Chapter 3

Card 1: Types of Securities

  • Classification:

    • Interest-Bearing Assets: Debt obligations providing interest payments.

      • Subtypes: Money market instruments and fixed-income securities.

    • Equities: Ownership shares in corporations.

      • Subtypes: Common stock and preferred stock.

    • Derivatives: Financial instruments deriving value from other assets.

      • Subtypes: Futures and options contracts.

Card 2: Interest-Bearing Assets

  • Money Market Instruments:

    • Characteristics:

      • Short-term debt (less than one year).

      • Single future payment.

    • Examples:

      • Treasury bills (T-bills).

      • Certificates of deposit (CDs).

      • Commercial paper.

    • Gains/Losses:

      • Fixed returns unless borrower defaults.

    • Pricing:

      • Sold at a discount; yields are quoted.

Card 3: Money Market Instruments Over Time

  • Interest Rates Trend:

    • 2020: Low yields, possibly near zero.

    • 2021: Slight increases in rates.

    • 2022: Continued upward trend in yields.

    • 2024: Rates may have stabilized or continued to adjust.

Card 4: Fixed-Income Securities

  • Characteristics:

    • Longer-term debt (more than one year).

    • Regular interest payments (coupons) and return of principal at maturity.

  • Examples:

    • Treasury notes and bonds.

    • Corporate bonds.

    • Car and student loans.

  • Gains/Losses:

    • Interest income.

    • Price changes due to interest rate fluctuations.

    • Default risk.

Card 5: Fixed-Income Securities Quotes

  • Key Components:

    • Coupon Rate: Annual interest as a percentage of face value.

    • Maturity Date: When the principal is repaid.

    • Ratings: Creditworthiness indicators (e.g., Moody's, S&P).

    • Price: Quoted per $100 of face value.

    • Yield to Maturity (YTM): Expected return if held to maturity.

Card 6: Equities - Common Stock

  • Definition: Shares representing ownership in a corporation.

  • Rights:

    • Voting on corporate matters.

    • Share in residual assets upon liquidation.

  • Gains/Losses:

    • Price appreciation or depreciation.

    • Dividends (not guaranteed).

  • Factors Influencing Prices:

    • Company performance.

    • Market conditions.

    • Investor sentiment.

Card 7: Equities - Preferred Stock

  • Characteristics:

    • Fixed dividends.

    • Priority over common stock in dividends and liquidation.

  • Gains/Losses:

    • Steady income from dividends.

    • Limited potential for price appreciation.

Card 8: Common Stock Price Quotes

  • Components:

    • Ticker Symbol: Unique identifier for a company's stock.

    • Last Trade Price: Most recent price at which the stock traded.

    • Change: Difference from previous closing price.

    • Volume: Number of shares traded.

Card 9: Factors Impacting Stock Prices (Fama-French)

  • Market Risk Premium: Return over the risk-free rate (CAPM Beta).

  • Size Effect (SMB): Small-cap vs. large-cap performance.

  • Value Effect (HML): High book-to-market vs. low book-to-market stocks.

  • Additional Factors:

    • Environmental, Social, and Governance (ESG) considerations.

    • Free cash flow.

    • Management characteristics (education, experience).

    • Political connections.

    • Gender diversity in leadership.

    • Systematic and idiosyncratic risks.

Card 10: Stock Market Anomalies

  • January Effect: Tendency for stocks, especially small caps, to perform well in January.

  • Sell in May and Go Away: Belief that stock performance is weaker from May to October.

  • Market Overreaction: Investors may overreact to news, causing price swings.

  • Investor Sentiment and Attention: High media coverage can influence stock prices.

Card 11: Derivatives

  • Definition: Financial instruments deriving value from underlying assets.

  • Primary vs. Derivative Assets:

    • Primary Asset: Issued by businesses/governments (e.g., stocks, bonds).

    • Derivative Asset: Value based on primary assets (e.g., options, futures).

Card 12: Futures Contracts

  • Definition: Agreement to buy or sell an asset at a future date at a predetermined price.

  • Types:

    • Financial Futures: Based on financial instruments (e.g., stock indices, currencies).

    • Commodity Futures: Based on physical commodities (e.g., oil, wheat).

  • Gains/Losses:

    • Profit or loss depends on the difference between contracted and market prices at maturity.

    • Potential for significant gains or losses.

Card 13: Futures Contracts Quotes

  • Components:

    • Contract Name: Specifies the underlying asset.

    • Settlement Date: When the contract expires.

    • Price: Agreed-upon price for future delivery.

    • Change: Price movement from the previous day.

    • Open Interest: Number of outstanding contracts.

Card 14: Option Contracts

  • Definition: Gives the holder the right, but not the obligation, to buy or sell an asset at a specified price within a certain time.

  • Types:

    • Call Option: Right to buy.

    • Put Option: Right to sell.

  • Key Terms:

    • Strike Price: Price at which the asset can be bought or sold.

    • Premium: Price paid for the option.

    • Expiration Date: Last date the option can be exercised.

    • American Option: Can be exercised any time up to expiration.

    • European Option: Can only be exercised on expiration date.

Card 15: Options vs. Futures

  • Obligations:

    • Futures: Both parties are obligated to transact at the set price on expiration.

    • Options: The buyer has the right, not the obligation; the seller has the obligation if the buyer exercises.

  • Payment:

    • Futures: No upfront payment; profits/losses realized at settlement.

    • Options: Buyer pays the premium upfront.

Card 16: Potential Gains/Losses - Call Options

  • Buyers (Long Call):

    • Profit: When market price > strike price + premium.

    • Maximum Loss: Limited to the premium paid.

    • Maximum Gain: Theoretically unlimited.

  • Sellers (Short Call):

    • Profit: Limited to the premium received.

    • Maximum Loss: Theoretically unlimited if the stock price rises significantly.

Card 17: Potential Gains/Losses - Put Options

  • Buyers (Long Put):

    • Profit: When market price < strike price - premium.

    • Maximum Loss: Limited to the premium paid.

    • Maximum Gain: Limited to strike price minus premium (if stock price falls to zero).

  • Sellers (Short Put):

    • Profit: Limited to the premium received.

    • Maximum Loss: Strike price minus premium (if stock price falls to zero).

Card 18: Option Contracts Quotes

  • Components:

    • Underlying Asset: The stock or commodity.

    • Strike Price: Exercise price of the option.

    • Premium: Cost to purchase the option.

    • Expiration Date: When the option expires.

    • Volume and Open Interest: Trading activity and number of contracts.

Card 19: Investing in Stocks vs. Options

  • Direct Stock Investment:

    • Capital Required: Price per share times number of shares.

    • Potential Return: Gain or loss based on price movement.

    • Risk: Loss limited to initial investment.

  • Option Investment:

    • Leverage: Control more shares with less capital.

    • Potential Return: Higher percentage gains due to leverage.

    • Risk: Premium paid can be lost entirely if the option expires worthless.

Card 20: Calculating Option Gains/Losses

  • Call Option Gain:

    • Formula: (Market Price - Strike Price - Premium) × Number of Shares.

  • Put Option Gain:

    • Formula: (Strike Price - Market Price - Premium) × Number of Shares.

  • Breakeven Point:

    • Call Option: Strike Price + Premium.

    • Put Option: Strike Price - Premium.

Card 21: Factors Influencing Option Prices

  • Intrinsic Value: Difference between the stock price and strike price (for in-the-money options).

  • Time Value: Potential for price movement before expiration.

  • Volatility: Higher volatility increases option premiums.

  • Interest Rates: Impact the cost of carry for options.

  • Dividends: Expected dividends can affect option pricing.

Card 22: Risks of Derivatives

  • Leverage Risk: Small price movements can lead to large gains or losses.

  • Counterparty Risk: The risk that the other party may default.

  • Liquidity Risk: Difficulty in entering or exiting positions.

  • Complexity: Understanding the terms and conditions is crucial.

Card 23: Useful Internet Resources

  • Bond Information:

    • Investing in Bonds: Basic bond education.

    • FINRA: Regulatory information and TRACE data.

  • Stock and Option Information:

    • Yahoo Finance: Quotes and financial news.

    • Market Data Centers: Futures and options quotes.

  • Educational Platforms:

    • The Motley Fool: Investment advice and education.

    • CME Group: Information on futures markets.

    • CBOE: Options trading resources.

Card 24: Key Takeaways

  • Understanding Security Types: Essential for building a diversified portfolio.

  • Interest-Bearing Assets: Provide income and can be low-risk.

  • Equities: Offer growth potential but come with higher risk.

  • Derivatives: Useful for hedging and speculation but require careful consideration due to leverage and complexity.

Card 25: Review Questions

  1. What are the main differences between common and preferred stock?

    • Common stock represents ownership with voting rights and variable dividends. Preferred stock has fixed dividends and priority over common stock in dividends and liquidation but typically lacks voting rights.

  2. How do futures contracts differ from option contracts?

    • Futures involve an obligation for both parties to transact at a future date, with no upfront premium. Options grant the right but not the obligation to buy or sell, requiring the buyer to pay a premium.

  3. What factors impact the pricing of an option?

    • Stock price, strike price, time to expiration, volatility, interest rates, and dividends.

  4. Why might an investor choose to use derivatives?

    • For hedging against price movements, leveraging positions, or speculating on future price changes.