knows future cash flows
 Known interest and principal payments

 If sold before maturity price will depend on interest rates at

that time

2-5
BOND CHARACTERISTICS
 Prices quoted as a % of par value
 Bond buyer must pay the price of the bond plus accrued interest since
last semiannual interest payment
 Prices quoted without accrued interest

 Premium: amount above par value

 Discount: amount below par value

2-6
INNOVATION IN BOND FEATURES

Zero-coupon bond
 Sold at a discount and redeemed for face value at maturity
 Locks in a fixed rate of return, eliminating reinvestment rate risk
 Responds sharply to interest rate changes
 Not popular with taxable investors
 May have call feature

2-7
MAJOR BOND TYPES

Treasury Securities
Federal Agency Securities
Municipal Securities
Corporates

2-8
CORPORATE BONDS

Usually unsecured debt maturing in 20-40 years,

paying semi-annual interest, callable, with par value
of $1,000
 Callable bonds gives the issuer the right to repay the debt prior to
maturity
 Convertible bonds may be exchanged for another asset at the
owner’s discretion
 Risk that issuer may default on payments

2-9
BOND RATINGS

 Rate relative probability of default

 Rating organizations
 Standard and Poors Corporation (S&P)
 Moody’s Investors Service Inc

 Rating firms perform the credit analysis for the investor

 Emphasis on the issuer’s relative probability of default

2-10
BOND RATINGS

 Investment grade securities

 Rated AAA, AA, A, BBB
 Typically, institutional investors are confined to bonds in these four
categories
 Speculative securities
 Rated BB, B, CCC, C
 Significant uncertainties
 C rated bonds are not paying interest

2-11
SECURITIZATION

Transformation of illiquid, risky individual loans into

asset-backed securities
 GNMAs
 Marketable securities backed by auto loans, credit-card receivables,
small-business loans, leases
High yields, short maturities, investment-grade
ratings

2-12
EQUITY SECURITIES
 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

2-13
PREFERRED STOCKS

 Hybrid security because features of both debt and equity

 Preferred stockholders paid after debt 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

2-14
COMMON STOCKS
 Common stockholders are residual claimants on income and assets
 Par value is face value of a share
 Usually economically insignificant

 Book value is accounting value of a share

 Market value is current market price of a share

2-15
COMMON STOCKS

Dividends are cash payments to shareholders

 Dividend yield is income component of return =D/P
 Payout Ratio is ratio of dividends to earnings

2-16
COMMON STOCKS

 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

 P/E ratio is the ratio of current market price of equity to

the firm’s earnings

2-17
INVESTING INTERNATIONALLY

 Direct investing
 US stockbrokers can buy and sell securities on foreign stock exchanges
 Foreign firms may list their securities on a US exchange or on Nasdaq
 Purchase ADR’s
 Issued by depositories having physical possession of foreign securities
 Investors isolated from currency fluctuations

2-18
DERIVATIVE SECURITIES

 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

 Warrants are options issued by firms

2-19
OPTIONS

 Exchange-traded options are created by investors, not

corporations
 Call (Put): Buyer has the right but not the obligation to
purchase (sell) a fixed quantity from (to) the seller at a fixed
price before a certain date
 Right is sold in the market at a price

 Increases return possibilities

2-20
FUTURES
 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

2-21
INDIRECT INVESTING

3-22
INDIRECT INVESTING
 Alternative to direct investment in or ownership of securities
 Refers to buying and selling the shares of intermediaries that hold
securities in portfolio
 Shares are ownership interest in portfolio entitled to portfolio income
 Shareholders also pay expenses

3-23
INVESTMENT COMPANIES
 Financial firm that sells shares to the public and uses the proceeds to
invest in marketable securities
 Acts as conduit for distribution of dividends, interest, and realized gains
 Can elect to pay no federal taxes on distributions
 Offers professional management

3-24
COMPANY TYPES
 Unit investment trusts: Typically holds an unmanaged, fixed-income
portfolio
 Assets not actively traded once purchased
 Trust ceases to exist when securities mature
 Passive investment

3-25
COMPANY TYPES
 Exchange Traded Funds: portfolio of assets that offer diversification over
a sector, region, or market
 Trade like individual equities on exchange
 Management fees low
 Investor controls realization of capital gains, losses
 Tax implications

 ETFs on equities, bonds, commodities

3-26
COMPANY TYPES
 Closed-end investment companies: No additional shares sold after initial
public offering
 Share prices determined and trade in a secondary market
 Price may not equal Net Asset Value of the shares
 Net Asset Value: Total market value of the security portfolio divided by total shares

3-27
COMPANY TYPES
 Open-end investment companies: Shares continue to be sold to the
public at NAV after initial sale that capitalizes the company
 Shares may be sold back to company at NAV
 Company size constantly changes
 Popularly called mutual funds

3-28
MUTUAL FUND CATEGORIES
 Money market mutual funds invest in portfolio of money market
securities
 Taxable or tax-exempt
 Commercial paper important investment
 Average maturity limit: 90 days
 Investors pay a management fee but not a sales or redemption charge (load)
 Not insured by the federal government

3-29
MUTUAL FUND CATEGORIES
 Equity, bond, and income mutual funds invest in portfolio of securities
consistent with the objectives of the fund
 Objectives set by the company’s board
 Disclosure of objectives to investors
 18 major categories of investment objectives

3-30
EQUITY FUNDS
 Most assets in equity funds rather than bond or income funds
 Most equity funds are either:
 Value funds, which invest in undervalued stocks as determined by fundamental
financial analysis
 Growth funds, which invest in stocks of firms expected to show future rapid earnings
growth

3-31
COST CONSIDERATIONS
 Closed-end fund prices may be at a discount or premium to NAV
 Liquidation value different than price

 “Load” funds charge a front-end fee to cover the costs of selling the
fund to investors
 May also be a redemption (back-end) fee or distribution fee (called 12b-1 fee)

3-32
COST CONSIDERATIONS
 All fees must be stated in the mutual fund prospectus
 No-load funds are purchased at NAV directly from the investment
company
 No sales force expense to cover
 Investors must seek out funds
 Still an annual operating expense paid out of fund income

3-33
PERFORMANCE
 Reported on a regular basis in the popular press
 Measured over a given time period as a percent of initial investment
 Total returns include reinvested dividends and capital gains
 Average annual return reflects the mean compound growth rate of investment over
a given time period

3-34
INTERNATIONAL FUNDS
 Some mutual funds specialize in international securities
 US investors can participate in emerging market economies
 International funds or global funds emphasize international stocks
 Single-country funds concentrate assets
 Actively or passively managed

3-35
NEW DIRECTIONS
 Mutual fund “supermarkets”
 Various mutual fund families can be purchased through a single source
 Brokerage account may provide access
 “Supermarket” managers earn fee

 Hedge Funds
 Largely unregulated investment companies available to private investors
 May use leverage, strategies not available to mutual fund managers
 Substantial initial investment required

3-36