Chapter 4: Overview of security types

Question 1

4.1 What are the 3 basic types of financial assets?

Answer 1

1. Interest Bearing: Money market instruments, Fixed income securities.
2. Equities: Common stock, Preferred stock.
3. Derivatives: Options, Futures.

Question 2

4.2 Interest-Bearing Assets: What are Money Market Instruments?

Answer 2

▸Money Market Instruments: Debt obligations of large corporations and governments with an original maturity of one year or less. Simplest form of Interest-Bearing Assets.

• 2 properties: 1. IOUs sold by large corporations/governments to borrow money.
  2. Mature in less than a year.
• Examples: 1. T-Bills which are sold at a discount (at a price less than FV) so when it matures investor receives full FV, and are risk-free (fixed potential gain) most liquid type of MMI. 2. Bank certificates of deposit (CDs). 3. Corporate,provincial and municipal MMI.

Question 3

4.2 Interest-Bearing Assets: What are Fixed-Income Securities?

Answer 3

▸Fixed-Income Security: Longer-term debt obligations of corporations/governments that promise to make fixed payments according to a present schedule.

• May have lives longer than 12 months.
• Examples: A 2 year Canada bond, you will receive a check every 6 months for 2 years for a fixed amount “coupon”, and in 2 years you receive the face amount on the bond.
• Coupon Rate ≠ Current Yield.
• Potential gains from owning a fixed-income security: 1. Fixed payments promised and final payment at maturity. 2. Prices rise when IR fall (possibility of gains with unfavourable movements in rates, but an unfavourable change in IR will cause loss).
• There is risk of issuer not paying but depends on issuer (does’t exist for Canadian government), fixed-income securities are quite illiquid (depending on issuer and type).

Question 4

4.3 Equities: What is Common Stock?

Answer 4

▸Common Stock: Represents ownership of a corporation. As a part owner you are entitled to pro rata share of anything paid out, vote on important matters regarding the corporation, receive share of whatever is left over after all debts/obligations are paid if corporation is sold/liquidated.

• Benefits of Common Stock: 1. Many companies pay cash dividends (neither time/amount guaranteed). 2. Value of stock may rise because share values generally increase or because future prospects for the corporation improve (or both). This might go the reverse if the opposite happens.
• Common Stock is more important than Preferred Stocks.

Question 5

4.3 Equities: What is Preferred Stock?

Answer 5

• Dividend fixed at some amount and never changes, in event of liquidation preferred stocks have a face value. Is called “preferred”because a company must pay fixed dividend on preferred stock before any dividends to common stock.
• Dividend on preferred stock can be omitted at discretion of board of directors, unlike a debt obligation there is no legal requirement to pay dividends (as long as common stock is also skipped). However, some preferred stock is cumulative (all skipped dividend must be paid in full but without interest).
• Advantages of preferred stock: promised dividends and gains from price increases. Disadvantages: skipped dividends, value of stock may decline from market-wide decreases in value or diminished prospects for the corporation’s future business (or both).

Question 6

4.3 Equities: Why is preferred stock sometimes classified as fixed-income security?

Answer 6

*Preferred Stock resembles a Fixed-Income Security (sometimes is even classified as F-IS). Preferred stock have fixed payment and fixed liquidation value (but not fixed maturity date). The main difference is that Preferred stock is not a debt obligation; also, in accounting preferred stock is treated as equity.

Question 7

4.4 Derivatives: What is Futures Contract?

Answer 7

*Financial Assets: Primary Asset and Derivative Assets.
▸Primary Asset: Security originally sold by a business or government to raise money. Represents a claim on the assets of the issuer (e.g stocks and bonds).
▸Derivative Asset: Financial asset derived from an existing traded asset rather than issued by a business or government to raise capital. More generally, any financial asset that is not a primary asset.
▸Futures contract: An agreement made today regarding the terms of a trade that will take place later. Simplest of all financial assets. Is essentially a bet on the future price of whatever is being sold or bought, no money exchanges hands today.
*If you change your mind after entering a contract you can sell contract to someone else and get a gain or loss.

Question 8

4.4 Derivatives: What are the general types of future contracts?

Answer 8

2 categories of futures contract:

1. Financial Futures (intangible: stocks, bonds, currencies, or money market instruments),
2. Commodity Futures (tangible: agricultural product or natural resource product).

Question 9

4.5 Option Contracts: What is a call option? A put option?

Answer 9

▸Option Contract: Agreement that gives the owner the right, but not the obligation, to buy or sell a specific asset at a specified price for a set period of time.
*Types of options: 1. Calls, and 2. Puts.
▸Call option: An option that gives the owner the right, but not the obligation, to buy an asset.
▸Put Option: An option that gives the owner the right, but not the obligation, to sell an asset.
▸Option Premium: The price you pay to buy an option.
▸Strike (or Striking or Exercise) Price: Price specified in an option contract at which the underlying asset can be bought (for call option) or sold (for put option).

Question 10

4.5 Option Contracts: What are the 2 key differences between a futures contract and an option contract?

Answer 10

1. The purchaser of a futures contract is obligated to buy the underlying asset at the specified price ( and the seller is obligated to sell). The owner of a call option is not obligated to buy; however, unless the owner wishes to do so has the right but not the obligation.
2. When you buy futures contract, you pay no money (and receive non if sell). However, if you buy an option contract, you pay the premium; if you sell an option contract, you receive the premium.