Investments: Analysis and

Management
Fourteenth Edition
Gerald R. Jensen and Charles P. Jones

Chapter 2
Investment Alternatives
Nonmarketable Financial Assets
• Commonly owned by individuals
• Personal transactions between owner and issuer
• Owner opens, closes, and maintains account
• In contrast, marketable securities trade in impersonal markets
• Usually very liquid or easy to convert to cash without loss
of value
• Examples: Savings accounts, M MDAs, and CDs

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Marketable Financial Assets
• Fixed-income: payment specified by a contract
• Money market securities and bonds (fixed & floating rate)
• Equity: represents ownership share in a firm
• Common and preferred stock
• Derivative securities: value is derived based on the prices
of other assets
• Options, futures, forwards, swaps

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Types of Securities
• Money Market Securities - securities with an original
maturity of 1 year or less
• Include: T-bills, commercial paper, banker’s acceptances,
certificates of deposit (CDs), repurchase agreements, etc.
• Capital Market Securities - securities with more than 1
year in original maturity
• Include: Common & preferred stock and bonds

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Money Market Securities
• Negotiable or salable in the marketplace
• Short-term, highly liquid, relatively-low risk debt
instruments—rates tend to move together
• Issued by governments and private firms
• Generally trade in large denominations
• Generally sell on a discount basis
• Generally are low risk securities

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Treasury Bills (T-bills)
• Obligations of the federal government
• Commonly referred to as the risk-free security
• Income earned on T-bills is exempt from state and local
taxes
• Auctioned regularly by the Treasury
• Bids can be competitive or non-competitive
• Sell in minimum denominations of $10,000

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Certificates of Deposit (CDs)
• Sell on an add-on interest basis
• Insured to $250,000 by the FDIC
• For the larger banks the insurance level is assumed to be
much larger
• CDs with denominations of $100,000 or more are
negotiable

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Commercial Paper (CP)
• Basically a short-term, unsecured note (bond)
• Maturities of 270 days or less are exempt from SEC
registration requirements
• Less liquid than other money market securities
• Frequently CP is directly placed

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Bankers Acceptances
• A time draft drawn on and accepted by a commercial
bank
• Generally created by a transaction between exporters
and importers in different countries
• Maximum maturity is legally established at 180 days

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The Market for Overnight Money
• Federal Funds - short-term lending between banks
generally to maintain required reserves
• Other financial inst. have entered this market
• Repurchase Agreements (Repos) - Sale of a security
with the agreement to repurchase the security at a
higher price in the near future
• Eliminates price risk for the lender

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Pricing Money Market Securities
• Pricing formula for money market securities that trade
on a discount basis e.g. T-bills

 n 
Price P  F  1  rBD  
 360 
• Where F is the security’s face value, rBD is its quoted
bank discount rate, and n is its days to maturity

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Returns on Money Market Securities
• Two principle return measures are: bond equivalent yield
rBEY  and effective annual yield rEAY 

F  P 365
rBEY  
P n
365
 F  P n
rEAY  1   1
 P 

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Capital Market Securities
• Marketable debt with maturity greater than one year
and equity securities, which have no maturity date
• Riskier than money market securities
• Fixed-income securities have a specified payment
schedule

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Bond Characteristics 1

• Bonds are long-term debt instruments/IOUs

• Buyer of a newly issued coupon bond lends money to
issuer, issuer agrees to pay interest and re-pay principal
at maturity
• Bonds are fixed-income securities
• Buyer knows future cash flows - interest and principal
payments

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Major Bond Types
• U.S. government/Treasury securities
• Government agency securities
• Federal agencies, GSEs, MBSs
• Municipal securities
• General Obligation and Revenue
• Exempt from federal taxes and potentially state and local
• Corporate bonds

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Treasury Notes & Bonds
• Obligations of the federal government
• Notes have less than 10 years to original maturity,
bonds have 10 or more years
• Income from T-notes and T-bonds is exempt from state
and local taxes
• Treasury strips: claims to a portion of either the
interest or principal payments

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Other Federal Government Bonds
• Government Agency Bonds - obligations of agencies of
the federal government
• Most were established to finance housing; farming and
student loans also exist
• Either federally related or govt. sponsored
• Many agencies issue debt with income that is exempt
from state and local taxes
• Example agencies include: Fannie Mae, Freddie Mac,
Ginnie Mae

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Bond Characteristics 2

• Bond is worth exactly face value at maturity

• Price changes depend on interest rates
• Interest rates and bond prices move inversely
• Bond buyer in secondary market must pay the price of the
bond plus accrued interest
• Price is quoted without accrued interest
• Premium: amount above par value
• Discount: amount below par value

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Callable Bonds
• Allow issuer to “call in” the bonds from investors
• Option is attractive to issuer when market rate drops
sufficiently below coupon rate
• Issuer saves by replacing higher interest-cost bonds with new,
lower rate bonds
• Wise investors note the bond’s call provision
• Most Treasury bonds cannot be called

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Corporate Bonds
• Usually unsecured and often callable
• Receive payment priority in bankruptcy or liquidation
• Convertible bonds may be exchanged for another asset
at the owner’s discretion
• Risk that issuer may default on payments
• New Type: Inflation-protected securities

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Bond Ratings 1

• Reflect probability of default, relative rating

• Rating organizations
• Standard and Poor’s, Moody’s, Fitch
• Rating firms perform credit analysis for investors, may
disagree on ratings
• Bond ratings and coupon rates are inversely related

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Bond Ratings 2

• Investment grade securities

• Rated AAA, AA, A, BBB
• Many institutional investors buy only these
• Speculative securities
• Rated BB, B, CCC, CC
• Significant uncertainties
• Junk bonds
• Rated BB or lower
• High-risk, high-yield bonds
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Securitization
• Packaging illiquid, risky individual loans into more
liquid, less risky asset-backed securities (ABSs)
• ABS is a securitized interest in a pool of non-mortgage
assets
• Alternative assets include: auto loans, credit-card
receivables, small-business loans, leases
• ABSs can be structured in tranches with different prices,
credit ratings, maturities

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State & Local Government Bonds
• Municipal Bonds - obligations of state and local
governments
• Interest income is exempt from federal taxation and
possibly state and local taxation
• Returns on municipal bonds:

RTEY Rm 1  t 

• Where: RTEY = taxable equivalent yield; Rm = yield on tax

exempt security; t = marginal tax rate
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Equity Securities
• Denote an ownership interest in a corporation
• Denote control over management, at least in principle
• Voting rights important
• Denote limited liability
• Investors cannot lose more than their investment should
the corporation fail

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Preferred Stocks
• Hybrid security: features of both debt and equity
• Preferred stockholders paid after bondholders but before
common stockholders
• Dividend known, fixed in advance
• Usually cumulative if dividend omitted
• Often convertible into common stock
• May carry variable dividend rate

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Common Stocks 1

• Common stockholders are residual claimants on income

and assets
• Book value is accounting value of a share
• Market value is current market price of a share
• Aggregate market value is market price per share times
number of shares outstanding
• Referenced as market cap

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Common Stocks 2

• Dividends are cash payments to shareholders

• Common stockholder has no specific promise to receive cash
from the corporation
• Lack of promise plus price volatility make common stocks
risky
• Dividend yield is income component of return
• Payout Ratio is ratio of dividends to earnings

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Common Stocks 3

• Stock dividend is payment to owners in stock

• Stock split is the issuance of additional shares in proportion
to the shares outstanding
• Additional shares, not additional value
• P/E ratio is the ratio of current stock price to the firm’s
most recent 12-month earnings
• Shows how much market pays for $1 of earnings

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Investing Internationally
• May provide higher returns, lower risk
• Changes in value of US dollar can increase interest in
owning foreign securities
• Investors can buy individual foreign securities or use
investment companies
• American Depository Receipts (ADRs) represent
ownership of foreign firm stock

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Private Equity
Major Classifications
• Buyouts – buyer acquires a controlling equity stake
• Venture Capital – capital extended to a new firm
• Seed stage, start-up stage, expansion stage, replacement
capital
• Private equity investors: pension funds, endowments,
insurance companies and high net-worth investors

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Private Equity Structure
• Generally organized as a limited partnership
• General partner is the managing partner
• Two phases: raising funds and managing equity
investments
• Initial success is important for subsequent funding
• Duration of 10-12 years, extendable 2-3 years

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Derivative Securities
• Securities whose value is derived from another security
• Futures and options are standardized and performance is
guaranteed by a third party
• Risk management tools
• Futures contract is an “obligation” to buy or sell
• Options contract is the “right” to do so
• Warrants are long-term options issued by a firm

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Options
• Options are created by investors, not firms
• Call (Put): Buyer pays premium for the right to purchase
(sell) shares at a fixed price
• Seller can re-sell option in secondary market
• Call (put) buyers betting the price of underlying stock will rise
(fall)
• Allow investors to speculate on short-term movements in
stock price

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Futures
• Futures contract: standardized agreement between parties
for delivery of an asset at a fixed price
• A “good faith deposit,” called margin, is required of both
buyer and seller to reduce default risk
• Long (short) position: commitment to purchase (deliver) the
asset
• Used to hedge the risk of price changes
• Small margin size can result in large profits

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Copyright
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