Chapter 2 Investment Alternatives

Organizing Financial Assets

Investment alternatives available through direct investing, which involves securities that
investors buy and sell themselves (typically using their brokerage accounts), primarily capital
market securities and derivative securities. Indirect investing is a very important alternative
for all investors to consider, and has become tremendously popular in the last few years with
individual investors.

Investors who invest directly in finacial markets, either using a broker or by other means,
have a wide variety of assets from which to choose.

Non-Marketable Financial Assets

A distinguishing characteristics of these assets is that they represent personal transactions

between the owner and the issuer. That is, you as the owner of a saving account at a bank
must open the account personally, and you must deal with the bank in maintaining the
account or in closing it.

These are safe investment, occuring at (typically) insured financial institutions or issued by
the U.S. government. At least some of these assets offer the ultimate in liquidity, which can
be defined as the ease with which an asset can be converted to cash.

Money Market Securities

Money market include short-term, highly liquid, relatively low risk debt instruments sold by
government, financial institution, and corporations to investors which temporary excess funds
to invest. This market dominated by financial institutions, particularly banks and
governments. The size of transactions in money market typically large. The maturities of
money market insruments range from one day to one year and are often less than 90 days.

Some of these instruments are negotiabe and actively traded, and some are not. Investors may
invest directly in some of these securities, but more often they do so indirectly through
money market mutual funds, which are investment companies organized to own and manage
a portofolio of securities and which in turn are owned by investor.

Fixed Income Securities

Capital markets encompass fixed-income and equity securities with maturities greater than
one year. Risk is generally much higher than in the money market because of the time to
maturity and the very nature of the securities sold in capital markets. The capital market
include both debt and equity securities, with equity securities having no maturity date.

Bonds

Bonds can descibed simply as long term debt instrument representing the issuers contractual
obligation, or IOU. The buyer of a newly issued coupun bond is lending money to the issuer
who, in turn, agrees to pay interest on this loan and repay the principal at a stated maturity
date.

Bond Characteristics

The par value (face value) of most bonds is $1000 and we will use this number as the amount
to be repaid at maturity. The typical bond matures on a specific date and is technically known
as a term bond. Most bonds are coupon bonds, where coupon refers to the periodic interest
that the issuer pays to the holder of the bonds.

A radival innovation in the format of traditional bonds is the zero coupon bonds, which is
issued with no coupons, or interest, to be paid during the life of the bond. The purchaser pays
less than par value for zero coupons and receives par value maturity.

Actually, bonds trade on an accrued interest basis. That is, the bond buyer must pay the bound
seller the price of the bond as well as the interest that has been earned (accrued) on the bond
since the last semiannual interest payment. At any point in time some bonds are selling at
premium (price above par value), reflecting a decline in market rates after that particular
bond was sold. Others are selling at discount (price below par value) because the stated
coupons are less than the prevailling interest rate on a comparable new issue.

The call provision gives the issuer the right to call in the bonds, thereby depriving investors
of that particular fixed-income security. Exercising the call provision becomes attractive to
the issue when market interest rates drop sufficiently below the coupon rate on outstanding
bonds for the issuers to save money.

Types of Bonds

Federal government securities

Government agency securities

Municipal securities

Corporate bonds

Rates on Fixed-Income Securities. Interest rates on fixed income securities fluctuate widely
over the years as inflationary expectations change as well as demand and supply conditions
for long-term funds.

Equity Securities

Preferred Stock

Preferred Stock is known as a hybrid security because it resemble both equity and fixed
income instruments. As an equity security, preferred stock has an infinite life and pays
dividends. Preferred stock resemble fixed-income securities in that the dividend is fixed in
amount and known in advance, providing a stream of income very similar to that of a bond.
Preferred stockholders are paid after bondholders but before the common stock holders in
terms of priority of payment of income and in case the corporation is liquidated. if the issuer
fails to pay the dividend in any year, the unpaid dividend will have to be paid in the future
before common stock dividends can be paid if the issue is cumulative.

Common Stock

Common stock represent the ownership interest of corporations, or the equity of the
stockholder, and we can use the term equity securities interchangeably.if a firms shares are
held by only a few individuals, the firm is said to be closely held. Most companies choose
to go public, that is, they sell common stock to the general public. This action is taken
primarily to enable the company to raise additional capital more easily.

As the residual claimants of the corporation, stockholders are entitled to income remaining
after the fixed income claimants (including preferred stockholders) have been paid, also, in
case of liquidation of the corporation, they are entitled to bthe remaining assets after all other
claims (including preferred stock) are satisfied.

As owner , the holders of common stock are entitled to elect the directors of the corporation
and vote on major issues. Each owner is usually allowed to cast votes equal to the number of
shares owned for each director being elected. Such votes occur at the annual meeting of the
corporation, which each shareholder is allowed to attend.

Characteristic of common stock

The par value. The par value (stated or face value) for a common stock, unlike a bond or
preferred stock, is generally not a significant economic variable. Corporation can make the
par value any number they choose.

The book value. The book value of a corporation is the accounting value of the equity as
shown on the books (i.e. balance sheet). It is the sum of common stock outstanding, capital
in excess of par value, and retained earnings. Dividing this sum, or tottal book value, by the
number of common shares otstanding produces the book value per share.

Dividens. Dividens are the only cash payment regularly made by corporations to their
stockholders. They are decided upon and declared by the board of directors and can range
from zero to virtually any amount the corporation can aford to pay (typically, up to 100
percent of present and past net earnings). The following two dividend terms are important

The dividend yield is the income component of a stocks return stated on a percentage
basis. Dividend yield typically is calculated as the most recent 12-month dividend
divided by the current maket price

The payout ratio is the ratio of dividens to earning. It indicates the percentage of afirms
earnings paid out in cash to its stockholders.
The P/E ratio. The P/E ratio also referred to as the earnings multiplier, is typically
calculated as the ratio of the current market price to the firms earnings. It is indication of
how much the market as a whole is willing to pay per dollar of earnings.

Derivative Securities

Options and futures contracts are derivative securities, so named because their value is
derived from their connected underlying security.

Options

Options are created not by corporations but by investors seeking to trade in claims on a
particuar common stock. A call (put) option gives the buyer the right to purchase (sell) 100
shares of a particular stock at a specified price (called the exercise price) within a specified
time. Put and calls allow both buyers and sellers (writers) to speculate on the short-term
movements of certain common stocks.

Futures contracts

Futures contracts is an agreement that provides for the future exchange of a particular asset
between a buyer and seller. The seller contracts to deliver the asset at a specified delivery
date in exchange for a specified amount of cash from the buyer. Most participants in future
are either hedgers or speculators. Hedgers seek to reduce price uncertainty over some future
period.
 Chapter 3 Investment Companies

Investing Indirectly Through Investment Companies

An investment company such as a mutual fund is a clear alternative for an investor seeking
to own stocks and bonds. Indirect investing refers to the buying and selling of the shares of
investments companies that, in turn, hold portfolios of securities. Investor who purchase
shares of a particular portfolio managed by an investment company are purchasing an
ownership interest in that portfolio of securities and are entitled to a pro rata share of the
dividends, interest, and capital gains generated.

Indirect investing essentially accomplishes the same things as direct investing. The essential
difference is that the investment company stands between the investors and the portfolio of
securities. The point about indirect investing is that investor gain and lose through the
investment companys activities in the same manner that they would gain and lose from
holding a portfolio directly

What is an Investment Company?

An investment is a financial service organization that sells shares in itself to the public and
uses the funds it raise to invest in a portfolio of securities such as money market instruments
or stocks and bonds.

A regulated investment company can elect to pay no federal taxes on any distribution of
dividends, interest, and realized capital gains to its shareholders. The investment company
acts as a conduct, flowing through these distributions to stockholder who pay their own
marginal tax rates on them. In effect, fund shareholders are treated as if they held the
securities in the funds portfolio. Shareholders should pay the same taxes they would pay if
they owned the shares directly.

Types of Investment Companies

Unit Investment Trust

An alternative form of investment company that deviates from the normal managed type is
the init investment trust, which typically is an unmanaged, fixed-income security portfolio
put together by a sponsor and handled by an independent trustee. Redeemable trust
certificates representing claims against the assets of the trust are sold to investors at net asset
value plus a small commision.

Closed-end investment companies

One of two types of managed investment companies the closed-end investment company,
usually sells no additional shares of its own stock after the initial public offering. The shares
of a close-end fund trade in the secondary markets (e.g. on the exchange) exactly like any
other stock. To buy and sell, investors use their brokers, paying (receiving) te current price at
which the shares are selling plus (less) brokerage commissions.
Because shares of closed-end funds trade on stock exchanges, their prices are determined by
the forces of supply and demand. Interestingly, however, the market price is seldom equal to
the actual per-share value of the closed-end shares.

Open-End Investment Companies (Mutual Funds)

Open-end investment companies, the most familiar type of managed company are popularly
referred to as mutual funds and continue to sell shares to investors after the initial sale of
shares that starts the fund. Mutual funds typically are purchased either

1. Directly, from a fund company, using mail, telephone, or at office locations

2. Indirectly, from a sales agent, including securities firms, banks, life insurance companies,
and financial planners.

Mutual funds may be affiliated with an underwriter, which usually has an exclusive right
to distribute shares to investors. Most underwriters distribute shares through broker/dealer
firms. Owners of fund shares can sell them back to the company (reedem them) any time
they choose, the mutual fund is legally obligated to redeem them. Investors purchase new
shares and reedem their existing shares at the net asset value (NAV), which for any
investment company shares is computed daily by calculating the total market value of the
securities in the portfolio, subtracting any trade payables, and dividing by the number of
investment company fund shares currently outstanding.

Major Types of Mutual Funds

There are two major types of mutual funds:

Money market mutual funds (short-term funds)

Stock funds and bond & income funds (long-term funds)

Money Market Funds

A major innovation in the investment company industry has been the creation, and
subsequent phenomenal growth, of money market funds (MMFs), which are open-end
investment companies whose portfolio consist of money market instruments. Money market
funds can be divided into taxable funds and tax-exempt funds.

Taxable MMFs hold asset such as Treasury bills, negotiable CDs, and prime commercial
paper. Some funds hold only bills, whereas others hold various mixtures. Tax-exempt money
market funds consist of national funds, which invest in short-term municipal securities of
various issuers, and state tax-exempt money market funds, which invest only in the issues of
a single state, thereby providing additional tax benefits.

Equity and Bonds & Income Funds

Investors in equity and bond & income funds have a wide range of investment objectives
from which to choose. Traditionally, investors often opted for growth funds, which seek
capital appreciation, or balanced funds, which seek both income and capital aprreciation.

Most stock funds can be divided into two categories based on their approach to selecting
stocks, value funds and growth funds. A value fund generally seeks to find stocks that are
cheap on the basis of standard fundamental analysis yardsticks, such as earnings, book value,
and dividend yield. Growth funds, on the other hand, seek to find companie that are expected
to show rapid future growth, in earnings, even if current earnings are poor or, possibly,
nonexistant.

The Mechanics of Investing Indirectly

Investors transacts indirectly via investment companies by buying, holding and selling shares
of closed-ends funds and mutual funds shares (as well as unit investment trusts).

Closed-End Funds

Historically, the market prices of closed-ends have varied widely from their net asset values
(NAVs). A discount refers to the situation in which the closed-end fund is selling for less
than the NAV. If the market prive of the fund exceeds the NAV, as it sometimes does for
some closed-end funds, the funds is said to be selling at a premium. That is:

Jika NAV > harga pasar, the fund is selling at a disount

Jika NAV > harga pasar, the fund is selling at a premium

By purchasing a fund at a discount, an investor is actually buying shares in a portfolio of

securities at a price below their market value. Therefore, even if the value of the portfolio
remains unchanged, an investor can gain or lose if the discount narrows or widens over time.
That is, a difference exists between the portfolios return, based on net asset values, and the
shareholders return, based on closing prices.

Mutual funds

Some mutual funds use a sales force to reach investors, with shares available from brokers,
insurance agents, and finacial planners. Mutual funds can be subdivided into:

Load funds (those that charge a sales fee)

No-load funds (those that do not charge a sales fee)

Load funds charge investors a sales fee for the costs involved in selling the fund. This sales
fee, added to the funds NAV, currently ranges up to about 6 percent. The load or sales
charge goes to the marketing organization selling the shares, which could be the investment
company itself or brokers. The fee is split between the salesperson and the company
employing that person.
No-load funds are bought at net asset value directly from the fund itself. No sales fee is
charged because there is no sales force to compensate. Investor must seek out these funds by
responding to advertisement in the finacial press, and purchase and redeem shares by mail,
wire, or telephone.

Investment Company Performance

Total return is used to measure the return from any financial asset, including mutual fund.
Total return for a mutual fund includes reinvested dividends and capital gains, and therefore
includes all of the ways investors make money from financial assets. A cumulative total
return measures the actual cumulative performance over stated period of time, such as the
past 3 , 5 or 10 years. This allows the investor to asses total performance over some stated
period of time.

Standard practice in the mutual fund industry is to calculate and present the average annual
return, a hypothetical rate of return that, if achieved annually, would have produced the same
cumulative total return if performance had been constant over the entire period. The average
annual return is a geometric mean and reflects the compound rate of growth at which money
grew over time.