Basis of Investments

Securities are instruments of markets that represent a claim on, or an interest in, other assets. Also use of securities detached ownership from use and possession of assets. This separation allows widespread ownership and easy transfer, facilitates reduction of risk by diversification, and encourages professional management. This in turn helps create capital markets with efficient application of resources, encouraging economic growth. The advantages of the security form of investment are not limited to physical assets. The appeal of securities over direct acquisition is evidenced by the «securitization» of financial assets. In this process normally illiquid assets are pooled, and shares in this diversified pool are then issued.

Securities simplify the investment process, but do not remove all problems. Analysis of securities, and their combination into portfolios, requires a high level of expertise. Additionally, the investor must be concerned with risk, or uncertainty about the anticipated returns. The safest asset class — Treasury bills, or T-bills, while the riskiest asset class — stocks of smaller firms.

Equity Securities

Equity securities are simply evidence of a partial share in the ownership of an enterprise. Thus, individual common stocks are referred to as "shares." Sale of shares is more attractive to the firm than direct investment. Since many shares can be issued for the same enterprise, the firm has access to a much wider pool of capital. This enables the firm to raise larger amounts and so consider larger projects.
Sale of shares is also attractive to management, at least in part, because it has more control over the firm due to the diffusion of ownership. The holder of a share does not have a direct voice in the management of the enterprise, but has an indirect control through the election of the members of the board of directors, who in turn choose the management of the firm. more...

Fixed - Income Securities - Bonds

Unlike equity securities, the cash flows to fixed-income securities are fixed or specified in advance and are a contractual obligation. The cash flows are the interest payments, generally paid semiannually, and the repayment of principal at maturity.

- Government Bonds
Government bonds are securities issued by the U.S. Treasury and by US. government agencies.
- Municipal Bonds
Municipal bonds are issued by state and local governments, with fixed interest payments and maturity values.
- Corporate Bonds
Corporates are simply bonds issued by corporations, typically with fixed interest payments and maturity. The credit risk of a corporate bond is a reflection of the viability of the issuer, and variations are wide.

Mortgage bonds are secured by a claim on a specific asset, usually real property. They may be: open-end, limited open-end, or closed-end, depending on the extent to which the collateral can be used as security for other issues.
Equipment trust certificates are a variation of mortgage bond using equipment as security, while collateral trust certificates use securities of other entities as security. more...

Callable bonds are bonds that can be repurchased by the firm at its option. The call price at which the forced repurchase is carried out includes a call premium, which is often equal to one year's interest. At the other extreme is the putable bond, which may be sold back to the issuer at the option of the investor. This feature is attractive to investors.

The maturity date of a bond issue is a time of some concern. While the firm may be able to make the periodic interest payment, the repayment of principal at maturity may be beyond the ability of the firm. Normally, an issue will simply be replaced by a new issue, but this may prove difficult or impossible. A sinking fund is a way of avoiding this end of life crisis. more...

Convertible bonds are bonds that can be converted into the common stock of the issuing firm. Zero coupon bonds are bonds mat have ho interest payment, but instead provide a return by being sold at a discount. In fact, there are a large variety of other characteristics that have been written into the bond indenture, the agreement under which the bond is issued, and the instrument is very flexible.

Mortgage - Backed Securities

Mortgage-backed securities, or pass throughs are securities that represent a claim to proceeds from a pool of mortgages. Ownership of an individual mortgage would be quite risky and would have high default risk, but ownership of a pool spreads default risk (allows diversification) over all investors holding securities based on the pool. The cash flows from the instrument are the principal and interest payments of the mortgages, which are passed through to the bondholders. Another source of cash flows is prepayment of the mortgages. Because of the right of the mortgagees to repay, which is strongly affected by interest rates, the cash flows are hard to predict.

Fixed-Income Securities-Preferred Stock

In the case of preferred stock, the specified cash flows take the form of a fixed dividend to be paid at set intervals. While some preferred stock has a maturity with a final payout, more often there is so fixed maturity. The stock is called preferred for two reasons. The first is that no dividends may be paid on common stock unless the dividend on preferred stock has been paid. Second, in bankruptcy the preferred stockholders have a higher priority for payment than the common stockholders. Balancing these preferences is the characteristic that preferred stock usually has no voting power.

The specification of dividends is a promise, rather than a contractual obligation. Dividends are declared at the discretion of the directors. The directors have no legal obligation to declare dividends at the indicated time and preferred stockholders cannot legally force payment. There are several reasons, however, why it is advisable for the directors to declare the dividend. First, the dividend is usually cumulative, and any skipped dividend is not forgotten but ia due and payable. Second, no dividends may be declared to common stockholders while preferred dividends are in arrears. Finally, the preferred stockholders are often granted voting power if preferred dividends are in arrears. Thus, theoretically, the directors will declare the dividends, if possible, to avoid the wrath of the now-voting and annoyed preferred stockholders. In reality, given the difficulties of mounting a challenge to an entrenched management, this may not be all that powerful a motivation. It may be that investor antipathy to a firm in arrears on preferred dividends, and the resulting isolation from capital markets, is more important.

It has been suggested that preferred stock may not be a desirable investment for individual investors. This suggestion arises from the tax treatment because dividends on preferred stock are not tax deductible, and hence the earnings supposedly behind the dividend have already been taxed once. When the dividend is paid to an individual, it is taxed again, for double taxation. If the dividend is passed through another firm that then pays the dividend earnings as a dividend, the earnings would have been subject to triple taxation. In order to reduce this multiple taxation effect, 70% of the dividends on preferred stock held by other firms are excluded from taxes (this exclusion does not extend to common stock). At a given price, the return on preferred stock is higher for firms than for individuals. Demand from firms thus results in overpricing from the individual viewpoint.

Money Market Securities

Money market securities are instruments that are highly marketable, have low credit risk, and are of short maturity, usually one year or less. These securities generally trade on a discount basis, where the cash flow is the final repayment of principal. The instruments provide a return by selling at a discount from maturity value. They are usually used by large institutions and mutual funds, and are seldom held by individual investors. Negotiable CDs are large certificates of deposit that can be traded among investors. Banker's acceptances are simply drafts on a bank, to be paid at some future date, which the bank has promised to honor or "accepted." These banker's acceptances are traded on a discount basis. Commercial paper is simply an unsecured loan to the issuing firm—they are sometimes called corporate IOUs. Only a small number of firms are able to use this instrument. T-bills, short-term government securities having original maturities of 91 days or 182 days, are issued weekly, while 52-week maturities are issued monthly. Eurodollars are dollar-denominated deposits at foreign banks or at the foreign branches of American banks. The term "Euro" is historic in origin, and the deposits may be in banks worldwide. Both these and the similar Eurodollar CDs escape regulation by the U.S. Federal Reserve Board. Repos are the purchase of government securities, with an agreement by the seller to repurchase the securities back at a set higher price — in effect, a very short-term collateralized loan.

Derivative Securities

Derivative securities or contingent claims are securities that provide payoffs according to the values of other assets such as commodities, stock prices, or values of a market index. In short their value is contingent on or derived from the value of other assets options. Call and put options grant the holder the right to decide whether or not a particular action will be taken. A call option grants the right to buy a fixed amount of assets, at a fixed price, for a fixed period, a put option grants the right to sell a fixed amount of an asset, at a fixed price, for a fixed period. The buyer of the option literally buys the right to decide whether or not the trade will be executed (the option exercised): the seller or writer must comply with the decision of the buyer. Most trading is in standardized options traded on an exchange, although individualized con-tracts are available. Options contracts are available on common stock, commodities, foreign currency, and bonds. Some options are actually written on futures rather than directly on the asset in question, although there is no practical difference. Since delivery of a market index is infeasible, the delivery on index options is made in cash. Options provide tremendous flexibility in creating financial strategies, and are often used to create hybrid securities. Options permit high leverage and may be very speculative, but can also be used to reduce exposure to some types of risk.

Futures and Forward Contracts

A forward contract is a commitment to trade a fixed amount at a fixed price at some future date. Futures contracts are simply a standardized form of forward contract that are traded on an exchange. The futures contract has the added feature of a clearinghouse that guarantees performance, and the daily marking to market or payment of gains or losses. Futures may be used by both producers and users of an asset to hedge against price changes, or they can be used as speculative investments.

Other Instruments

There are other instruments that separate ownership from possession and use, and provide limited liability. For various reasons, however, these instruments lack liquidity or other characteristics of securities. In limited partnerships, for example, only the managing partner exercises management control and assumes full risk. The rest of the partners are called limited partners. The limited partner's have no say in the management of the partnership, but in exchange have limited liability. This arrangement has been widely used in real estate investing. The major drawbacks to limited partnerships is the almost total reliance on the ability of the managing partner and the lack of liquidity.