Bonds and equities
The main types of financial securities are bonds and equities.
Bonds are debt instruments. They are a contract between a borrower and a lender in which the borrower commits to make payments of principal and interest to the lender, on specific dates. In return, the lender provides a loan to the borrower. The borrower is the issuer of the bond, and the lender is the bondholder. The interest payments are also known as coupons.
The main components of a bond are:
Maturity – this is the date when the bond must be repaid
Principal or face value – this is the amount that will be repaid at maturity (for instance, $1,000)
Coupon – this is the interest rate paid by the issuer of the bond, applied to the face value.
Bonds are issued by governments (Government or Treasury bonds), local governments (Municipal bonds) and corporations (Corporate bonds).
The market price of a bond is computed as the value of the future payments, discounted at an appropriate rate of interest. We discount future payments to account for the time value of money. Time value means we prefer to receive a payment of money sooner rather than later. Discounting also takes into account the opportunity cost of investing in the bond, meaning what we could do with our money if we were not investing in the bond.
For instance, if a bond with a three-year maturity promises to pay a fixed annual coupon of $40 and the principal $1,000, and if the relevant rate of interest for discounting is 5%, the market price of the bond is:
Thus, the value of the bond, ie, its market price, is $972.77. You will notice the interest rate used to discount the bond payments (5% in this case) is not necessarily the same as the interest rate used to calculate the coupon payments (4%). Notice also how payments that will be received further into the future are discounted more than payments that will be received sooner.
Ordinary shares, or common stock, represent a share of ownership in a corporation. Shareholders are regarded as the owners of the corporation and usually have the right to vote. They are entitled to the residual profits of the company after all other claims are satisfied. Shareholders are also entitled to receive dividends, although companies are usually under no obligation to pay dividends to ordinary shares.
Preferred stock, or preference shares, confer to their holders the right to receive a claim on the firm’s earnings, before dividends on ordinary shares can be paid. Preferred stock is also a senior claim on the firm’s assets in the event of a liquidation of the company. They are therefore a less risky form of investment than common stock.
What do you get if you hold a stock for a period of time? If the stock price goes up over the period you make a capital gain. If the stock price goes down you make a capital loss. And you receive a dividend payment if one is made. If we express these relative to the initial value of the stock, this is known as the total holding period return:
where are the dividends paid on the stock, is the value of the stock at the start of the period, and is the value of the stock at the end of the period. The difference is the capital gain on the stock; if it is negative, it is the capital loss.