Securities are classified as fixed-income instruments, equities, or pooled investment vehicles.
Fixed income investments include promises to repay borrowed money and a variety of other instruments with payment schedules. People, companies, and governments create fixed income instruments when they borrow money. While there is no consensus definition on the exact cut-offs, fixed income securities are often classified based on maturity date as short-term (less than one or two years), intermediate-term (two to five years), and long-term (greater than five years). Fixed income investments include:
Notes: fixed income instruments, usually with a maturity of ten years or less.
Bonds: fixed income instruments, usually with a maturity of more than ten years.
Convertible bonds: can be converted into the issuing corporation’s stock by the holder after a specified amount of time.
Bills/Securities of Deposit/Commercial Paper: short-term securities, usually maturing in a year or less, issued by governments, banks, and corporations.
Repurchase Agreements: short-term lending instruments in which the borrower sells an instrument and promises to buy it back at a higher price.
Money Market Instruments: debt instruments maturing in one year or less, purchased by money market funds and corporations seeking a return on short-term cash balances.
Equities represent ownership rights in companies, and include:
Common Stock: shareholders have a right to company dividends, elect the company’s board of directors, and a share of the proceeds if the company is liquidated.
Preferred Stock: shareholders have no voting rights, but generally have the right to a regular dividend and have priority over common shareholders to liquidation proceeds. Cumulative preferred equity are preferred shares that require a company to repay any omitted preferred dividends before dividends are paid to common shareholders.
Warrants: securities issued by a corporation that give the holder the option to buy a company’s securities (usually common stock) at the exercise price at any time before the warrant’s expiration.
Pooled investments represent indirect ownership of assets held by an entity through the purchase of shares, units, depository receipts, or limited partnership interests. Pooled investments are typically used to gain access to skilled investment management and/or to efficiently diversify an investor’s portfolio. Pooled investments are made up of two types of investment vehicles: open-ended and closed-ended funds. Open-ended funds issue new shares and redeem existing shares at the fund’s net asset value (usually on a daily basis), and investors are typically able to trade their shares directly with the fund. On the other hand, closed-ended funds issue shares in primary market offerings, and those limited shares are traded in the secondary market. Since shares of closed-ended funds are not redeemable at their net asset value, shares may trade at a discount or premium to NAV. Pooled investment include:
Mutual Funds: open-ended and closed-ended investment vehicles that pool money from many investors for investment in a portfolio of securities.
Exchange-traded funds (ETFs): open-ended funds that investors can trade in the secondary markets. ETFs rarely trade at significant discounts or premiums because a class of investors known as authorized participants are able to trade directly with a fund and can profit from any differences between the NAV and market price.
Asset-backed Securities: securities whose values and income payments are derived from a pool of assets, such as mortgage bonds, credit card debt, or car loans.
Hedge Funds: usually organized as limited partnerships in which the managers are the general partners and the qualified investors are the limited partners. Hedge funds employ a wide variety of strategies and are subject to different regulatory requirements depending on the jurisdiction. Defining characteristics of most hedge funds include the use of leverage to boost fund returns, and a fee structure that charges a performance fee when positive returns are achieved in addition to the standard management fee.
There are approximately 175 currencies worldwide, some of which are considered reserve currencies – currencies held by banks and other monetary authorities in large quantities. Primary reserve currencies include the US dollar and the euro. Secondary reserve currencies include the British pound, the Japanese yen, and the Swiss franc.
Contracts are agreements to trade other assets in the future, many of which are derivatives. Derivative contracts are assets that derive their value from the prices of underlying assets. Derivatives are classified by the nature of their underlying assets. For instance, a contract based on the price of gold would be considered a physical derivative, while a contract based on Costco’s stock price or the S&P 500 would be considered a financial derivative – or more specifically, an equity derivative. Types of contracts include:
Forward Contracts: agreements to trade the underlying asset in the future at a price agreed upon today, often used by traders to hedge the risk of adverse price movements. There are two primary issues with trading in forwards: counterparty risk and limited liquidity. Counterparty risk describes the risk that the other party will fail to honor the terms of the contract. Forward contracts have limited liquidity because the consent of the other party is needed before the contract can be traded.
Futures Contracts: similar to forward contracts, but not hindered by the same problems. The buyer of a futures contract will receive the physical delivery or its cash equivalent at the specified date; the seller will deliver the asset or its cash equivalent. Since clearinghouses ensure that no trader is harmed by another trader’s default, there is not counterparty risk. Additionally, futures contracts are standardized so obligations can be eliminated by taking an offsetting position (a buyer selling the same futures contract or a seller buying the same futures contract).
Swap Contracts: agreements to exchange payments of periodic cash flows that depend on future asset prices or interest rates. Variable payments are based on a pre-determined variable interest rate like the London Interbank Offered Rate (Libor). Commonly used swaps include interest rate swaps, commodity swaps, currency swaps, and equity swaps.
Option Contracts: call options (put options) allow the buyer to purchase (sell) an underlying instrument at a set strike price before a specified date. If the market price of the underlying security rises above the strike price, the call holder can exercise the option at a profit. If the price of the underlying security falls below the strike price, the put holder profits from exercising the option. European-style contracts allow the holder to exercise only on the maturity date, while American-style contracts allow the holder to exercise the options early.
Credit Default Swaps: insurance contracts that promise payment of principal in the event that a company defaults on its bonds. A company’s bondholders may invest in related credit default swaps to hedge against the company’s risk of default, or well-informed traders may choose to invest in a company’s credit default swaps without bond exposure to essentially bet on the company’s default.
Commodities include precious metals, energy products, industrial metals, agricultural products, and carbon credits. Exposure to commodities can be achieved directly through the spot markets or indirectly through the forward and futures markets. The producers and processors of industrial metals and agricultural products are the primary users of the commodity spot markets because they tend to have an informational edge and have access to inexpensive storage. Information-motivated traders often trade in the commodities forward or futures markets to hopefully profit from future price movements without needing to pay for storage of the underlying assets.
Real assets are investments in tangible properties, usually held by operating companies. Investors find real assets attractive due to their potential income and tax benefits and low correlation to other asset classes. Direct investments in real assets are usually quite costly as investors must either maintain the property themselves or hire a manager to do it for them. No two real assets are exactly the same, making real assets difficult to value and trade. These issues play into the hands of information motivated traders targeting undervalued investments acquired from less informed sellers. Of course, the excess returns generated by these traders may be partially or completely offset by the additional costs of finding and managing the undervalued properties. Financial intermediaries like real estate investment trusts (REITs) and master limited partnerships (MLPs) securitize real assets and passing through most of their net income after management fees to investors. These investment vehicles allow investors to gain indirect exposure to real assets without the same shortcomings of direct investments.
Louis, a wheat farmer, wants to protect himself against the risk of falling wheat prices without sacrificing all the upside if wheat prices spike. What should Louis most likely do to achieve this goal?
A. Sell Futures Contracts
B. Buy Call Options
C. Buy Put Options
The correct answer is C.
The sale of futures contracts would successfully hedge against declining wheat prices, but would obligate Louis to sell at the agreed upon price even if market prices were higher at the time. The purchase of call options would allow him to capture more upside if wheat prices increased while still leaving him fully exposed if prices fell. The purchase of put options would allow Louis to sell his wheat at a set price without obligating him to do so in the event that the market price exceeded the strike price at the time of maturity.
Short Term Capital Management (STCM) generates extraordinary returns by identifying small market inefficiencies and employing a high amount of leverage. Since the fund’s inception, STCM’s managers have become incredibly wealthy due in large part to the performance-based fees charged to fund investors. STCM is most likely a:
A. Mutual Fund
B. Hedge Fund
C. Exchange-traded Fund
The correct answer is B.
Hedge funds are often highly leveraged and usually charge performance-based fees, while mutual Funds and ETFs are generally unleveraged and charge only a management fee as a percent of total assets.