Financial

Securities
LECTURE 7

Banking, Taxation & Audit

FN3002
Cyryx College
Ahmed Munawar@2020
 Financial Securities

• Financial securities are a tool used in financial

markets to match savers seeking an investment
opportunity with borrowers in need of capital.
• A financial security is a contract between
borrower and lender. Securities are owned by
the lender/investor.
• Each security specifies future compensation to
lender (return) and consequences if the
borrower does not pay

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 Debt and Equity

There are two major types of securities.

• Debt securities promise to pay the owner
according to a prearranged schedule.
• Equity securities make the owner also an
owner in the firm, with payment related to
the firm’s performance.
• Over ½ of U.S. households invest in/own
securities.

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 The Bond Market and Interest Rates
• A security (financial instrument) is a claim
on the issuer’s future income or assets.
• A bond is a debt security that promises to
make payments periodically for a specified
period of time.
• An interest rate is the cost of borrowing or
the price paid for the rental of funds.

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 The Bond Market and Interest Rates

Source: Federal Reserve Bank of St. Louis, FRED database:

https://fred.stlouisfed.org/series/TB3MS; https://fred.stlouisfed.org/series/GS10;
https://fred.stlouisfed.org/series/BAA

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 The Stock Market

• Common stock represents a share of

ownership in a corporation.
• A share of stock is a claim on the residual
earnings and assets of the corporation.

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 Stock Prices
Measured by the Dow Jones Industrial Average, 1950–2017

Source: Federal Reserve Bank of St. Louis, FRED database: https://fred.stlouisfed.org/series/DJIA

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 U.S. Debt and Equity Securities
Fourth Quarter 2004

Figure 2.2

The total amount of debt

and equity held is over
four times U.S. output.

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 Who Issues Securities?
Figure 2.3 Debt and Equity, By Issuer Fourth Quarter 2004

Debt and Equity, By User Fourth Quarter 2004

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 Debt and Equity (cont’d)

• Two features distinguish debt from equity:

• Maturity (length of time until the borrowed
funds are repaid)
– Debt instruments specify a maturity date; equity
owners may (seek to) liquidate at any time.
• Type of Periodic Payments Made
– Debt securities pay a specified amount of interest
(payments made in exchange for the use of
money in addition to the repayment of principal).
– Equities (may) pay a dividend (payment made
from the company’s earnings which is dependent
on the level of said earnings).

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 Who Owns Securities?
Figure 2.4 Debt and Equity, By Investor Fourth Quarter 2004

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 Pros and Cons of Debt Securities

Pros Cons
• principal is repaid and • payments do not
interest earned as increase if company
does better than
terms of contract
anticipated; potential
• fixed schedule of return is limited
payments to borrower • May be a short term
• debt owners repaid cash need on part of
before equity owners (borrowing) company
in bankruptcy

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 Pros and Cons of Equity Securities

Pros Cons
• Equity = ownership; • Dividends subject to
owners have input firm’s performance;
into operations and
not all pay dividends
are entitled to
dividends when paid • Equity owners last to
• If firm performs well, be repaid in
returns are nearly bankruptcy cases
unlimited

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 Prices of Securities

• Securities prices are determined by supply

and demand, no matter which market they
are traded in
• Savers will want to purchase more securities
the greater the return; borrowers are
interested in borrowing more at lower interest
rates
• Equilibrium prices and quantities vary as
market conditions change
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 Supply & Demand

• Quantity demanded depends on price: lower

price today implies higher quantity of
securities demanded
• Quantity supplied also depends on price:
lower price today implies lower quantity of
securities supplied

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 Supply & Demand (cont’d)

Figure 2.7 Supply and Demand for a Security

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 Shifts in Supply & Demand

• Shifts in supply and/or demand affect the

equilibrium price & quantity
• Businesses wanting to expand capacity in
anticipation of growth may borrow more,
increasing supply of their securities (a shift
to the right)
• Businesses fearful of a downturn may
borrow less, decreasing the supply of their
securities (a shift to the left)

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 Example: Supply Shift
Figure 2.8 Shift for a Security

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 The Financial System &
Economic Growth
• Businesses need funds to be able to invest in
capital goods in order to offer more and more
goods and services
– Retained earnings (past profits)
– New funds via borrowing (selling securities)
• Countries with efficient financial systems
grow faster than others
– Savers and borrowers are efficiently matched
– The costs of saving and investing are relatively
low

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 Broken Systems: The Asian Crisis

• October 1997 marked a rush of investors out

of Asia, a once-thriving area
– Few accounting standards to convey information
to investors about their investments
– Government involvement in the financial sector
– Weak banking systems & debt management
– Inconsistent plans for monetary policy & exchange
rates

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 What Do Investors Care About?
Five Determinants of Investors’ Decisions
1. Expected return (the gain the investor
anticipates making via the investment)
2. Risk (the degree of uncertainty regarding an
investment’s return)
3. Liquidity (the ease of converting an
investment into cash)
4. Taxes (How much will capital gains be taxed?)
5. Maturity (How long must the investor wait for
to earn a return?)

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 Expected Return
Return = current yield + capital-gains yield
• Current yield = income/initial value
• Capital-gains yield = capital gain/initial value
(note: capital gains yield may be negative, or a capital loss)

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 Risk
• Return is ALWAYS unknown; risk measures
the degree of uncertainty about future
returns

Sources of risk
– Default (when the borrower fails to make payment)
– Unexpected change in dividend
– Change in price of security
– Unexpected change in inflation rate

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 Quantifying Risk

• How far are possible returns from

expected return, and how likely are they?
• Tool for Measuring: standard deviation
– Standard deviation is the square root of the
average of squared deviations from the
expected return
– Standard deviation =
[p1 (X1 - E)2 + p2 (X2 - E)2 + . . . + PN (XN - E)2]1/2

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 Quantifying Risk (cont’d)

Interpreting standard deviations

• Higher standard deviation means a riskier security

• The likelihood of a security with a high standard

deviation meeting its expected return is lower

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 Liquidity

Liquidity: how easy it is to convert a

security (by buying or selling) into cash
• May also be thought of as ease of transferring
in the secondary market
• Only marketable securities are liquid
• The time and cost it takes to sell or buy are a
measure of liquidity
Why a concern? Investors may want or
need to sell a security prior to its maturity.

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 Taxes
• Interest and dividends earned are subject to
taxation; after-tax expected return is what
investors are ultimately concerned with
After-tax expected return
= (1 – tax rate) × pre-tax expected return
• Tax rate affects investment decisions; tax
avoidance and tax evasion may result
• Tax rates affect equilibrium security prices…tax-
exempt securities have lower pre-tax expected
returns

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 Maturity
• When does the investor get the principal
back?
• People have different preferences as a result
of different goals, stages of life, etc

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 Choosing an Investment Portfolio

• Portfolio = your collection of securities

• Investors care about return, risk, etc. of
whole portfolio, not each security
individually
– Diversify a portfolio to reduce idiosyncratic
risk (also called unsystematic risk) if the cost
to do so is low
– It is not possible to diversify market risk (also
called systematic risk); a diversified stock
portfolio reflects risk of entire stock market

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Choosing an Investment Portfolio (cont’d)

• The main trade-off when assembling a portfolio

is between expected return and risk
• Portfolios with higher expected returns also
have higher risk
• What should you do? The answer depends on
your preferences

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 Data Bank: Default Risk on Debt

• Corporations rated on financial strength by

Moody’s, Standard & Poors, and others
– Example: S&P
• AAA >AA>A>BBB>BB>B > CCC>CC>C>R>SD>D
• Could have a + or – to grade
• Investment grade is a rating of BBB or better;
ratings of BB and below have “significant
speculative characteristics”
• Investors trade off risk and expected
return, so interest rates reflect risk

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 Data Bank: Default Risk on Debt (cont’d)
Figure 2.A Interest Rates on Aaa versus Baa bonds

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 Default Risk on Debt (cont.)
Figure 2.B Risk Spread (Aaa vs. Baa)

• The risk spread on debt (the amount by which interest

rate is higher because of risk) varies over time
• Risk spread is strongly affected by the business cycle

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 Risk from Inflation
Figure 2.C Actual and Expected Inflation

• One of the most difficult tasks for investors is forecasting

inflation
• Example: In the 1970s, high unexpected inflation destroyed
much of investors’ wealth

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