Chapter

3 Overview of
Security Types

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 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, and
– How its prices are quoted in the financial press.

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 Classifying Securities

Basic Types Major Subtypes

Money market instruments
Interest-bearing
Fixed-income securities
Common stock
Equities
Preferred stock
Futures
Derivatives
Options

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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 or governments.
– These securities promise to make fixed payments according to a pre-set
schedule.
– When they are issued, their lives exceed one year.

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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 do calculate prices

from the quoted rates.

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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. (Illiquidity
means it is possible that you cannot sell these securities quickly.)

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 Quote Example: Fixed-Income Securities

• Price quotations from www.wsj.com—the online version of

The Wall Street Journal (some columns are self-explanatory):

The price (per $100 face) of the

You will receive 6.875% of the bond’s face bond when it last traded.
value each year in 2 semi-annual payments.

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 rated 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,

Dell shares, etc.

• Potential gains/losses:
– Many companies pay cash dividends to their shareholders.
However, 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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Common Stock Price Quotes

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Common Stock Price Quotes Online
at http://finance.yahoo.com

First, enter symbol.

Resulting
Screen

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 Preferred Stock

• Example: Citigroup preferred stock (Do a Google search for it).

• Potential gains/losses:
– Dividends are “promised.” However, there is no legal requirement
that the dividends be paid, as long as no common dividends are
distributed.
– The stock value may rise or fall depending on the prospects for the
company and market-wide circumstances.

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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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Futures Contracts: Online Price Quotes

Source: Markets Data Center at www.wsj.com.

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Futures Price Quotes Online

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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.

– Note that, for buyers, losses are limited, but gains are not.

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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.

– Note that, for buyers and sellers, gains and losses are limited.

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 Option Contracts: Online Price Quotes
for Hewlett-Packard (HPQ) options

Source: www.finance.yahoo.com

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 Investing in Stocks versus Options, I.

Stocks:

• Suppose you have $10,000 for investments. Macron

Technology is selling at $50 per share.

• Number of shares bought = $10,000 / $50 = 200

• If Macron is selling for $55 per share 3 months later, gain = ($55
 200) - $10,000 = $1,000

• If Macron is selling for $45 per share 3 months later, gain = ($45
 200) - $10,000 = -$1,000

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 Investing in Stocks versus Options, II.

Options:

• A call option with a $50 strike price and 3 months to maturity is

also available at a premium of $4.

• A call contract costs $4  100 = $400, so number of contracts

bought = $10,000 / $400 = 25 (for 25  100 = 2500 shares)

• If Macron is selling for $55 per share 3 months later, gain =

{($55 – $50)  2500} - $10,000 = $2,500

• If Macron is selling for $45 per share 3 months later, gain = ($0
 2500) – $10,000 = -$10,000

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 Useful Internet Sites

• www.nasdbondinfo.com (current corporate bond prices)

• www.investinginbonds.com (bond basics)
• www.finra.com (learn more about TRACE)
• www.fool.com (Are you a “Foolish investor?”)
• www.stocktickercompany.com (reproduction stock tickers)
• www.cmegroup.com (CME Group)
• www.cboe.com (Chicago Board Options Exchange)
• finance.yahoo.com (prices for option chains)
• www.wsj.com (Online version of The Wall Street Journal)

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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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