Chapter 3

Overview of Security Types

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 Overview of Security Types

“An investment operation is one which

upon thorough analysis promises
safety of principal and an adequate
return. Operations not meeting these
requirements are speculative.”

–Benjamin Graham

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 Learning Objectives

Price quotes for all types of investments are

easy to find, but what do they mean?

Learn the answers for:

1. Various types of interest-bearing assets.

2. Equity securities.
3. Futures contracts.
4. Option contracts.

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 Security Types

 Our goal in this chapter is to introduce the

different types of securities that investors
routinely buy and sell in financial markets
around the world.

 For each security type, we will examine:

 Its distinguishing characteristics
 Its potential gains and losses
 How its prices are quoted in the financial press.

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Classifying Securities

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 Interest-Bearing Assets

 Money market instruments are short-term

debt obligations of large corporations and
governments.
 These securities promise to make one future payment.
 When they are issued, their lives are less than one
year.

 Fixed-income securities are longer-term

debt obligations of corporations and
governments.
 These securities promise to make fixed payments
according to a pre-set schedule.
 When they are issued, their lives exceed one year. 3-6
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 Money Market Instruments

 Examples: U.S. Treasury bills (T-bills), bank

certificates of deposit (CDs), corporate and
municipal money market instruments.

 Potential gains/losses: A known future

payment, except when the borrower defaults (i.e.,
does not pay).

 Price quotations: Usually, the instruments are

sold on a discount basis, and only the interest
rates are quoted.

 Therefore, investors must be able to calculate

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 Fixed-Income Securities

 Examples: U.S. Treasury notes, corporate bonds,

car loans, student loans.

 Potential gains/losses:
 Fixed coupon payments and final payment at maturity,
except when the borrower defaults
 Possibility of gain (loss) from fall (rise) in interest rates
 Depending on the debt issue, illiquidity can be a problem.

If you cannot sell securities quickly for their

current market value, the market is said to be
illiquid.
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 Quote Example:
Fixed-Income Securities
 Price Quotations from https://finra-
markets.morningstar.com/BondCenter. Looking for
bonds from the 3M Company (some columns are self-
explanatory):

The bond is callable.

The price (per $100 face)

You will receive 3.875% of the bond’s face of the bond when it last
value each year in 2 semi-annual payments. traded.

The Yield to Maturity (YTM) of the

bond.

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 Equities

 Common stock: Represents ownership in a

corporation. A part owner receives a pro rata
share of whatever is left over after all obligations
have been met in the event of a liquidation.

 Preferred stock: The dividend is usually fixed

and must be paid before any dividends for the
common shareholders. In the event of a
liquidation, preferred shares have a particular face
value.

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 Common Stock

 Examples: IBM shares, Microsoft shares, Intel

shares, Apple shares, etc.
 Potential gains/losses:
 Many companies pay cash dividends to their shareholders.
Neither the timing nor the amount of any dividend is
guaranteed.
 The stock value may rise or fall depending on the
prospects for the company and market-wide
circumstances.

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 More on Common Stock

 Common stock represents ownership in a corporation.

 If you own 1,000 shares of IBM, for example, then you

own about .00011 percent of IBM (IBM has roughly 900
million shares outstanding).

 As a part owner, you are entitled to your share of

anything paid out by IBM.

 As an owner, you also have the right to vote on

important matters regarding IBM.
 Your .00011 percent share doesn’t carry much weight.
 One vote per share, except....
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 The Dual-Class Share System
and its Sunset Provision

 Some companies have a dual-class share system.

 Under this system, there is a special voting class stock—usually
retained by the founding owners.
 This special voting class has more than one vote per share.
 So, the founders of the firm can maintain control of the firm
without owning a majority of the shares.
 For example, for every share of the special voting stock that Mark
Zuckerberg, Facebook’s founder, owns, he receives 10 votes.

 A sunset provision is a recent trend for these share

structures.

 Under a sunset provision, the special share class becomes a

one-share, one-vote structure, say, for example, in five
years.
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Examples of Companies with
Dual-Class Shares

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 Common Stock Price Quotes
 NYSE Most Active Stocks

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Common Stock Price Quotes Online:
http://finance.yahoo.com
First, enter symbol, JWN

Resulting Screen
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 Derivatives, I.

 Primary asset: Security originally sold by a

business or government to raise money.

 Derivative asset: A financial asset that is

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.

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 Derivatives, II.

 Futures contract: An agreement made today

regarding the terms of a trade that will take place
later.

 Option contract: An 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.

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 Futures Contracts

 Examples: financial futures (i.e., S&P 500, T-

bonds, foreign currencies, and others), commodity
futures (i.e., wheat, crude oil, cattle, and others).

 Potential gains/losses:
 At maturity, you gain if your contracted price is better
than the market price of the underlying asset, and vice
versa.
 If you sell your contract before its maturity, you may gain
or lose depending on the market price for the contract.
 Note that enormous gains and losses are possible.

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Online Price Quotes: U.S. 10-Year
T-Note Futures Contracts

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Futures Price Quotes Online
Source: www.cmegroup.com

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 Option Contracts, I.

 A call option gives the owner the right, but not the
obligation, to buy something, while a put option gives the
owner the right, but not the obligation, to sell something.

 The “something” can be an asset, a commodity, or an

index.

 The price you pay today to buy an option is called the

option premium.

 The specified price at which the underlying asset can be

bought or sold is called the strike price, or exercise
price.

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 Option Contracts, II.

 An American option can be exercised anytime

up to and including the expiration date, while a
European option can be exercised only on the
expiration date.

 Options differ from futures in two main ways:

 Holders of call options have no obligation to buy the
underlying asset.
 Holders of put options have no obligation to sell the
underlying asset.
 To avoid this obligation, buyers of calls and puts must pay
a price today. Holders of futures contracts do not pay for
the contract today.
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 Option Contracts, III.

 Potential gains and losses from call options:

 Buyers:
 Profit when the market price minus the strike price is greater
than the option premium.
 Best case, theoretically unlimited profits.
 Worst case, the call buyer loses the entire premium.

 Sellers:
 Profit when the market price minus the strike price is
less than the option premium.
 Best case, the call seller collects the entire premium.
 Worst case, theoretically unlimited losses.

 For buyers of call options: option losses

are limited to the purchase price; gains are
theoretically unlimited.
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 Option Contracts, IV.

 Potential gains and losses from put options:

 Buyers:
 Profit when the strike price minus the market price is greater
than the option premium.
 Best case, market price (for the underlying) is zero.
 Worst case, the put buyer loses the entire premium.

 Sellers:
 Profit when the strike price minus the market price is less
than the option premium.
 Best case, the put seller collects the entire premium.
 Worst case, market price (for the underlying) is zero.

 For buyers and sellers of put options: both

gains and losses are limited.

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Option Contracts: Online Price Quotes
for Nike (NKE) Call and Put Options

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 The Method to
Decode Option Symbols

In 2010, a new option symbol system was

introduced.

Example: NKE190215C00060000

 The symbols expand from 5 letters up to 20 letters and

numbers.
 The stated goal is to reduce confusion by explicitly stating:

 the underlying stock symbol, NKE

 option expiration date, 190215 (i.e., February 2, 2019)
 whether the option is a call or a put, C (uh, Call)
 the dollar part of the strike price, 00060 (i.e., 100—prices can be up to 5
digits)
 the decimal part of the strike price, 000

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 Investing in Stocks versus Options, I.

Stocks (we assume no dividends):

 Suppose you have $15,000 for investments. Visa

Corporation is selling at $150 per share.

 Number of shares bought = $15,000 / $150 = 100

 If Visa is selling for $165 per share 3 months later, gain

= ($165  100) − $15,000 = $1,500 (10% gain)

 If Visa is selling for $135 per share 3 months later, loss

= ($135  100) − $15,000 = −$1,500 (10% loss)

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 Investing in Stocks versus Options, II.
 A call option with a $150 strike price and 3 months to
maturity is also available at a premium of $10.

 Traded option contracts are on a bundle of 100 shares.

 One call contract costs $10  100 = $1,000
 number of contracts bought = $15,000 / $1,000 = 15
(controlling 15  100 = 1,500 shares)

 If Visa is selling for $165 per share 3 months later,

gain = {($165 − $150)  1,500} − $15,000 = $7,500 (50%
gain)

 If Visa is selling for $135 per share 3 months later,

loss = ($0  1,500) − $15,000 = −$15,000 (100% loss)

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 Useful Internet Sites

 www.investinginbonds.com (a reference for bond basics)

 www.finra.org (learn more about TRACE)
 www.fool.com (Are you a “Foolish investor”?)
 www.cmegroup.com (CME Group)
 www.cboe.com (Chicago Board Options Exchange)
 jmdinvestments.blogspot.com (reference for recent financial
information)

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 Chapter Review, I.

 Classifying Securities

 Interest-Bearing Assets
 Money Market Instruments
 Fixed-Income Securities

 Equities
 Common Stock
 Preferred Stock
 Common and Preferred Stock Price Quotes

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 Chapter Review, II.

 Derivatives
 Futures Contracts
 Futures Price Quotes
 Gains and Losses on Futures Contracts

 Option Contracts
 Option Terminology
 Options versus Futures
 Option Price Quotes
 Gains and Losses on Option Contracts
 Investing in Stocks versus Options

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