Investment Alternatives

Chapter 2

Price of a Bond
The bond price reflect the par value and any accrued

interest and increase or decrease in the market

interest yield.
If bond is selling at discount, it means that the
interest rate on the bond is below the current interest
rate on similar bonds in the market and vice versa.

Zero Coupon Bonds

An innovation in traditional format of bonds.
These bonds are sold at discount.
Issuers of zero coupon bonds include local and

federal government.
Bond prices are quoted as a percentage of par
value.

Callable Bonds
If a bond is callable, the issuer can call it back by

paying off the obligations.

Exercising the call provision become attractive to the
issue when market interest rate fall significantly
below the coupon rate on the bond.
Cost of calling back include call premium or
administrative costs.

Senior Securities
Corporate bonds are senior securities, which means

they are senior to any preferred stock and to the

common stock in terms of priority of payment.
Within bonds categories, there exist differences of
priority of claims.
Debentures - unsecured bond that is not backed by
a specific asset.

Convertible Bonds
Bonds that are convertible at the issuers option into

common stocks.

Junk Bonds
High risk, high yield bonds carrying low rating.

Equity Securities
Equity securities represent ownership in a

corporation
These securities represent residual claim
There are two types of equities:
Preferred stock
Common stock

Preferred Stock
Dividend is fixed in amount and known in advance

on preferred stocks (like debt).

The stream of dividends continues forever unless it
is called (like callable bonds) .
Preferred shareholders cannot force the firm into
liquidation if their dividend is not paid (like in case of
common stock).
Preferred stock is also known as hybrid security
because it resembles both equity and fixed income
securities.

Preferred Stock

Preferred stocks have the feature of cumulative

dividends.
Preferred stock may also have feature of
convertibility into common stock (may be
mandatory or optional).

Common stock
Common stock represents the ownerships interest of

the corporation.
Ownership is concentrated or closely held when the
firms shares are held by few individuals.
Ownership is scattered when shares are held by lots
of people.

Characteristics of Common Stock

Common shares give the right to shareholders to

vote.
It gives the right to receive dividends, however,
dividend rate is not fixed.
Common shares also give the right to purchase new
shares.
Common shares are riskier than preferred stock and
bonds.

Derivative Securities
Securities that derive their values from an asset or

security.
There are two types of derivative securities:
Future Contracts
Options Contracts

Future Contracts
A future contract obliges traders to purchase or sell

an asset at an agreed-upon price at a specified

future date.
The contract can be used for commodities or
securities.
Cash is not required to be paid until delivery, only a
margin is required to reduce the chances of default
of the other party.

Future Contracts
The margin is small compared to the value of the

purchase or sale.
Many investors in future markets are hedgers or
speculator.
Hedgers seek to reduce price uncertainty over some
future period of time.
Speculators seek to profit from future uncertainty in
prices.

Types of Future Contracts

There are two types of future contracts:
1. Long Position:
The long position is held by a trader who commits to

purchasing the asset on the maturity date.

2. Short Position (Short-selling)

The short position is held by a trader who

commits to delivering the asset on the maturity

date.

Advantages of Future contracts

Helps in hedging.
Investors can benefit from price fluctuations
whether prices fall or rise.
Helps producers to get orders at current prices
and continue production without worry.
Buyers do not have to pay the full price, still they
can obtain the commodities in future at current
price.
Buyers dont have to worry about storage
problems.

Option Contracts
Option is a right to buy or sell a stated number of
units of an asset within a specified period at a
specified price.

Parties in Option Contract:

Option writer gives the right to the buyer of
the option in exchange for a price.
Option holder obtains the right to buy or sell
the asset.

Option Contracts
There are two types of option contracts:
1. Call Option
A right to buy a stated number of units of an asset
at a stated time at a specified price.
2. Put Option
An option to sell a stated number of units of an
asset at a stated time at a specified price.

Call Option

*
(Option Holder)

*
(Option Writer)

Put Option

*
(Option Holder)

*
(Option Writer)

Difference between Futures and

Options
A futures owner has the obligation to buy or sell a

specified quantity of an asset at a specified price on

a specified date.
In contrast, an option holder has the right (but not
the obligation) to buy or sell a specified quantity of
an asset at a particular price over a specified time
period.