Chapter 2-Investment Alternatives
Q 2-1: What is meant by indirect investing?
Indirect investing refers to the buying and selling of
securities issued by investment companies that hold the portfolio of securities
that are traded in financial markets. By investing in securities of investment
companies, the investors are relieved from making decisions about the
portfolio. Investors who purchase shares of a particular portfolio managed by
an investment company are purchasing an ownership interest in that portfolio of
securities and are entitled to a pro rata share of dividends, interest and
capital gains generated by the portfolio. Shareholders of the investment
company must also pay a pro rata share of the company’s expenses and management
fee, which will be deducted from the portfolio’s earnings as it flows back
to the shareholders.
Q 2-2: What does it mean for Treasury bills to be sold at discount?
Treasury bills are short term, highly liquid and risk-free
money market security, which are offered at a price less than its face value.
Here is no interest payment made to the security holder till the maturity of
the security. At the time of maturity the holder of the security receives the
face value of the bill. The rate of return on the security (interest rate) is
the underlying spread between discounted purchase price and the maturity value
(face value).
Q 2-3: Distinguish between a negotiable certificate of
deposit and the certificate of deposit in the section “non-marketable
securities?
A certificate of deposit is a security issued in
exchange of a deposit. A negotiable certificate of deposit is a
marketable security that can be sold in the open market on the other hand a
non-negotiable certificate of deposit cannot be sold in the market. The holder
of such a security has to wait till maturity for principal.
Q 2-4: Name four issuers of bonds. Which do you think is
the most risky as a general proposition?
The four issuers of bonds are
Federal government
Federal agencies
Municipal government
corporations
The bonds issued by corporations are considered to be the
most risky since the probability of a default by a corporation is greater than
any of the other three issuers. The securities issued by federal government in
the denomination of local currency are free from default risk since the federal
government can print notes to avoid a default on payment. The federal agency
and municipal government securities are backed by the federal government and in
case the agency or the municipal government defaults, the federal government
will bail them out by providing them with additional funds. The corporations
may default on interest payments and therefore are considered the most risky as
a general proposition.
Q 2-5: From an issuer standpoint, what is the distinction
between Fannie Mae and Ginnie Mae?
Fannie Mae (Federal National Mortgage Association) was
created as a federally sponsored credit agency. Ginnie Mae (Government National
Mortgage Association) is a government agency. The securities of government
agency are guaranteed by government while those of the federally sponsored
credit agencies are not.
Q 2-6: Name and explain the difference between two types of municipal securities?
The two types of municipal securities are general obligation
bonds and revenue bonds. General obligation bonds are backed by the full faith
and credit of the issuer. The funds raised by these bonds may not produce
revenues and the issuer taxes the residents to pay for the bond interest and
principal. On the other hand, revenue bonds are repaid from the revenues
generated by the project, for which these securities were issued. Since the
interest payments on the revenue bonds are linked to the cash flows generated
by the project that the municipal government has funded through issuance of
bonds, the revenue bonds are considered to be more risky than the general
obligation bonds.
Q 2-7: What does it mean to say that investors in Ginnie
Mae face the risk of early redemption?
Ginnie Mae (Government National Mortgage Association)
purchases mortgages from the bank and thrift institutions and issues securities
against the assets bought. Although, by securitization, the default risk of
these securities is minimized, they pose uncertainty to the investors as they
can receive varying amounts of monthly payments depending on how quickly the
owners of the assets pay of their mortgages. Due to this fact, while the stated
maturity can be as long as 40 years, the average life of the security is much
shorter and many such securities experience early redemption as the mortgages
are paid off before maturity of the mortgage.
Q 2-8: What are the advantages and disadvantages of Treasury bonds?
The government issues treasury bonds for a long maturity
ranging from 10 to 30 years. These bonds carry very low risk as the bonds are
issued by the government and the return on these bonds is also very low as
compared to bonds of other issuers. These bonds generally experience a liquid
market. Where the liquidity and the low risk of the security can be viewed as
advantages of the bond, low return and usually long maturity can be considered
as disadvantages. Owing to the longer maturity, these securities are more
sensitive to interest rate changes. The newer types of Treasury bonds have more
advantages as they provide investors protection against inflation and
deflation. These bonds guarantee face value if the consumer prices drop—a guard
against deflation. Taxes are paid according to inflation adjustments, although
the actual cash is not received till maturity—a guard against inflation.
Q 2-9: Is there any relationship between a saving bond and a US Treasury bond?
A saving bond is a non-traded debt of the US government, is
non-marketable, non-transferable and non-negotiable. These bonds cannot be used
for collateral. When saving bonds are held for at least five years, the
investor receive higher of the market-based rate or a guaranteed minimum rate.
The market-based rate is calculated as 85 percent of the average return on
treasury securities with five years maturity. Hence, the rate of saving bond is
tied to the rate offered by Treasury securities.
Q 2-10: Why is preferred stock referred to as ‘hybrid’ security?
Preferred stock is an equity security with an intermediate
claim (between the bondholders and the common stockholders) on a firm’s assets
and earnings. Preferred stock is considered a hybrid security because it
carries the features of both equity and fixed-income instruments. As an equity
security, preferred stock usually has an indefinite life and pays dividends,
although some of the preferred stocks may have a maturity of 50 years. The dividend is fixed in amount and known in
advance, providing a stream of income very similar to that of a bond.
Q 2-11: Why is the common stockholder referred to as a residual claimant?
The common stockholders are referred to as residual
claimants as they are entitled to the remaining income after the fixed income
claimants (including the preferred stockholders) are paid in full. In case of
liquidation also, the stockholders would be considered as the residual
claimants, i.e. they would be paid if the claims of the bondholders and
preferred stockholders are paid off.
Q 2-12: Do all common stocks pay dividends? Who decides?
Dividends are payments regularly made by corporations to
their stockholders. They are decided upon and declared by the board of
directors and can range from zero to 100
percent of present and past net earnings. The common stockholder has no
specific promises to receive any cash from the corporation since the stock never
matures and dividends are not mandatory to be paid.
Q 2-13: What is meant by the term derivative security?
Securities that derive their value in whole or in part by
having a claim on some underlying security are known as derivative securities.
Options and future contracts are popular derivative securities.
Q 2-14: What is meant by the term securitization?
Securitization refers to the transformation of
illiquid, risky loans into more liquid, less risky securities by backing them
up with assets.
Q 2-15: Give at least two examples of asset-backed securities?
Asset-backed securities are those securities which have been
converted into more liquid and less risky assets through the process of
securitization. Pass-through securities and collateralized mortgage obligations
are two examples of asset-backed securities, which differ in maturity,
yields and face value.
Q 2-16: Why should we expect six-month Treasury bill rates
to be less than six months CD rates of six month commercial paper rates?
The Treasury Department is the issuer of treasury bills,
while banks and other financial institutions issue CDs and commercial papers.
The US government has no risk of default, whereas banks and other financial
institutions may default. Since the Treasury bill is a risk-free security, the
return offered on it would be lesser than any other security that carries some risk,
no matter how little.
Q 2-17: Why is the call provision on a bond generally a disadvantage to a bondholder?
The call provision gives the issuer the right to call
in the bonds, thereby depriving the investors of that particular fixed-income
security. Exercising the call provision usually takes place when market
rates drop sufficiently below the coupon rate on the bonds. Exercising call
provision helps the bond issuer to save money, by avoiding payments on a rate
higher than the market interest rates. Costs are incurred to call the bonds,
such as call premium and administrative expense. However, issuer expects to
sell new bonds at a lower interest rate, thereby replacing existing higher
interest cost bonds with new, lower interest cost bonds. However, some
investors who purchase the bond at a price above the face value may suffer
losses when the bond is unexpectedly called in and paid off.
Q 2-18: Is a typical investor more likely to hold
zero-coupon in a taxable account or a non-taxable account? Why?
A
typical investor would prefer to hold zero-coupon bonds in a non-taxable
account since the actual return of a security in a taxable account is expected
to be lesser than that of a non-taxable account. Zero coupon securities make no
coupon payments and the bond holder gets the benefit only at the time of
maturity when the implied interest is paid; however, the bondholder is taxed
every year
Q 2-19: What are the potential advantages and
disadvantages of DANs (Direct Access Notes) to investors compared to the
conventional bonds?
To
make bonds more accessible to individual investors, high credit quality forms
have started issuing direct access notes.
These notes eliminate some of the traditional details associated with
conventional bonds by issuing them at par value, which means no premium,
discount or accrued interest. Coupons are usually fixed on these notes and
maturities range from nine months to 30 years. The company issuing the bonds
typically “posts” the maturities and rates that it is offering for one week,
allowing the investors to shop around. Some companies act as the wholesalers of
these bonds to their extensive network of brokerage firms, from which the investors
would buy the bond. The brokerage firm buys the notes from the wholesaler at a
discount and pays the broker’s commission.
One
potential disadvantage of these notes is that they are best suited for
buy-and-hold investor. A seller has no assurance of a good secondary market for
the bonds, and therefore there is no assurance of the price that may be
received by selling these notes in the secondary markets.
Q 2-20: What is an ADR? What advantages do they offer to
investors?
American
Depository Receipts (ADRs) represent indirect ownership of a specified number
of foreign company shares. These shares are held on deposit in a bank, in the
issuing company’s home country, while the US banks, known as depositories,
issue the ADRs. In effect, ADRs are tradable receipts issued by depositories
that have physical possession of the foreign securities through their
correspondent banks or custodian abroad . The bank holding the securities
collect the dividends, pays any applicable foreign withholding taxes, converts
the remaining funds into dollars and pays the amount to the ADR holders.
Holders can choose to convert their ADRs into specified number of foreign
shares represented by paying a fee. This simplifies the process of investing in
companies outside US for investors.
Q 2-21: Of what value to investors are stock dividends and
splits?
Stock
dividend and stock splits attract considerable investor’s attention. With a
stock split the book value and the par value of the equity are changed. On
practical basis, there is a little difference between a stock split and a stock
dividend. The real question before the investor is that although the number of
shares owned has increased, but has anything of real value been received or
not? Other things being equal, these additional shares do not represent
additional value because proportional has not changed. Regardless of the above
mentioned fact, there is ample evidence that the stock price receives a boost
following a split. The company, which announces a split, seems confident about
its future prospects, which boosts the confidence of the investor.
Q 2-22: What are the advantages and disadvantages of being
a holder of a common stock of IBM as opposed to being a bondholder?
As
a bondholder of IBM, the investor would not find it hard to forecast the
returns as despite being a corporate bond, its ranking as investment grade
security suggests that the bond carries a little default risk. However, the
returns on the common stocks of IBM would be higher than that of bonds. Still there
is no certainty that the stream of dividends would remain stable. The risk
involved in common shares may be greater, but so is the return. The
shareholders also participate in the growth of the company’s profits. As the
profits will grow so would the dividend earned by the shareholders. However,
the bondholders do not get any such benefit with the growth of the company.
Q 2-28: Assume that a company in whose stock you are
interested will pay regular quarterly dividend soon. Looking in the Wall Street
Journal, you see a dividend figure of $3.20 listed for this stock. The board of
directors has received dividend payable on September 1, with a holder of record
date of August 15. When must you buy the stock to receive this dividend, and
how much will you receive if you buy 150 shares?
To
receive a declared divided, an investor must be holder of record on the
specific date a company closes its stock transfer book and compiles the list of
stockholders to be paid. The brokerage industry has established a procedure
according to which the right to dividend remains with the stock until four days
before the holder of record date. On fourth day , the right to dividend leaves
the stock. To be entitled to the dividend the stock needs to be bought before
August 12. If 150 stocks were to be bought a dividend of $3.20 per share would
provide the investor with 150 X 3.20 = $480
Problems
2-1: Assuming an investor is in the 15 percent tax
bracket, what taxable equivalent yield on must be earned on a security to equal a municipal
bond yield of 9.5 percent?
The
taxable equivalent yield can be calculated using the following formula.
TEY
= Tax-exempt municipal yield/ 1 – Marginal tax rate
TEY
= 0.095/ (1 – 0.15) = 0.095/0.85 = 0.111764 or 11.1764 percent
Q 2-2: Assume an investor is in the 36 percent tax
bracket. Other things being equal, after taxes are paid, would this investor
prefer a corporate bond paying 12.4 percent or a municipal bond paying 8
percent?
We
can compare the two bonds by finding the taxable equivalent yield of the
municipal bond
TEY
= Tax-exempt municipal yield/ 1 – Marginal tax rate
TEY
= 0.08/ (1 – 0.36) = 0.08/0.64 = 0.125 or 12.5 percent
Comparing
the rates of the two bonds, a municipal bond offering 8 percent is a better
choice.
Q 2-3: Assume an investor is in 31 percent federal tax
bracket and faces a 7 percent marginal tax rate. What is the combined TEY for a
municipal bond paying six percent?
To
calculate the TEY in such cases, first determine the effective state rate
Effective
state rate = marginal state tax rate X (1 – federal marginal rate)
Effective
state rate = 0.07 X (1 – 0.31) = 0.0483 = 4.83 percent
Then
calculate the combined tax rate
Combined
tax rate = effective state rate + federal rate
Combined
tax rate = 0.0483 + 0.31 = 0.3583 or 35.83 percent
Taxable
equivalent yield (TEY) = Tax-exempt municipal yield/ (1 – marginal tax rate)
Taxable
equivalent yield (TEY) = 0.06/ (1 – 0.3583) = 0.06/0.6417 = 0.0935 or 9.35
percent
ed to b� } s y xt� �?� o the chances of default by the corporation. Treasury bonds are issued by US
Government Treasury Department, and despite their long maturities, they are
considered less risky as
Q 1-18: Discuss some reasons why investors should be concerned with the
international investing? Do you think that the exchange rate value of dollar
will have nay effect on the decision to invest internationally?
A
global marketplace of round-the-clock investing opportunities is emerging.
Investors’ concern with the international market owes to the fact that the
revenue base of the multi-national companies could be abroad and they would
need to know how well these companies are performing in their homeland and
other exchanges. Investors should be aware of the capital flows from abroad
into domestic financial markets. These investments from abroad can
significantly influence the market performance. Another reason can be the high
rates of return by some market abroad. Adding foreign securities allows the
investor to achieve beneficial risk reduction through diversification of
portfolio.
Q
1-19: What is meant by the distinction between the old economy and the new
economy?
New challenges are facing
investors as a result of changes in the economic environment. In the past,
there was a one large financial market, with securities ranging from trading
minnows to corporate mammoths, from shaky companies to stable and successful
ones, from local to multinational firms. However, the changing economic
investment environment, the old rules and analysis procedures do not deem fit
to the new system. Old economy refers to the traditional ‘smokestack’ companies
and traditional services, consumer and financial companies. They produce goods
and services, sell them, show a profit and reward their stockholders fairly
consistently. These companies may have a lengthy history of success, but they
are not exciting for the investors in the present economic order.
On the other hand, the new
technology related stocks have produced nothing but losses in the beginning,
however, a firm like Amazon.com which had not been earning any profits
compelled the investors to pay as much as $500 for its scrip. Despite the new trends,
a sharp decline in the prices of technology shares makes one believe that the
old valuation model is still relevant and useful to the investors.
