Module 2: Inventorying the Major Asset Classes Flashcards
Identify the major asset classes held in Canadian registered retirement plan funds including an example of a type of security held in each major asset class.
An “asset class” is a group of securities that exhibit similar characteristics, behave similarly in the marketplace, and are subject to the same laws and regulations.
The major asset classes used by Canadian registered retirement plan funds are fixed income, equity, derivatives and alternative investments. Money market and bond securities fall within the asset class of fixed income. A stock falls within the asset class of equity. A futures contract is considered a derivative, while an investment in real estate is an example of an alternative investment.
Differentiate between the “money market” and the “capital market” and describe examples of securities included in each market.
Financial markets are traditionally segmented into money markets and capital markets. Bonds with maturities of less than one year are referred to as short-term securities or money market investments. As such, the money market is a subsector of the fixed-income market. Money market instruments include short-term, marketable, liquid, low-risk debt securities. Money market instruments are sometimes called “cash equivalents” or “cash.” Examples of money market securities are Treasury bills (T-bills), certificates of deposit (CDs), commercial paper and bankers’ acceptance (BA).
Capital market securities are much more diverse than those found in the money market and include longer term and riskier securities. Examples include bonds with maturities of greater than one year (longer term bonds), equities, and options and futures.
Outline basic characteristics of T-bills
T-bills provide the government with a way to raise money from the public. Investors buy T-bills at a price that is a discount from the stated maturity value. At maturity, the investor receives a payment from the government equal to the maturity value.
The difference between the purchase price and ultimate maturity value constitutes the investor’s earnings.
T-bills are purchased primarily by chartered banks, investments dealers, the Bank of Canada and individuals who obtain them on the secondary market from a government securities dealer. They are highly liquid, as they are easily converted to cash and sold at a low transaction cost with little price risk. They are offered in denominations of $1,000, $5,000, $25,000, $100,000 and $1 million.
Identify the primary reason registered retirement plan funds invest in money market instruments.
The primary reason registered retirement plan funds invest in low-risk T-bills and other money market securities is to meet liquidity needs. Holding such securities is usually regarded as equivalent to holding cash.
Outline basic characteristics of a certificate of deposit (CD).
A CD is a time deposit with a chartered bank. Time deposits may not be withdrawn on demand. The bank pays interest and principal to the depositor at the end of the fixed term of the deposit. Although CDs are not transferrable in Canada, some bank time deposits issued in denominations greater than $100,000 are negotiable—i.e., they can be sold to another investor if the owner needs to cash in the deposit before its maturity date. In Canada, these marketable securities are known as bearer deposit notes (BDNs).
Outline basic characteristics of commercial paper, and identify why it is issued.
“Commercial paper” (called “paper” or “notes”) is an unsecured debt instrument issued by a corporation. It is typically used to finance accounts receivable, inventories and short-term liabilities. Many firms issue commercial paper with the intent of rolling it over at maturity—that is, issuing new paper to obtain the funds necessary to retire the old paper.
Commercial paper maturities typically range up to one year. Longer maturities must be registered with the relevant securities commission, so they are almost never issued. It is most often issued with maturities of less than one or two months and minimum denominations of $50,000, and therefore, small investors can invest in commercial paper only indirectly, via money market mutual funds.
The debt is usually issued at a discount, reflecting prevailing market interest rates. Commercial paper is often backed by a bank line of credit, which gives the borrower access to cash that can be used, if needed, to pay off the paper at maturity. Almost all commercial paper is rated for credit quality by major rating agencies. It is a fairly safe asset because a firm’s condition can presumably be monitored and predicted over a term as short as one month. Since commercial paper is not backed by collateral, only companies with excellent credit ratings from a recognized credit agency will be able to sell paper at a reasonable price.
Outline basic characteristics of bankers’ acceptances. Identify where bankers’ acceptances are most widely used.
“Bankers’ acceptances” are money market instruments that consist of an order to a bank by a customer to pay a fixed amount at a future date, typically within six months. In return for a “stamping fee” (the fee charged by the bank for providing this guarantee), the bank endorses the order for payment as “accepted,” assuming responsibility for ultimate payment to the holder of the acceptance. This guarantee makes an acceptance second only to T-bills in terms of default security. At this point, the acceptance may be traded in secondary markets like any other claim on the bank. Acceptances sell at a discount from the face value of the payment order, just as T-bills sell at a discount from face value, with a similar calculation for yield.
Bankers’ acceptances are used widely in foreign trade where the creditworthiness of one trader is unknown to the trading partner. Traders can substitute the bank’s credit standing for their own.
Bankers’ acceptance rates are the main benchmark for Canadian-dollar interest rates known as the Canadian Dealer Offered Rate (CDOR), which serves both money and derivative markets.
Outline basic characteristics of repurchase agreements.
“Repurchase agreements” represent short-term borrowing in which a dealer sells government securities to an investor on an overnight basis. They include an agreement to buy back those securities the next day at a slightly higher price; the increase in the price is the overnight interest.
Explain the difference between “bond equivalent yield” used to quote yields for T-bills and the “effective annual yield” on a T-bill.
Financial pages report bond equivalent yields for T-bills rather than reporting their prices or their effective annual rates of return. The main difference between these concepts is that the bond equivalent yield uses simple interest based on a 365-day year, and the effective annual yield uses compound interest technique.
Explain how the formula used to calculate the bank discount yield for U.S. T-bills differs from the formula used to calculate the bond equivalent yield for Canadian T-bills and what this means for investors.
The calculation of the bank discount yield for U.S. T-bills uses a 360-day year (versus 365 days for Canada) and the par value of 1,000 in the denominator instead of price (P). To properly compare the returns for Canadian and U.S. T-bills, the same formula needs to be used for both.
Define the terms “principal,” “term to maturity,” “coupon rate,” “coupon payment” and “duration” in the context of bonds.
“Principal” is the amount the bond issuer agrees to pay on the date of maturity. Other terms for principal are “denomination” and “face value.”
“Term to maturity” is the time between the date a bond is issued and the date the bond issuer must pay the face value of the bond (called “redeeming the bond”) to the bondholder. The date when that occurs is the “maturity date” of the bond.
“Coupon rate” is the percentage of the bond’s face value that will be paid as income to the bondholder over the lifetime of the bond.
“Coupon payment” is the regular and fixed interest the bond issuer pays the bondholder. Usually paid on a semiannual basis.
“Duration” is a measure expressed as a number of years that can be used to identify the sensitivity of a bond’s price to a change in interest rates. Duration is calculated based on the bond’s features and its present value at time of calculation, and a higher duration (normally described as “longer”) shows that the bond has a greater sensitivity to changes in interest rates.
Explain the significance of “face value, “par,” “discount” and “premium” in the context of bonds. Provide an example.
”Face value” is the amount the bond issuer agrees to pay on the date of the bond’s maturity.
“Par,” “discount” and “premium” are used to describe the relationship between the face value of the bond to the current market, or trading, price of the bond. When the market value of the bond equals its face value, the bond is trading at “par.” For example, if the current price and face value are both $100, then the bond is trading at par. If the current price is lower than face value, the bond is trading at a discount, i.e. if the current price is $95 and face value is $100, the bond is trading at a discount. The bond is trading at a premium when the opposite occurs and the bond’s current price is above par—i.e., if the current price is $105 and face value is $100, the bond is selling at a premium.
Explain the concept of the yield curve as it applies to fixed income investments. Outline information that is revealed by the shape of the following curve.
A “yield curve” is a line that plots the interest rates of bonds (yields) with different maturity dates but equal credit quality at a set point in time. The graph shows a normal yield curve—Bonds with a long-term maturity have higher yields than shorter term bonds.
(Shape is the top left shape of a circle, so an arc with progressively decreasing slope)
Describe key risks associated with bonds and how investors can use bond rating services to assess their creditworthiness.
Inflation risk: The risk that the rate of inflation exceeds the rate of return, thus eroding the purchasing power of the bond.
Default risk: The risk that the issuer of the bond will not make payments as promised, e.g., in the event the issuer is bankrupt and insufficient assets exist to pay the bondholders.
Interest rate risk: The risk that a bond’s price will be negatively affected by changes in market interest rates.
Call risk: Callable bonds come with the risk that bond issuers exercise their right to repurchase the bond in advance of its maturity date, which results in the cessation of coupon payments.
Reinvestment risk: The risk that the future proceeds from bonds purchased will be reinvested at a time when interest rates have dropped.
Default risk can be assessed by an investor by making use of services offered by independent bond rating services. These include Standard & Poors (S&P), DBRS Morningstar, Moody’s and Fitch. These companies issue bond ratings that are based on their research into the financial status of the bond issuer, the nature of the obligations associated with their bonds and subsequent assessment of the likelihood of default. Each rating service has its own methodology, and each issues ratings using terms like AAA (highest rating), AA, BBB, etc. These letters indicate the likelihood that the issuer is financially strong and able to make the interest payments and repay the debt in full.
Compare Government of Canada, provincial and corporate bonds.
Government of Canada bonds are longer term marketable debt securities issued by the federal government. These bonds have varying maturities at issue date, ranging up to 40 years. They are generally noncallable and make semiannual coupon payments that are set at a competitive level designed to ensure their issue is at or near par value. (They are considered part of the money market when their term becomes less than three years.)
Provincial bonds are similar to federal government issues, with a variety of maturities and coupon rates. These securities are considered extremely safe assets, although not as safe as comparable Government of Canada bonds. Because of this, the yield of provincial bonds tends to be slightly higher than on Government of Canada bonds. The yield of provincial bonds also varies from province to province.
Corporate bonds enable private firms to borrow money directly from the public. These bonds are similar in structure to government issues. They typically pay semiannual coupons over their term to maturity and return the face value to the bondholder at maturity. They differ most importantly from government bonds in degree of risk; default risk is a real consideration in the purchase of corporate bonds.
Corporate bonds usually come with options attached. Callable bonds give the issuing firm the option to repurchase the bond from the holder at a stipulated call price. Retractable and extendible bonds give the bondholder the option to redeem the bonds earlier and later, respectively, than the stated maturity date. Convertible bonds give the bondholder the option to convert each bond into a stipulated number of shares of stock.
Explain how yield to maturity on Government of Canada bonds is reported.
Yield to maturity on Government of Canada bonds (also known as Canada bonds) is quoted on an annual percentage rate basis rather than as an effective annual yield.
This is calculated by determining the semiannual yield and then doubling it.
Describe basic characteristics of common stock.
“Common stocks,” also known as equity securities or equities, represent ownership shares in a corporation. Each share of common stock entitles its owner to one vote on any matters of corporate governance that are put to a vote at the corporation’s annual meeting, as well as to share in the financial benefits of ownership.
The two most important characteristics of common stock as an investment are its residual claim and limited liability features:
(1) Residual claim: In a liquidation of a firm’s assets, shareholders have a claim to what is left after all other claimants such as the tax authorities, employees, suppliers, bondholders and other creditors have been paid. Common shareholders are last in line of all those who have a claim on the assets and income of a corporation. For a corporation not in liquidation, shareholders have a claim to the part of operating income left over after interest and taxes have been paid. This may be paid in dividends or reinvested in the business to increase the value of the shares.
(2) Limited liability: This means the greatest amount most shareholders can lose in the event of failure of a corporation is their original investment. They are not personally liable for the firm’s obligations.
Differentiate between preferred stock and common stock.
“Preferred stock” has features similar to both equity and debt. Like a bond, it promises to pay to its holder a fixed amount of income each year, and it does not convey voting power regarding the management of the firm. Instead, owners of preferred shares have priority over owners of common stock at certain times.
The priority of preferred shareholders over common stockholders comes into play in two ways.
(1) Dividends payable to owners of preferred shares are normally fixed and cumulative. Therefore, if a corporation chooses not to pay a dividend in a given period, but does pay dividends in the future, owners of preferred shares will receive both their past and current dividends before the distribution of dividends to owners of common stock.
(2) In the instance of bankruptcy, after the corporation’s bondholders have been repaid, preferred shareholders have first claim on the corporation’s remaining assets.
Explain the terms “market capitalization,” “large cap stocks,” “mid cap stocks” and “small cap stocks.”
“Market capitalization” is the aggregate value of all outstanding shares, determined by multiplying the current stock price by the number of outstanding shares. In Canada (vs. the United States where the definitions vary), “large cap” generally means stocks of companies with market capitalization of $1 billion or higher, “mid cap” generally means stocks of companies with market capitalization of between $500 million and $1 billion, and “small cap” normally means shares issued by companies with market capitalization of less than $500 million.
Differentiate between a growth stock and a value stock.
A “growth stock” is stock of a company that is expected to experience above average growth compared to the average growth in the market. Issuers of growth stocks do not usually pay dividends because the companies normally want to reinvest earnings to accelerate growth in the short term.
A “value stock” is stock of a company that is considered undervalued when compared to an analysis of its financial status. Companies whose stocks are considered to be “value stocks” may be characterized by high dividend yields as well as low price-to-book and low price-to-earnings ratios. Investors believe value stocks will increase in value once the market recognizes the companies’ true values.
Provide an example of why a Canadian pension plan might invest in derivative investments.
A Canadian pension plan that invests in markets outside of Canada will experience both investment risk and foreign exchange or currency risk in respect of those nondomestic investments. Derivatives, if used prudently, can be used as a way to mitigate that currency risk.
Explain how the value of derivative assets is determined and name some examples of derivative assets.
“Derivative assets” provide payoffs that depend on the value of other assets, such as commodity prices or bond and stock prices, or on market index values. Their value is derived from, or contingent on, the values of other assets.
Options, futures contracts, warrants and swaps are all examples of derivative assets.
Explain the difference between a call option and a put option. Provide an example of each.
A “call option” gives its holder the right to purchase an asset for a specified price, called the exercise or strike price, on or before a specified expiration date. A “put option” gives its holder the right to sell an asset for a specified exercise price on or before a specified expiration date.
An illustration of a call option is the option to purchase 100 shares of XYZ stock for a $2 premium per share. The contract would expire in March and with a strike price of $75 per share. Suppose an investor purchases the option, in anticipation of the stock price increasing above $75 before March. The stock price increases in February to $85, the investor exercises his call option, purchasing 100 shares at $75, and then resells the shares on the open market for the market price of $85 per share. The investor spent $200 on the premium to purchase the option and $7,500 to buy the shares and then receives $8,500 upon selling the shares, resulting in a gain of $800. Had the market price stayed below the strike price through the period to the expiry date in March, the investor could have left the call option unexercised, and it would have expired without value. Cost to the investor was $200.
An illustration of a put option is the option to sell 100 shares of XYZ stock at a cost of $2 per share, expiring in 30 days, and with a strike price of $650. Suppose an investor purchases that option in anticipation of the stock price dropping below $650 within 30 days. The stock price drops to $625 in two weeks’ time and the investor exercises their option, selling 100 shares at $650. The investor spent $200 to buy the put option and receives $65,000, instead of receiving $62,500. Of course, if the market price stayed above the strike price through to the expiry date, the investor could have left the put option unexercised, and it would have expired without value.
Compare a futures contract to an option, and describe the structure of a futures contract. Use an example to contrast the long and short position in such a contract
Options contracts are just that—the purchaser of an option has no obligation to take action after the purchase of the option.
Futures contracts are different—they represent an obligation to either buy or sell an asset. A futures contract calls for delivery of an asset or its cash value at a specified maturity or delivery date for an agreed-upon price, called the futures price, to be paid at contract maturity. The long position is held by the trader who commits to purchasing the commodity on the delivery date. The trader who takes the short position commits to delivering the commodity at contract maturity.
For example, an investor who expects XYZ stock to increase in price in the coming months purchases a futures contract to buy 100 shares of XYZ at $50 in six months’ time. This investor is said to be “long” 100 shares of XYZ stock. Another party agrees to deliver the 100 shares of XYZ stock in six months’ time, at the same price. The second investor is said to be “short” 100 shares of XYZ stock.
The investor holding the long position profits from price increases—i.e., ignoring fees, the long position profits if the market value of the stock on the delivery date is greater than $50 and takes a loss if the market value of the stock on the delivery date is less than $50. In this situation, the short position’s loss equals the long position’s profit.
However, the investor holding the short-position (often referred to as a “shortseller”) profits when the stock price declines between the purchase of the futures contract and its delivery (maturity) date.
