Understanding Securities and Investments

Chapter 15

Understanding Securities and Investments

Chapter Overview

Stocks and bonds are called securities because they represent secured, or asset-based, claims on the part of investors.  Stocks represent an ownership stake, while bonds represent a financial stake.  Primary securities markets involve the buying and selling of new stocks and bonds, while secondary markets involve the trading of stocks and bonds that already exist.  Investment bankers specialize in issuing securities in primary markets.

Common stock affords investors the prospect of capital gains and/or dividend income.  Common stock value can be expressed in terms of par value, market value, and book value.  Market value – the current market price of one share of stock – is the most important to investors.  Preferred stock is less risky than common stock, offering the prospect of steadier dividend income, but lower potential gains.  Both common and preferred stock are traded on stock exchanges by “members,” who act as brokers, executing buy-and-sell orders for non-members.  Key U.S. exchanges include the New York Stock Exchange, The American Exchange, and NASDAQ.  Foreign exchanges are growing rapidly, providing competition for the leading U.S. exchanges.

A bond is essentially an IOU.  The issuer of a bond promises to pay the buyer a certain amount of money by a specified future date, usually with interest paid at regular intervals.  U.S. government bonds are issued by government agencies and institutions, municipal bonds are issued by state and local governments, and corporate bonds are issued by companies to gain long-term funding.  Bonds vary significantly in terms of safety.  The level of safety is rated by Moody’s and Standard & Poor’s.

Like stocks and bonds, mutual funds – organizations that pool investments to purchase portfolios of financial instruments – offer investors different levels of risk and growth potential.  Futures contracts – agreements to buy specified amounts of commodities at given prices on preset dates – are traded in the commodities market.  Futures trading is highly risky.

Many tools are available to help investors learn about investment options.  Key information sources include market indexes, and newspaper and online stock, bond, and OTC quotations.  After selecting a strategy, investors can place market orders to buy or sell at current prevailing prices.  But since investors do not know exactly when market orders will be executed, they may issue limit or stop orders that are to be executed only if prices rise to or fall below a specified level.  Round lots are multiples of 100 shares, while odd lots are fractions of round lots.  Financing options include purchasing on margin or as part of short sales.
The securities industry engages some self-regulation, but the Securities and Exchange Commission provides government regulation and enforcement to protect investors.

Chapter Objectives

Explain the difference between primary and secondary securities markets.

Discuss the value to shareholders of common and preferred stock and describe the secondary market for each type of security.

Distinguish among various types of bonds in terms of their issuers, safety, and retirement.

Describe the investment opportunities offered by mutual funds.

Explain the process by which securities are bought and sold.

Explain how securities markets are regulated.

 

REFERENCE OUTLINE

Opening Case:  The Street Hits the Wall

Securities Markets

Primary and Secondary Securities Markets—Investment Banking

 

Stocks

Common Stock—Investment Traits of Common Stock

Preferred Stock—Investment Traits of Preferred Stock

Stock Exchanges

The Trading Floor

Brokers

Discount Brokers

Online Trading

Full-Service Brokers

The Major Exchanges and the OTC Market

The New York Stock Exchange

The American Stock Exchange

Regional Stock Exchanges

Foreign Stock Exchanges

Over-the-Counter Market

NASDAQ and NASD

Bonds

U.S. Government Bonds

Municipal Bonds

Corporate Bonds

Interest Payment:  Registered and Bearer Bonds

Secured Bonds

Debentures

Secondary Markets for Bonds

 

Mutual Funds

Reasons for Investing

Making Choices for Diversification, Asset Allocation, and Risk Reduction

Diversification

Asset Allocation

Buying and Selling Securities

Financial Information Services

Stock Quotations

Bond Quotations

Mutual Fund Quotations

Market Indexes

The Dow

The S & P 500

The NASDAQ Composite

Placing Orders

Financing Purchases

Margin Trading

Short Sales

 

Securities Market Regulation

The Securities and Exchange Commission

Insider Trading

Blue-Sky Laws

LECTURE OUTLINE

Securities Markets  (Use PowerPoint 15.3.)

 

Stocks and bonds are referred to as securities because they represent secured claims on the part of investors.  Shares of stock represent ownership, whereas, bonds represent financial liability for money owed to bondholders by a company or the government.  Stocks and bonds are sold in securities markets.

Primary and Secondary Securities Markets  (Use PowerPoint 15.4.)

 

Newly-issued stocks and bonds are bought and sold in primary securities markets; existing stocks and bonds are actively traded in secondary securities markets.

Investment Banking.  Investment banks issue and resell new securities, as well as create the distribution networks for selling the securities.  Existing securities are sold in the secondary market, including the New York Stock Exchange.

 

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

Stocks

 

Common Stock  (Use PowerPoint 15.5, 15.6.)

Common stocks have the greatest potential for profit but are also the most risky.  Buyers of common stocks generally have voting rights.  Common stock values may be expressed as par value, market value, or book value.  Par value is the face value of a share of stock at the time of its original issue.  Market value is the current share price in the stock market.  Book value of common stock is stockholders’ equity divided by the number of outstanding shares.

Investment Traits of Common Stock.  Growth prospects in various industries change from time to time.  Blue chip stocks are stocks of well-established firms that consistently provide investors with secure income from dividend payouts.

 

Preferred Stock  (Use PowerPoint 15.7.)

Preferred stock is usually issued with a stated par value; dividends are expressed as a percentage of par value.  Preferred stocks are less risky because they have first rights to dividends.

Investment Traits of Preferred Stock.  Most preferred stock is cumulative, with missed dividends paid as soon as the firm is able to pay.  All late dividends must be paid to preferred stockholders before firms can pay dividends to common stockholders.

 

Stock Exchanges  (Use PowerPoint 15.8, 15.9.)

A stock exchange is an organization of individuals that provide an institutional setting in which stock can be bought or sold.  Exchange members purchase “seats” that allow them to make trades.  Seats may be bought or sold.

The Trading Floor.  Each exchange governs the places and times when trading occurs.  Trading is allowed only on the trading floor.

 

Brokers.  Brokers receive and execute orders from non-exchange members and earn commissions as a result.

Discount Brokers.  These brokers are fast and low-cost, providing no advice or sales consultations.

 

Online Trading.  This is possible via convenient access to the Internet; this is ideal for self-directed investors.

Full-Service Brokers.  Consulting advice and financial planning are provided here.

 

The Major Exchanges and the OTC Market.  The two major exchanges in the United States are the New York Stock Exchange and American Stock Exchange.

The New York Stock Exchange (NYSE).  More than half of all shares traded are done so on the NYSE; firms must meet certain requirements to be listed on the NYSE.

 

The American Stock Exchange.  AMEX accounts for 3 percent of all shares traded on U.S. exchanges; requirements for listing are less stringent than those of the NYSE.

Regional Stock Exchanges.  Seven regional stock exchanges serve investors outside of New York.  Many firms list their stocks regionally, as well as on one of the national exchanges.

 

Foreign Stock Exchanges.  Transactions on U.S. exchanges are second to those on Japanese exchanges.  New exchanges have emerged in many parts of the globe, including Shanghai, China and Warsaw, Poland.

Over-the-Counter Market.  The OTC has no trading floor.  The privilege of trading in the OTC market is granted by federal regulators and by the NASD.

 

NASDAQ and NASD.  NASD focuses solely on securities regulation and includes every broker/dealer in the U.S., whereas, NASDAQ is a telecommunications system that broadcasts trading information on an intranet to 350,000 terminals.  NASDAQ is an electronics network that can replace trading floors of traditional exchanges.

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

Bonds  (Use PowerPoint 15.10, 15.11.)

 

The U.S. government, municipalities, and corporations supply the U.S. bond market.  Some publications rate bond quality according to default risk, which is the likelihood that promised payments will be deferred or even missed.

U.S. Government Bonds

 

The federal government issues a variety of government bonds, including T-bills, Treasury notes, and Treasury bonds, in order to finance its debt.  Government agencies also issue bonds.  Because they are backed by the federal government, government bonds are the safest investment available.

Municipal Bonds

 

State and local governments issue municipal bonds to finance school and transportation systems, as well as other projects.  Investors do not pay taxes on interest received.

Corporate Bonds  (Use PowerPoint 15.12.)

 

Maturities on corporate bonds range from 10 to 30 years.  Longer-term corporate bonds are somewhat riskier than shorter-term bonds.  Good sources to help investors evaluate risk are Standard & Poor’s and Moody’s.

Interest Payment:  Registered and Bearer Bonds.  Registered bonds register the names of holders with the company, which mails out the checks; bearer bonds require bondholders to clip coupons from certificates and send them to the issuer to receive payment.

 

Secured Bonds.  With secured bonds, issuers can reduce risk to holders by pledging assets in case of default.  These bonds are usually backed by mortgages or other assets.

Debentures.  Debentures are unsecured bonds that have an inferior claim on corporate assets.  Holders do have claims against property not otherwise pledged in the company’s other bonds, though no specific property is pledged as security.

 

Secondary Markets for Bonds

Almost all secondary trading in bonds occurs in the OTC market.  Riskier bonds fluctuate more widely than higher-grade bonds.

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

Mutual Funds  (Use PowerPoint 15.13.)

 

Mutual funds pool investments from individuals and organizations to purchase a portfolio of stocks, bonds, and short-term securities.  No-load funds do not charge investors sales commissions when shares are bought or sold; load funds charge investors commissions ranging from 2 to 8 percent.

Reasons for Investing

 

Mutual funds are flexible in their investment goals.

Making Choices for Diversification, Asset Allocation, and Risk Reduction

 

Diversification.  Through diversification, investors buy several kinds of investments rather than one kind; this strategy reduces investor risk by “not having all eggs in one basket.”

Asset Allocation.  Asset allocation is the proportion of funds invested in each of the investment alternatives.

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

Buying and Selling Securities

 

The buying and selling of securities includes deciding your investment objectives, selecting a broker, opening an account, and placing an order.

Financial Information Services  (Use PowerPoint 15.14, 15.15, 15.16.)

 

Stock Quotations.  Daily NYSE transactions are reported in numerous sources.  Stock prices are stated as dollars per share with the smallest fraction of a dollar being 1/8, or 12 ½ cents.  Cash dividends and dividend yield, price/earnings ratio, the current price of the stock divided by the firm’s current annual earnings per share, number of shares, high, low, close, and net change are generally shown.

Bond Quotations.  These quotations contain the same type of information as stock quotations, as well as the year of maturity.

 

Mutual Fund Quotations.  In these quotations, each fund’s objective is reported; each fund’s recent and long-term performance is ranked against other funds with similar objectives.

Market Indexes.  Market indexes summarize trends.  Bull markets are periods of increasing stock prices; bear markets are periods of decreasing stock prices.

 

The Dow.  The Dow Jones Industrial Average is the sum of market prices for 30 of the largest industrial stocks listed on the NYSE. 

The S & P 500.  This index consists of 500 stocks; the S & P is a broader market measure.

 

The NASDAQ Composite.  All NASDAQ companies are included, which makes this index more critical than others according to some analysts.

Placing Orders  (Use PowerPoint 15.17.)

 

A market order signals a broker to buy or sell a security at the current market price.  A limit order authorizes the purchase of a stock if its price is less than or equal to a specified amount.  A stop order authorizes the broker to sell if a stock price falls to a certain level.  Round lots are 100 shares of a stock; odd lots are fractions of round lots.

Financing Purchases

 

Margin Trading.  Buying on margin allows the buyer to put down a portion of the stock’s price while borrowing the balance from the broker.

Short Sales.  In a short sale, the buyer borrows a security from the broker, sells it, and restores an equal number of shares of the issue to the brokerage at a later date, along with a fee.  A falling stock price yields a profit for the buyer.

 

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

Securities Market Regulation  (Use PowerPoint 15.18.)

 

The Securities and Exchange Commission  (SEC)

The SEC oversees many phases in the security issuance process to protect investors and to maintain functioning markets.  A detailed prospectus is filed by the firm with the SEC to protect investors from fraudulent issues.

Insider Trading.  Insider trading is the use of special knowledge about a firm for profit.

 

Blue-Sky Laws.  Blue-sky laws require that securities be registered with state officials.

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

Answers to Questions and Exercises

Questions for Review

What are the purposes of the primary and secondary markets for securities? 

 

The purpose of the primary market is to sell newly issued stocks and bonds, while the purpose of the secondary market is to trade existing stocks and bonds. 

Which of the three measures of common stock value is most important?  Why?

 

Many experts believe that market value is the most important measure, since it reflects investors’ willingness to invest in a company at any given time.

How do government, municipal, and corporate bonds differ from one another?

 

Government bonds are issued by the Treasury and various federal agencies to finance the work of the government.  These bonds are the safest.  Municipal bonds are issued by state and local governments to finance schools, transportation, and other projects.  These bonds are relatively safe.  Corporate bonds are issued by companies to fund long-term capital needs.  They may be registered or bearer, and secured or unsecured.  These bonds vary greatly in terms of safety.

How might an investor lose money in a short sale of a security?

 

In a short sale, the buyer borrows a security from the broker, sells it, and restores an equal number of shares of the issue to the brokerage at a later date, along with a fee.  A falling stock price yields a profit for the buyer.

How does the Securities and Exchange Commission regulate securities markets?

 

The SEC monitors many phases in the securities issuing process in order to protect investors and maintain smoothly functioning markets.  For instance, the SEC helps prevent fraud by requiring a detailed prospectus from every firm issuing a new security, and enforces laws against insider trading.

Which U.S. stock market has the largest volume of trade?

NASDAQ has the largest volume of trade, although the total market value of NASDAQ’s U.S. stocks is only about one-half of NYSE.

Questions for Analysis

Suppose you decide to invest in common stocks as a personal investment.  Which kind of broker – full-service or online discount – would you use for buying and selling?  Why?

 

Answers will vary, but students should recognize that achieving results without a full-service broker would probably require much more time spent on research.

Which type of mutual fund would be most appropriate for your investment purposes at this time?  Why?

 

Answers will vary, but students should consider their financial goals and risk tolerance.

Using a newspaper, select an example of a recent day’s transactions for each of the following:  a stock on the NYSE, a stock on AMEX, a stock on NASDAQ, a bond on the NYSE, and a mutual fund.  Explain the meaning of each element in the listing.

 

Answers will vary, but most stock listing will include the year’s high and low prices, the stock’s symbol, the annual dividend payable, the price-earnings ratio, the volume of shares traded, the day’s high and low prices, the closing price, and the net change from the previous day’s closing price.  Bond quotations also reveal the bond’s year of maturity.  Mutual fund quotations list each fund’s objective as well as ranking each fund’s recent and long-term performance against other funds with similar objectives.

Application Exercises

Interview the financial manager of a local business or your school.  What are the investment goals of this person’s organization?  What securities does it use?  What advantages and disadvantages can you see in its portfolio?

 

Answers will vary.

Either in person or through a toll-free number, contact a broker and request information about setting up a personal account for trading securities.  Prepare a report on the broker’s policies regarding the following:  buy/sell orders, credit terms, cash account requirements, services available to investors, and commissions/fee schedules.

 

Answers will vary depending on the broker.

Answers to Building Your Business Skills

Do you see any similarities in the movement of the various stocks during the same period?  For example, did the stocks move up or down at about the same time?  If so, do you think the stocks were affected by the same factors?  Explain your thinking.

 

Many factors, both internal and external, affect stock prices, such as the firm’s earnings, layoffs, labor problems, management issues, and mergers, as well as the state of the industry in general and any threats of political crisis, weather conditions, interest rate changes, and inflation and unemployment data and forecasts.

Based on your analysis, did internal or external factors have the greatest impact on stock price?  Which factors had the most long-lasting effect?  Which factors had the shortest effect?

 

Answers will vary.

Why do you think it is so hard to predict changes in stock price on a day-to-day basis?

 

Answers will vary, but students should acknowledge the difficulty of both knowing all possible information about factors that affect stock price and judging accurately what kind of effect those factors will have.

Answers to Exercising Your Ethics

Why might a conservative versus risky choice be different at a not-for-profit organization than at a for-profit organization?

 

The choice might be different since the ultimate goal of a business is to maximize profit, while the ultimate goals of a not-for-profit organization is to provide a service efficiently.

What are the main ethical issues in this situation?

 

The main ethical issues in this situation are how to best fulfill YDC’s responsibility to the students it serves, while most effectively stewarding the money entrusted to the organization through charitable donations.

What actions should the board take?

 

Answers will vary.

Classroom Activities

Divide the class into groups of three.  Ask each group to research the stock market history of three competing companies (within the same industry).  (Each student within each group should be responsible for researching one company.)  Students should pay particular attention to rises and falls in the stock price, providing possible explanations for those rises and falls.  Students in each of the groups should then compare their three companies to determine whether a rise/fall pattern existed for the entire industry or whether the rise/fall pattern was company-specific.

 

Ask students to assume they have been given $10,000 to invest in mutual funds.  Ask the students to collect prospectuses from a few mutual fund companies – such as Janus, T. Rowe Price, Fidelity, Scudder, etc.  Then ask the students to determine the levels of risk and potential returns associated with each of the various funds they are researching.  Which funds will they invest in?  Will they diversify?  If so, how?