Transcript Lecture 5

Investment
Analysis II
MGMT-6330 Investment Analysis II
Asset Classes, Commodities and
Derivatives
Investment Analysis II - © 2012 Houman Younessi
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Investment
Analysis II
Asset Classes
In order to have a diversified portfolio, we need to understand various asset
classes as investment options.
Assets are often classified into two distinct classes:
Traditional Assets, and
Alternative Investments
There is no fundamental economic difference between these classes
except that alternative investments generally:
Are less liquid
Are more difficult to value
Have limited historical risk and return data
Compared to traditional assets
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Investment
Analysis II
Alternative Asset Classes
Investment Funds
Investment funds are intermediaries that invest investor pooled funds for a fee.
The investor usually receives a share of the fund proportional to his/her investment.
Investment funds are either managed or unmanaged.
Unmanaged funds are also called Unit Investment Trusts
and hold a fixed portfolio for the life of the trust and is often
tax exempt. Unmanaged funds are usually ready to redeem
investors’ shares immediately at market value.
Managed funds are in turn classified in terms of their
readiness to redeem investors’ funds.
shares
Open-end funds (Mutual Funds) do redeem
at request
Closed-end funds do not . Instead they issue
that are then traded on secondary markets
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Investment
Analysis II
Traditional Asset Classes
Traditional asset classes include:
Domestic equity
U.S. treasury bonds
U.S. municipal bonds
International developed market equity
International emerging market equity
U.S. blue chip corporate bonds
Cash
We have already
studied these in
Investment Analysis I
and earlier in this
course
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Investment
Analysis II
Alternative Asset Classes
Alternative asset classes include:
Investment Funds
Tangible Assets
Commodities
Absolute Return Investments
Derivatives and Exotics
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Investment
Analysis II
Alternative Asset Classes
Investment Funds
Valuation
The basic valuation metric is Net Asset Value (NAV), the per share value of the
investment company’s assets minus its liabilities. The most significant liability
comes from fees owed to investment managers (if any).
For unmanaged and open-end investment funds, the share value is the NAV as
they stand ready to redeem at market value.
For closed-end funds, the share price is determined in a secondary market and
may be at a premium to the NAV or at a discount to it.
Fees are usually calculated as a % and are
either one-time or periodic (e.g. annual). Onetime fees may be front-end loaded (a % of
purchase) or back-end loaded (a % of value at
exit). Back-end charges may be declining
(reduce as you stay in the fund)
Investment
Analysis II
Alternative Asset Classes
Investment Funds
Exchange Traded Funds (ETF)
ETFs allow investors to buy or sell exposure to an index through a single
financial instrument. They trade on a stock market just as shares of any
individual company.
ETFs have many advantages:
Can assist in diversification. With a specific type of ETF
(say an equity-oriented ETF), the investor can gain
exposure to different types of capitalization (large cap,
mid cap, etc.), style (value or growth), sector, industry or
country or region.
ETFs trade as stock and can be sold long or short or
bought on margin.
Traditional mutual-funds often are traded only once a day
at closing, ETFs trade throughout the day.
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Investment
Analysis II
Alternative Asset Classes
Investment Funds
Exchange Traded Funds (ETF)
ETFs advantages (cont’d):
For many – if not most – ETFs, there exists futures
and options contracts on the same index.
ETF portfolios are published on a daily basis whereas
other funds are only published quarterly at best.
ETFs are cost efficient. You can buy exposure with
one transaction that otherwise would require
establishing an entire portfolio wit many individual
transaction fees
ETFs are cost effective. There are no load fees, and
the expense ratio can be held low as there is no
shareholder accounting at the account level.
Dividends are reinvested immediately whereas for
mutual funds timing of reinvestment varies.
Investment
Analysis II
Alternative Asset Classes
Investment Funds
Exchange Traded Funds (ETF)
ETFs dis-advantages:
In many countries, actively traded ETFs track
only a narrow-based index, such as only
large-cap stocks. No ETFs are often available
for mid and small cap investments. This is
NOT the case in the US.
Some ETFs do not have sufficient trading
volume to have a small bid-ask spread.
ETFs are often of limited use to very large
institutional investors as they can invest
directly in an index (roll their own). The costs
may be less and the tax situation usually
better.
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Investment
Analysis II
Alternative Asset Classes
Risks of ETFs:
Investment Funds
Exchange Traded Funds (ETF)
The following are the risk elements that must be considered when valuing an
ETF. Note that not all risks impact all ETFs uniformly:
Market risk: Like all other market based investments, the value/price of
an ETF (NAV) changes with the changes in the market.
Asset class/sector risk: Any asset class or sector may underperform
the market.
Trading risk: As there may always be market impediments, the ETF
may trade at a discount to its NAV.
Tracking error risk: ETFs are constructions. They are designed to track
their corresponding index closely. They cannot guarantee this.
Country and currency risk: ETFs may be subject to unfavorable
fluctuation in currency or stability of the country in which the ETF has
invested.
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Investment
Analysis II
Alternative Asset Classes
Investment Funds
Exchange Traded Funds (ETF)
Applications of ETFs
Implementing asset allocation: ETFs can be used to effect asset allocation
among baskets of stocks, bonds and other assets
Diversifying sector or industry exposure: ETFs can be used to diversify away the
sector or industry specific event risks
Gaining exposure to specific market on a broad basis
Equitizing cash: By investing in ETFs investors may be able to put idle cash to
good short-term use
Adjusting the portfolio: Investors can use ETFs to quickly adjust exposure to an
industry or sector to re-align an overall strategy
Applying sophisticated tactics: Investors can long, short, leverage and time ETFs
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Investment
Analysis II
Alternative Asset Classes
Tangible Assets
Tangible assets, as opposed to financial assets, are those assets that may be
touched and seen in themselves in addition to their ownership documents.
Tangible assets come in a wide variety including:





Land
Buildings
Natural resources (timber, minerals, fish)
Vehicles (e.g. ships), containers, etc.
Artworks
We will concentrate on Real Estate (land, buildings and land based
resources), as it is by far the largest section of this category
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Investment
Analysis II
Alternative Asset Classes
Real Estate
Real estate investments may be actual (tangible) or derivative (intangible).
Actual real estate may be:
Non-value added (land)
Value-added (land and buildings)
Value-adding real estate (timberland, mines, etc.)
Derivative real estate investment are securities derived from the sale of real estate
or related to the sale of real estate (such as buying mortgages or mortgagebacked security bundles)
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Investment
Analysis II
Alternative Asset Classes
Real Estate
Forms of Real Estate Investment
Free and clear holding: Unencumbered full ownership rights for an indefinite period
Leveraged equity: Full ownership rights for an indefinite period encumbered by
debt (a promissory note unrelated to the real asset under consideration) or a
mortgage (a pledge that in case of inability to discharge the debt, the ownership
would transfer to the mortgagor)
Mortgages: Loans secured by the underlying real estate made to third parties
Aggregation vehicles: Aggregates investors and gives them access to real estate
investment to which they may not otherwise have access. Real Estate Limited
Partnerships (RELP) and Real Estate Investment Trusts (REIT) are examples of
these aggregation vehicles
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Investment
Analysis II
Alternative Asset Classes
Real Estate
Valuation
Real estate valuation is very difficult
One often has to estimate the actual value of the asset, AND the value of the
potential “value added” income streams, AND the on-going cost of ownership
Note that:
Properties are immovable and usually indivisible
and as such usually very illiquid
Properties are only approximately comparable in
value
There is no national or international real estate
auction market, to determine values by
consensus
Transaction costs and management fees are
usually very high
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Investment
Analysis II
Alternative Asset Classes
Real Estate
Valuation
Basically there are four approaches:
1. The replacement cost approach:
How much would it cost today to replace this real asset? Of course one
needs to estimate the value of land (an independent exercise), PLUS
estimating today’s cost of the current improvements.
This approach is limited in value as a) we
still need to estimate the value of the land,
and b) the market value of a building may
differ enormously from its construction cost
(an office building may be very valuable
because it has some prestigious, long term
tenants)
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Investment
Analysis II
Alternative Asset Classes
Real Estate
Valuation
2. The sale comparison approach:
How does this property compare to a similar property whose value is
known, or the median or average of a collection of “similar” properties.
A variation called hedonic valuation is when the major characteristics of
a property are evaluated on an ordinal (1-10) or absolute ($) scale and
and used to modify the estimate.
This approach has
become standard in
valuation of residential
properties and its use in
commercial appraisals is
increasing
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Investment
Analysis II
Alternative Asset Classes
Real Estate
Valuation
3. The income approach:
This method uses a perpetuity discount model to value real estate.
The perpetuity is the annual Net Operating Income (NOI). NOI is gross
potential income minus expenses including vacancy, collection losses,
insurance, property taxes, repairs, utilities, and maintenance costs.
Appraisal rate = NOI ÷ Market Cap Rate
where Market Cap Rate = Benchmark NOI ÷ Benchmark Transaction Price
Benchmark may be a single property or the average or median of a number
of properties
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Investment
Analysis II
Alternative Asset Classes
Real Estate
Valuation
4. The discounted after-tax cash flow approach:
This method is based on the fact that an investment is worthwhile when its
expected net present value is positive. Alternatively, the investment yield
(internal rate of return) should exceed the investor’s required rate of return.
WORKSHOP
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Investment
Analysis II
Alternative Asset Classes
Commodities
While investing in most stocks and in corporate bonds allow the investor to invest
in an economy’s manufacturing and service sectors, and government bonds
allow investment in the government, commodities allow investment in the primary
production of an economy.
Commodities generally come in three categories:
Agricultural and farming products (soft
commodities:
Fibers, grains, livestock,
beverages (coffee, cocoa, etc) ,
spices, dairy
Energy:
Oil, gas, electricity
Minerals:
Gold, silver, copper,
coal, aluminum
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Investment
Analysis II
Alternative Asset Classes
Commodities
Most investors do not wish to store grain or oil or tend to animals. Very few
investors (as opposed to consumers) buy the actual commodity.
Investment in commodities is usually indirect by way of:
Future contracts
Commodity or inflation indexed bonds
Stock of primary production companies
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Investment
Analysis II
Alternative Asset Classes
Commodities
Futures Contracts
As we have learned, a futures contract is a standardized, exchange-traded
agreement between two parties in which the buyer agrees to buy an asset from
the seller at a future date at a price agreed upon at contract time.
Futures contracts are the easiest and cheapest way to invest in commodities.
There are two types of commodities futures indices:
Broad-based (tracker)
Investible Index
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Investment
Analysis II
Alternative Asset Classes
Commodities
Futures Contracts
Broad-based Tracking Indices:
Several commodity indices have been developed. Some traditional indices are
broadly based and have a global perspective and aim to track the changes in
input prices.
Investible Indices:
are in turn based on a limited basket of the most liquid commodity futures
contracts so they can be easily replicated by taking proportional positions in the
participating commodities. For example, the Goldman Sachs Commodity Index
(GSCI) is a world-production weighted index of 24 commodities with liquid
futures contracts
Although available elsewhere, commodities usually have their own
exchanges. For instance the Chicago Mercantile Exchange (CME)
is the largest of its kind in the US.
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Investment
Analysis II
Alternative Asset Classes
Commodities
Commodity-Linked Bonds
During inflationary periods, many governments have
been forced to offer loans (bonds) with coupons or
principal indexed to either the price of a specific
commodity or an inflation index.
Examples are: The Gilt in Britain (based on the price
of gold and introduced in the 1980s) and the
Treasury Inflation Protected Securities (TIPS). The
principal is indexed to the consumer price index CPI
and as such (somewhat indirectly) to commodity
prices.
Many other countries such as France, Australia,
Sweden, Canada, and Italy have offered bonds
based on the price of gold, oil, or agricultural
products.
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Investment
Analysis II
Alternative Asset Classes
Commodities
Stock of Primary Production Companies
BHP Billiton (BHP) is an Australian conglomerate involved in oil production, oil
exploration, gold mining, agriculture, coal, bauxite, and commodities
management. Of course buying a share of BHP Billiton would be investing in a
diversified basket of commodities!!
There are many companies similar to BHP and those that are more focused on
a single or narrow range of commodities such as Exxon-Mobil. Single product
mining companies are a good example of a stock very directly influenced by the
price of the underlying product.
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Investment
Analysis II
Alternative Asset Classes
Commodities
Investment Features
Commodities tend to have positive correlation with inflation
They tend to have a low or negative correlation with stocks
Supply and demand clearly has a determining role in the price of commodities as
often do weather and fuel (transportation) costs.
The general growth in population and demand from emerging nations would in
long-term help to increase all commodity prices
Improvements in technology, transport and means of production would tend in
long-term to lower commodity prices.
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Investment
Analysis II
Alternative Asset Classes
Commodities
Investment Examples
Futures:
Cocoa (CJ, CC); Coffee (C, KC, KT, KO); Corn (ZC); Cotton (TT, CT)
Company Stock:
Monsanto (MON); Deere and Co. (DE); Bunge (BG)
Funds:
DB Agriculture Fund (DBA); MLCX Grains Index (GRU); Dow Jones USB
Cocoa Total Return (NIB); Dow Jones USB Sugar Total Return (SGG)
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Many investments seek above market returns (alpha) through pursuing
opportunities that do not correlate with specific market securities, indices or
securities markets. In fact, the only way to generate alpha is to go beyond the
characteristics and provisions of the market.
There are two ways of creating such absolute return:
Working outside the “market”
Playing “against” the market
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Private Equity Investing
Working outside the markets means creating absolute return and hopefully
absolute value, by working outside or almost outside the context of the public
securities market.
Private Equity Investment is the means by which an investor can play outside or
almost outside the securities markets sandbox. There are several approaches:
 Venture capital investing
 Privatization through buy-outs, takeovers,
(management buy-outs), and leveraged buy-outs
 Vulture (distressed asset) Investing
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Playing against the market means using hedging and other techniques to try to
create opportunities to reduce or eliminate risk or increase return not normally
available in the regular market.
Although the original “hedge funds” were funds that used hedging to secure
an advantage, today this term is applied to a wide variety of funds whether or
not they engage in hedging. Colloquially, a hedge fund these days is any fund
that:
 Uses sophisticated means and vehicles of
investing to isolate specific bets to generate alpha
 Is focused on performance relative to a preassigned benchmark
 Has greater flexibility (fewer constraints) in how it
can invest
 Has a small and “elite” client base with high barrier
to entry
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Private Equity Investing
Private equity investing has several characteristics that although some are
common to other alternative investing in general, make private equity investing
what it is:
 Illiquidity
 Long term commitment required
 Difficulty in valuation
 Limited historical risk and return data
 Investor (equity company) and
management mismatch
 Hands-on
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications
 Long/Short (Real Hedge) Funds
 Market-Neutral Funds
 Macro (Global Macro) Funds
 Managed Futures Funds
 Emerging Markets Funds
 Emerging Sectors Funds
 M&A Arbitrage Funds
 Fund of Funds Funds
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications
Long/Short funds are traditional hedge funds, taking short
and long bets in generally common stocks. They vary their
long and short exposures according to forecasts, use
leverage and operate on numerous markets throughout the
world. They often maintain net positive or net negative
positions.
These funds are seeming the simplest in terms of philosophy
but often amongst the most sophisticated in terms of
execution and technology (they need to be).
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications
Market neutral funds attempt to hedge against a general market
movement. They take bets on valuation differences of individual securities
or funds within some market segment. This could involve simultaneous
long and short positions in closely-related securities with a zero net
exposure to the market itself. A market-neutral portfolio is usually
constructed so it is:
Dollar neutral (equal $ value of long and short positions)
Beta neutral (total sensitivity of long positions equal that of short positions)
Long positions may be (usually are) in stocks considered undervalued, and
the shorts are in stock considered overpriced.
Leverage is generally and often liberally used to enhance the returns
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications
Global Macro Funds take bets on the direction of a market,
a currency, an interest rate, a commodity, or any
macroeconomics variable. These funds tend to be highly
leveraged and make extensive use of derivatives.
There are many sub-groupings but three are particularly
prominent:
Managed Futures Funds
Emerging Markets Funds
Emerging Sectors Funds
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications
Managed Futures Fund are pools in which fund managers take bets on
directional moves in the positions they hold (long or short) usually in a
single asset class, such as currency, fixed income, or commodities and
tend to use many actively traded futures contracts.
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications
Emerging–markets funds primarily take bets on all types of
securities in emerging markets. The securities in these
economies are usually less efficient and less liquid than those
in the developed markets thus allowing for greater arbitrage
potential. But as there typically is not an organized lending
market for securities, it is difficult to sell short or leverage
most positions. Emerging markets represent growth but they
also tend to be more volatile and subject to political and
currency risks.
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications
Emerging-sectors funds primarily take bets on all types of
securities in emerging sectors and technologies. These securities
are usually subject to a good deal of growth although there is a
corresponding level of volatility. As emerging sectors are by
definition new, there is little historical data to guide investment.
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications
Merger and acquisition arbitrage funds bet on the price difference
between the stock price of a company just before merger or acquisition
goes through and the acquisition strike price. Before the effective date of
a merger, the stock of the acquired company will typically sell at a
discount to its acquisition value as officially announced. A hedge fund
manager simultaneously buys stock in a company being acquired and
sells short stock in the acquirer.
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Classifications
Funds of funds have been created to allow easier access to hedge funds
by small investors. An FoF has access to a large potential investor base
(albeit each may invest a much small amount; that is the point) but has
enough funds to invest in a variety of hedge funds thus providing retailing,
access, diversification, and expertise to those who otherwise may not be
able to enjoy these in the context of multiple hedge funds.
There are drawbacks with FoFs. They have fees of their own on top of the
base hedge fund fees, their performance will be diversified (diluted) if not
all funds perform. Also, as funds in FoFs are selected based on past
performance, they may be already passe by the time they make it into a
FoF.
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Investment
Analysis II
Alternative Asset Classes
Absolute Return Investments
Hedge Funds
Sources and Indices
There are literally thousands of hedge funds around. To be able to operate as a
true hedge fund, they are not allowed (by the SEC) to advertise for the purpose
of investor solicitation. However, there are several firms, banks, index providers
and even educational institutions that provide indices in which these funds can
“volunteer”.
These include:
Specialist firms: Hedge Fund Research, Van Hedge, Hennessee,
Greenwich
Banks: Credit Suisse/Tremont, ABN AMRO EurekaHedge
Index providers: MSCI, S&P, FTSE
Educational Institutions: CISDM (Umass), EDHEC (school in France)
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Investment
Analysis II
Derivatives
The previous pages show us that we no longer live and invest in the simple world
of stocks and bonds. Many new instruments have emerged, several – if not most
– of which no longer represents a direct investment in an asset but ones that offer
a return based on the return of another underlying asset. These are called
derivatives.
Derivative: A financial instrument that offers a return based on the return of
some other underlying asset.
Derivatives are called thus as their value is
derived from the return of the underlying asset
A derivative is a contract that
initiates on a certain date and
terminates on a later date. Often
(but not always) the payoff is
determined on the expiration date
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Investment
Analysis II
Derivatives
Types of Derivatives
There are two distinct but ultimately related markets for derivatives. Derivatives
may be:
Exchange traded contracts: which
have standard terms and features
and are traded on an organized
trading facility/exchange such as a
futures exchange or an options
exchange.
Over-the-counter contracts: which
are transactions created by two
parties but not traded on an
exchange and usually representing
a “private” deal vis a vis an
underlying. This could be a wide
array of deals including purchasing
of insurance.
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Derivatives
Forms of Derivatives
There are two distinct forms of derivatives. Derivatives may be:
Forward commitments: which are
agreements between two parties in
which one party agrees to buy from
the other party an underlying asset
at a future date at a price
established at the start.
Contingent claims: which are
derivatives in which the payoff
occurs if a specific event occurs.
We generally call these types of
claims as options.
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Derivatives
Forms of Derivatives
Forward Commitments
Forward commitments come in three categories:
Forward contracts or Forwards: This is a
forward commitment in which the two
parties “privately” design and therefore
customize the deal. The underlying could
be anything from a pizza to Pizza Hut Inc.
Swaps: which are a variation of a forward
contract (actually it is simply a series of
forward contracts) in which the parties
agree to swap a series of future cash
flows. Generally at least one cash flow’s
value is determined by a later outcome
Futures contracts: which are a variation
of a forward commitment that is a
public, exchange-traded, standardized
transaction the protection re the default
on which is guaranteed by the
exchange. Futures are available on a
wide range of commodities, currencies,
stocks, funds, etc.
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Derivatives
Forms of Derivatives
Contingent Claims
Warrants
Options are by far the largest category of contingent claims. Other forms of
contingent claims (all having option-like features) are:
Warrants: are issued by the firm whose stock (sometimes bonds) serves as the
underlying. At the time of issue, a warrant entitles the holder to purchase one
share of the stock for the appropriate exercise price. Further stock splits may
alter the proportion, always reflecting the original offer. The major differences
between warrants and call options are that:
Warrants have longer expiry than call options,
sometimes they are perpetual;
Warrants are dilutive, when a warrant is
exercise, the company must issue new stock;
Most warrants are over-the-counter
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Investment
Analysis II
Derivatives
Forms of Derivatives
Contingent Claims
Callable/Putable Bonds
Callable/Putable bonds: We have seen these before (lecture 3). A
callable/putable bond gives the issuer/buyer the right to redeem the bond for a
pre-agreed price before the maturity or (in rare occasions) under certain prespecified conditions).
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Investment
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Derivatives
Forms of Derivatives
Contingent Claims
Convertible Bonds
Convertible bonds: Again, we have seen these before. A convertible bond is a bond
that carries the right at the holder’s option (the contingent claim) to convert it to
another security, often common stock.
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Investment
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Derivatives
Forms of Derivatives
Contingent Claims
Asset-backed Securities
Asset-backed Securities represent a claim on a pool of securities which may be
mortgages, automotive loans, bonds, and similar instruments. As borrowers
always have the option to pre-pay these loans when interest rates are favorable
(re-finance), they hold an option. The investor who buys into the pool of such
loans, is in fact selling an option.
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Investment
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Derivatives
Forms of Derivatives
Contingent Claims
Options
All contingent claims have an option (in the sense of a choice to take action) at
their core. As such one can consider them all as types of option instruments
(some do).
A proper option however is usually a standardized, more often than not
exchange traded instrument that has a contract associated with it called a term
sheet that at a minimum specifies the following:
The underlying asset
The right(s) or exercise terms, (call/put)
Settlement terms (e.g. deliver the underlying or an equivalent value)
Expiration date
Strike price (the price of the underlying)
Option price (the premium payable/paid to hold the option)
We shall study options and their pricing in the next lecture
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