Core Investment Alternatives all this is fair game on the 1st exam

Amazing as it may seem, a single dollar invested in a typical small companys stock in 1926 would have grown to over $12,231 by the beginning of 2010 a compound annual growth rate of about 11.9%. What if youd put it in a typical large companys stock? It would have done well, earning a compound growth rate of about 9.8%. However, that 2.1% difference in return between the small stock and the large stock adds up over time. With the large company stock, you would have ended up with about $2,592 about 79 percent of what your small stock investment grew to. How about if you would have put that same dollar in Treasury bills? In that case, your investment would have only grown to $21 -- a compound annual growth rate of 3.7 percent. Do these numbers mean that you should invest in only small stocks and avoid large stocks and Treasury bills? Heck no. What it shows is that small differences in rates of return add up dramatically over time. It also shows that there are a lot of investment alternatives out there, and as we will see, there is a time and place for all of them. The purpose of this write-up is to introduce you to the basic types of investment alternatives out there. In follow-up courses, and later in this course, we will revisit these investment choices in much more detail, but for now this introduction will help you in reading the Wall Street Journal and in following whats happening in the investment markets.

Investment Choices
Today there are more investment choices than ever. Fortunately, the choices arent as hard to understand as you might think . In fact, there are only three basic categories of investments. Learn these first, then --as you will see later -- the distinction between these categories can blur.

Lending Investments. Money market instruments and bonds --basically debt instruments issued by corporations and by the government -- are examples of lending investments.

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Ownership Investments. Common stocks and preferred stocks, are investment vehicles that represent an ownership position in a corporation. Income-producing real estate is also an ownership investment.

Derivative Investments. Derivatives are investments that get, or derive, their value from the price of a specified asset. These investments involve contracts that give the contract holder the obligation or choice to buy or sell a specified asset over or at a specified time period.

Lets take a closer look at these investment categories.

Lending Investments
Whenever you put money in a money market account, or buy a bond, youre actually lending someone your money. The amount youve lent them is your investment. The returns from your investment come in the form of interest. The debt markets are generally talked about as if they were two markets set apart by the length of the obligations, with short-term, highly marketable debt considered money market or cash investments and long-term debt considered capital market investments. Money Market or Cash Investments

Money market or cash investments are short-term debt or IOUs that are highly marketable with original maturities of one-year or less; as a result, they can be converted into cash at little or no cost or penalty. Examples include savings accounts, money market mutual funds, certificates of deposit (CDs), and Treasury bills.

Savings Accounts. Most people know what savings accounts are. A savings account is an interest-earning account at a commercial bank, savings and loan association, or credit union. You deposit your money at the financial institution and your deposit earns a stated interest rate. With a savings account, you have the ability to withdraw as much of your savings as you want, any time you want. Money Market Mutual Funds. A money market mutual fund works much like an interest-bearing checking account. You generally get interest that is tied to short-term

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interest rates as well as limited check-writing privileges. When you invest in a money market mutual fund, your money is pooled with the money of other investors. A professional investment manager from the investment company operating the fund invests your money for you.

CDs. Certificates of deposit (CDs) are a type of money market or cash investment in which you receive a fixed rate of interest and are required to keep your funds on deposit for a set period of time -- anywhere from 30 days to several years. The longer the time period for which the funds are tied up, the higher the interest rate you get on the CD. Because the interest rate is generally fixed, if interest rates drop you still receive the promised rate. If interest rates rise, the interest you receive on your CD stays fixed at its lower rate.

In addition, the rate your CD earns depends on its size. Generally, the bigger the CD you purchase, the higher the interest rate youll receive. One downside of investing in a CD is that if you need your money before the CD matures, you may face an early withdrawal penalty.

Treasury Bills. Another common type of money market investment is the U.S. Treasury bill, or T-bill. Treasury bills are short-term notes of debt issued by the federal government, with maturities of from 4 weeks to one year. The minimum denomination, or face value, is $1,000. When you purchase a T-bill, you dont receive any interest payment. Instead, your interest comes in the form of appreciation. That is, you pay less than its face value, and when the T-bill matures, you receive its full face value. One benefit of money market or cash investments is their liquidity. Liquidity means having access to your money when you need it. You can access your money market fund at any time simply by writing a check. Funds invested in Treasury bills and many CDs must remain invested until they mature if you are to receive the rate that you were promised when you made the investment. However, if you need the money earlier, you can either sell the Treasury bill or cash in your CD.

Another benefit of money market investments is their stability. Because money market investments generally invest in only high quality borrowers for a brief period, there is little

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chance that you will lose money. This investment alternative is a good place to put your emergency funds money you might need at a moments notice.

The primary drawback of money market investments is that while your investments are safe, the interest rates they pay are low. In fact, the rates they pay tend to be close to the rate of inflation. So, while money market investments are a good place to put emergency money, they dont work well for long-term investments. Commercial Paper. Commercial paper refers to short-term, unsecured promissory notes sold by large corporations to raise cash. In effect, they are corporate IOUs. Because they are unsecured, they are primarily issued by large corporations with strong credit ratings. They come in denominations that range from $5,000 to $5 million, or even more. They also have very short maturities, ranging anywhere from 3 days to 270 days in length. Notes with maturities greater than 270 days are very rare because they have to be registered with the Securities and Exchange Commission a task firms avoid whenever possible because it is time consuming and costly.

These notes are generally sold on a discounted basis meaning you buy them for less than you get back at maturity. For practical purposes, there is no active trading in commercial paper. Thus, when youre evaluating commercial paper as a possible investment, you should plan on holding it until maturity. Fixed-Income Securities

Fixed-income securities are long-term borrowing instruments such as Treasury notes and bonds, federal agency debt, and municipal and corporate bonds. It is common to refer to fixed-income securities as bonds, although the term fixed-income securities covers more than bonds. With a fixed-income security, you know your return ahead of time. It has a set maturity date, at which time the bond terminates and the investor gets the money he lent. The face value of the bond, which is the amount you receive when the bond matures, is also called the par value or principal.

Bonds vary according to the issuer, maturity, and credit quality. Corporations, the Federal government, municipalities, and federal agencies all issue bonds, and the bonds

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they issue can vary dramatically in maturity. Bonds with maturities of less than five years are considered short-term; those with maturities of five to 10 years, intermediateterm; and those with maturities greater than 10 years, long-term. The credit quality of bonds can also vary dramatically, ranging from Treasury bonds, which are backed by the full faith and credit of the Federal government, to corporate high-yield or junk or high risk bonds which which could easily default on their payments. As we know from Investment Principle 3, the more risk, the higher the return. So, the lower the credit quality, the higher the interest rate on a bond.

Treasury Bills, Notes, and Bonds. The U.S. federal government is a big player in the debt markets owing to the huge deficits it has built up over the past 20 years. When the government spends more than it takes in, its choices are to print more money, sell some of its assets, or borrow money. Unfortunately, the countrys deficit is usually too large to be handled by simply printing more money. Selling assets the White House, for instance is politically infeasible. So the government has to borrow, and it does so through Treasury bills, notes, and bonds. Federal debt is generally categorized by its length of maturity: Treasury bills, which we just discussed and are considered money market instruments because of their short maturities usually have maturities of less than one year; Treasury notes have maturities of one to 10 years; and Treasury bonds have maturities of greater than 10 years at the time of issuance. The government issues these fixed-income securities in denominations that begin at $1,000 and range upward to $1,000,000.

Federal Agency Debt. There are also federal credit agencies that issue bonds. Some of these agencies are part of the federal government, while others are federally sponsored. The distinction is that debt issued by federal agencies is fully guaranteed by the Treasury, while debt issued by federally sponsored agencies is not guaranteed by the federal government, although federally sponsored agencies do have the right to draw on Treasury funds up to a set level. The Government National Mortgage Association, or Ginnie Mae, and the Tennessee Valley Authority, or TVA, are federal agencies, while the Federal National Mortgage Association, the Federal Home Loan Mortgage Association, the Federal Home Loan Bank, the Farm Credit System, and the Student Loan Marketing Association are all federally sponsored agencies. All of these agencies are extremely safe investments.

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Municipal Bonds. Debt issued by state and local governments to finance schools and hospitals, build roads, bridges, and the like are municipal bonds. These bonds fall into two basic categories, revenue bonds and general obligation bonds, and most are issued in units of $5,000. A revenue bond is a municipal bond that is backed by income from a specific project. For example, it may be used to finance a toll road and the revenue from that toll road would be designated to pay that bonds interest and principal. A general obligation bond, in contrast, is a municipal bond that is backed by only the full faith and power of the municipality. Unfortunately, in the past, some municipalities have not honored their payment obligations.

The advantage of municipal bonds is that interest from these bonds (but not capital gains) is exempt from federal income tax and, if the bonds are issued in the investors state of residency, they are also exempt from state taxes. The same goes for local taxes if the investor lives in the locality that issued the bonds. Because of this tax advantage, these bonds generally pay less than taxable bonds.

To compare municipal bonds with taxable bonds we need to calculate an equivalent taxable yield. This formula assumes that the bond is selling at par, that is, there is no income from capital gains. The equivalent taxable yield is that rate that a taxable bond would have to pay in order to match the return on the municipal bond after taking taxes into consideration. To do this, we need to divide the tax-free rate by 1 minus the investors marginal tax rate.

equivalent taxable yield = tax-exempt yield/(1 marginal tax rate)

(2-1)

For example, if you were considering a taxable bond with a yield of 6.8 percent and a municipal bond with yield of 5.0 percent, which would be best assuming your marginal tax rate was 28 percent? In this case, the equivalent taxable yield would be 6.9444 percent [5.0/(1 - .28)], making the municipal bond best on an after-tax basis. For an investor in the 25 percent tax bracket, the equivalent taxable yield would be 6.6667 percent [5.0/(1 - .25)], and in this case the taxable bond would be best. In effect, since different investors have different marginal tax rates, the equivalent taxable yield will be

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not be the same for everyone. The higher the individuals marginal tax rate, the higher the equivalent taxable yield.

Example Equivalent Taxable Yield Assume you are in a 30% tax bracket and you are considering two bonds, one of which is tax-exempt. The yield , or measure of return, on the tax-exempt municipal bond is 7.0 percent, and the yield on the taxable corporate bond is 9.6 percent. Which one delivers the highest after-tax yield? To answer this we must convert the tax-exempt yield to an equivalent taxable yield otherwise we are comparing apples to oranges. To do this you can calculate the equivalent taxable yield for the municipal bond and then compare the two bonds: equivalent taxable yield = tax-exempt yield/(1 marginal tax rate) = 7.0%/(1 - .30) = 10.0% Or, you could use that same equation to solve for the tax-exempt yield on the corporate bond and then compare this to the yield on the municipal bond which is tax-exempt. In effect, if we just compared apples to apples, were now comparing oranges to oranges: equivalent taxable yield = tax-exempt yield/(1 marginal tax rate) tax-exempt or after-tax yield = taxable yield (1 marginal tax rate) = 9.6 (1- .30) = 6.72% Either way you calculate it, for this example, youre better off with the tax-exempt bond.

Corporate Bonds. Most corporate bonds trade in units of $1,000. The quality level of bonds issued by corporations matches the quality of the issuing corporation and varies dramatically from one corporation to another. Over the life of the bond, you receive semi-annual interest payments, which remain the same over the life of the bond. The coupon rate is the actual rate of interest the bond pays. On corporate bonds as will all bonds, the amount of interest you receive annually is equal to the coupon rate times the face value. Most bonds have fixed interest rates, but some have variable or floating rates that change periodically to reflect current interest rates.

Lets assume, for example, that you buy a General Electric bond with a face value of $1,000, a coupon rate of 8 percent, and a maturity of 10 years. That means youll receive $80 ($1,000 X .08) each year in interest payments made in two semi-annual installments of $40 each year until the bond matures. Then at maturity youll receive the

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face value of $1,000 back from General Electric and the bond will be terminated. It doesnt matter what you paid for the bond when you bought it -- it could have been more or less than $1,000, --youll still receive the face value back when the bond matures.

With lending investments, you usually know ahead of time exactly what your return will be, which isnt always a good thing. For example, say you own a bond with 10 years until maturity that pays eight percent interest a year and suddenly inflation climbs to 16 percent. The result will be that your return will not keep up with inflation. However, if inflation drops to zero, your eight percent may look even better than it did when you purchased the bond.

The biggest problem with corporate bonds, and fixed income securities in general, is that sometimes the lender experiences financial difficulties and cant pay the interest on the bond, or cant pay off the bond at maturity. If the firm that issued the bond goes bankrupt, the bondholders can lose their entire investment. Unfortunately, even though fixed income securities let you share a lenders financial pain, they dont let you share any of the pleasure. If the lender suddenly makes a ton of money, the interest rate on your bond stays the same and you still only get bonds the face value at maturity.

With fixed income securities, the best-case scenario is that the issuer pays you all the interest and at maturity gives you back your principal. If you need money before your bond matures, you can simply sell it to another investor. While all this may not seem all that exciting, the returns from these types of investments can be quite respectable.

Reading Corporate Bond Quotes

Below is a visual summary of how to read corporate (not government) bond listings (this is from www.wsj.com). As youll see, there can be more than one bond listed for any given corporation depending on each bonds maturity and coupon rate. The selling price of corporate bonds, which generally have a par value of $1,000, is quoted as a percentage of par (although, there are a few corporate bonds that have par values of $5,000). Lets take a look at the Morgan Stanley bond listed second. That is a bond issued by Morgan Stanley with a 4.10 percent coupon interest rate, meaning it pays annual interest equal to 4.1 percent of its par value, and it matures in January 2015.

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This bond is listed as selling at 102.527, meaning it is actually selling at 102.527 percent of its par value ($1,000) -- or $1,025.27.

Issuer Name GENERAL ELECTRIC CAPITAL CORP MORGAN STANLEY COX COMM

Symbol

Coupon

Rating Maturity Moody's/S&P/ Fitch Dec 2012 Jan 2015 Dec 2014 May 2013 Sep 2036 Feb 2011 Nov 2017 Sep 2016 Apr 2011 Nov 2013 Aaa/AAA/-A2/A/A Baa2/BBB/BBB A1/A+/A+ Ba1/BBB/BBBAa2/AA/AA Aa3/AA-/A+ Ba1/BBB/BBBA3/BBB+/AA2/A/BBB

High

Low

Last

Change

Yield % 1.094 4.822 3.485 1.699 8.074 0.743 4.606 8.873 N/A 8.010

GE.HIH MS.HPT COX.HN

2.125% 4.100% 5.450% 4.850% 6.450% 4.125% 6.000% 5.950% 6.600% 5.250%

102.704 99.550 108.057 109.025 86.250 102.350 109.110 96.000 104.610 97.000

102.000 96.600 107.992 108.042 82.054 101.780 107.932 84.500 103.589 91.375

102.527 97.062 108.057 108.820 82.400 102.123 108.635 86.250 103.950 92.000

0.092 -0.734 -1.833 0.220 -3.350 -0.095 0.365 -0.250 -0.521 -1.575

GLAXOSMITHKLINE GSK.GK CAPITAL ANADARKO PETROLEUM CORP WAL-MART STORES WACHOVIA BANK NA ANADARKO PETROLEUM CORP KELLOGG CO BP CAPITAL MARKETS PLC APC.HF WMT.HP WFC.GFQ APC.HE K.GF BP.JE

Whats listed isnt exactly what youd pay if you purchased the bond. Youre also expected to pay for any accrued interest on the bond. Remember, interest is generally paid only every six months. If its been five months since interest was paid, the bond has accrued five months worth of interest. The listed price of the bond doesnt show the accrued interest, but you still need to pay the seller for the accrued interest that the bond has already earned.

Reading Treasury Bond Quotes

Below are Treasury security listings, again taken from the Wall Street Journal online. When reading these security listings, youll notice quotes for both a bid and an ask price, with the bid price representing what another investor was willing to buy the security for and the ask price representing what another investor was willing to sell the security for. In addition, youll see that Treasury and agency securities trade in thirty-seconds (1/32). So, if a security is listed at

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102:31, that translates to 102 31/32 percent of the securitys par value. If the par value of this bond is $10,000, then it would sell for $10,296.88 ($10,000 X 102 31/32%).

Maturity 2010 Jun 30 2010 Jul 15 2010 Jul 31 2015 May 15 2015 May 31 2015 Jun 30 2015 Aug 15 2039 Feb 15 2039 May 15 2039 Aug 15

Coupon 2.875 3.875 2.750 4.125 2.125 1.875 4.250 3.500 4.250 4.500

Bid 100:01 100:07 100:08 110:14 101:01 99:22 111:04 90:03 102:22 106:31

Asked 100:01 100:07 100:09 110:16 101:02 99:22 111:06 90:06 102:25 107:01

Chg unch. unch. -1 +1 +1 -42 +2 -14 -16 -16

Asked yield -0.2348 -0.0837 0.0395 1.8673 1.8982 1.9392 1.9518 4.0851 4.0858 4.0848

Ownership Investments
The three major forms of ownership investments are common stock, preferred stock, and real estate. As with lending investments, when you buy an ownership investment, youre buying something that generates a return. Lets take a brief look at these investment alternatives. Common Stock The most popular ownership investment is common stocks, but the actual ownership isnt of an asset you can hold in your hand or live in. Common stock is a unit of ownership in a corporation. When you purchase 50 shares of Disneys common stock, youve actually purchased a tiny sliver of the Walt Disney Company. You own a piece of each studio, a piece of its movies, and its parks, including Euro Disney. The more shares you buy, the bigger the portion of Disney that you own. Although 50 shares may seem like a lot of stock, it will give you only about a 0.00000239 percent ownership in Disney. In effect, when you buy common stock you become an owner of the company, but you rarely get much power.

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What do you get as an owner of Disney? Dont count on free tickets to Disney World or a copy of Toy Story 3. In the case of common stock ownership, you get a chance to vote for the board of directors, which oversees Disneys operations. If Disney earns a profit, youll most likely receive a portion of those profits in the form of dividends payments, which are simply a distribution of earnings, that companies dole out quarterly or annually to shareholders with Disney paying dividends annually.

As profits and dividends continue to increase, investors see the stock as more valuable and are willing to pay more to purchase it. So, the price goes up. Theres no limit as to how high a stocks price can rise. And as weve seen recently, prices can also drop! Reading Common Stock Quotes

Most stock prices are reported online but the format for reporting them is the same whether they are listed on the NYSE or on another exchange. The price and volume listings for stocks listed on the NYSE are actually a combination of all trades of NYSElisted firms, regardless of where the trade occurred whether on the NYSE or on one of the regional exchanges.

Symbol Open High

Low Close

Net %Chg Chg

Vol

52 Week 52 Week Div Yield High Low 37.98 99.45 22.05 29.02

PE

YTD %Chg

DIS WLT

34.36 34.63 34.05 34.34 -0.01 -0.03 9,473,961 70.16 71.00 67.15 70.32 1.06 1.53 1,827,370

0.35 1.02 17.98 6.48 0.50 0.71 33.97 -6.63

By looking at the stock quote in the paper, investors can see how much a stocks price moved up or down the previous day by examining its highest and lowest prices listed. Also listed is the stocks closing price on the previous day, as well as the change in closing price from the day before that. The change in closing price, along with the stocks high and low over the past 52 weeks, gives you a sense of the direction the stock price is taking. Prices are listed in dollars and cents.

Interestingly, a NYSE listed stock can trade a number of places. In fact, there are 9 exchanges that route orders to NYSE listed stocks: NYSE, Nasdaq, ISE, BATS, Boston, Cincinnati (National Stock Exchange), CBOE, ARCA and Chicago. Each exchange submits a bid and/or offer price for each stock they wish to make a market in. The highest bid price becomes the National Best Bid and the lowest offer price becomes the

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National Best Ask. Exchanges compete, fiercely at times, to become the best bid or offer because that is where orders will be sent for execution. Preferred Stock

Preferred stock is often referred to as a hybrid security because it has many characteristics of both common stock and bonds. Preferred stock is similar to common stock in that both have no fixed maturity date, nonpayment of dividends does not bring on bankruptcy, and dividends are not deductible for tax purposes. Preferred stock is similar to bonds in that dividends are fixed in amount, with the preferred stockholder receiving a constant annual dividend as long as the firm has the cash to pay. In addition, the only time youll get to vote for the board of directors if you own Disney preferred stock is if Disney has suffered some financial problems and omitted some preferred stock dividends.

Companies have an obligation to pay interest to debt holders before they can distribute dividends to stockholders, and preferred stockholders take a preferred position relative to common shareholders that is, they receive their dividends first. Common stockholders then receive their dividends from whatever is left over. If interest payments on debt eat up a companys profits, stockholders get no dividends; however, those dividends will cumulate and must be paid in full before common shareholders can receive any dividends.

The size of the preferred stock dividend is generally fixed, either as a dollar amount or as a percentage of the par value. For example, Texas Power and Light has issued $4 preferred stock, while Toledo Edison has issued some 4.25 percent preferred stock. The par value on the Toledo Edison preferred stock is $100; each share pays 4.25% X $100, or $4.25 in dividends annually. These dividends are fixed, meaning preferred stockholders do not share in the residual earnings of the firm but are limited to their stated annual dividend.

Derivative Investments

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Derivative investments differ from lending and ownership investments in that they are not created by a corporation or by the government other investors create them. They are called derivatives because their value, or price, is derived from the price of another asset, exchange rate, or interest rate. We need to be familiar with them for four reasons. 1. We can use these instruments to reduce the risks associated with fluctuations in interest and exchange rates, and stock and commodity prices. 2. Derivatives provide leverage -- that is, with derivatives you have the chance for unlimited capital gains with a small investment. 3. Derivatives allow you to significantly increase the set of possible investment alternatives available. 4. They were at the heart of the recent financial meltdown. Futures

While the futures markets date back to the Middle Ages, over the past 20 years their use has exploded. A future, or futures contract, is a written contract to buy or sell a stated commodity (such as soybeans or corn) or financial claim (such as U.S. Treasury bonds) at a specified price at some specified future date. It is important to note here that this is a contract that requires its holder to buy or sell the asset, regardless of what happens to its value during the interim. That is, when you buy a futures contract youre not really buying anything, youre just signing a contract that sets a price and time at which youll buy something. The money that exchanges hands is like the good faith money that is put down to insure that youll honor the contract. Its akin to buying a house. You put good faith money down on a house, set the purchase price, and agree to buy it at some future date, but you dont actually buy the house until the closing date. If the price of houses goes up dramatically between now and then, youve made money the same logic holds for futures. Investors and financial managers might use futures to lock in future prices of raw materials, interest rates, or exchange rates, thereby reducing and even eliminating risk.

For example, say a corporation is planning on issuing a large amount of debt in the near future, perhaps to finance a new business. If the corporation is concerned about a possible rise in interest rates between now and when the debt will be issued it might sell a U.S. Treasury bond futures contract with the same par value as the proposed debt

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offering and with a delivery date the same as when the debt offering is to occur. This strategy would allow the corporation to effectively lock in the current interest rates and not have to worry about rates rising between now and when the debt offering occurs.

Alternatively, with the use of a futures contract, companies such as Ralston-Purina or Quaker Oats can lock in the future price of corn or oats or whatever they wish. Because a futures contract can also lock in commodity prices, the costs associated with any possible rise in those prices are completely offset by the profits made by writing or selling the futures contract. These contracts can go out for several years.

Futures also allow investors to speculate on the future price of interest and exchange rates and commodity prices. For example, if you feel the price of crude oil is going to rise and would like to cash in on that rise, you could purchase a crude oil futures contract. That would lock in the transaction the date you are to buy the crude oil, the amount, and price you are to pay for it. Then if oil prices double, youll make money because your futures contract will allow you to buy oil or at below the market price. Now, lets face it, you dont want several thousand barrels of crude oil delivered to your house, so you sell the contract before your transaction date comes up. On the other side of the deal, someone who was writing the futures contract -- the person who has contracted to sell the crude oil to close out their position they must buy a contract. That way they have bought and sold (or wrote) a contact and they have no further obligation. But what makes this unusual is that they sold something (the contract) before they bought it. Thus, the person who wrote the futures contract simply buys an identical futures contract and that combination of buying one futures contract and selling another cancel each other out.

What draws many traders to the futures markets is the low cost of getting involved. Remember, you arent really buying anything, just signing a contract that sets the date and price for a future purchase. As a result, when you make a futures transaction, you must deposit some good faith money or financial guarantee. This initial deposit is called an initial margin or a performance bond margin, and it is required of both the buyers and writers (or sellers) of a futures contract. Because you are putting down only a good faith deposit, it tends to be a fraction of the value of the futures contract. In fact, this margin, which is set by the futures exchange where the futures contract is traded,

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ranges between five and 18 percent of a contracts face value, although brokerage firms can require a larger deposit.

With futures, small movements in the price of the underlying asset produce huge movements in the value of the contract. In addition, these contracts tend to be for large quantities of items, meaning their overall price will change greatly with small changes in the prices of the items they contain. For example, a corn futures contract covers 5,000 bushels of corn, so a 10-cent change in the price of a bushel of corn results in a $500 change in the price of the futures contract. This characteristic can be wonderful if prices move in the right direction. For example, USAirways uses gasoline futures to lock in gas prices. When gas prices soared in 2001, USAirways was able to offset the increased costs of fuel with the gains it made in gasoline futures.

However, look at the example of Nick Leeson a 27-year-old futures trader who was stationed in Singapore for Barings Bank. In January 1995, Nick had a hunch that Japanese stocks were going to climb, and without the knowledge of Barings Bank, started the wholesale buying of Japanese stock index futures. To say the least, his timing was poor on January 17 an earthquake struck the city of Kobe, Japan and the Japanese stock market fell by about 13 percent. To cover his loss and to keep Barrings from finding out, he doubled his bets, and things went the wrong way, so he doubled them again, and so forth, and in just over a month by the time he fled to Germany to avoid fraud charges he had lost about $1.2 billion and caused the collapse of Barings Bank. Today, he watches the financial markets from his jail cell.

Options

While a future involves an obligation to buy or sell an asset, an option gives its owner the right to buy or sell an asset. In other words, if its not of value, you dont have to exercise the option. As with a futures contract, the price at which the option holder can buy or sell the asset is specified. This price is called the exercise or strike price. In addition, options have an expiration date.

There are two basic types of options: calls and puts. A call option gives its owner the right to purchase a given number of shares of stock or some other asset at a specified

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price over a given period. If the price of the underlying common stock or asset goes up, a call purchaser makes money That only makes sense because while the purchase price is set by the call option, the value of the stock has risen. This is essentially the same as a rain check or guaranteed price. You have the option to buy something, in this case common stock, at a set price. In effect, a call option gives you the right to buy, but it is not a promise to buy. A put gives its owner the right to sell a given number of shares of common stock or some other asset at a specified price over a given period. A put purchaser is betting that the price of the underlying common stock or asset will drop. A put option gives its holder the right to sell the common stock at a set price, but it is not an obligation to sell. Thus, if the stock price drops, you can buy the stock cheaply and then sell it at the price set by the put option.

Because calls and puts are just options to buy or sell stock or some other asset, they do not represent an ownership position in the underlying corporation, as does common stock. In fact, there may be no direct relationship between the underlying corporation and the option. An option may merely be a contract between two investors, but unlike a futures contract, it will only be exercised if it is in the option holders best interest.

An option purchaser is, in a sense, betting against the option seller or writer. For this reason, the options markets, along with the futures markets, are often referred to as a zero sum game. If someone makes money, then someone must lose money; if profits and losses were added up, the total for all options, ignoring trading costs, would equal zero. As we will see later, the options markets are quite complicated and risky. Some experts refer to them as legalized institutions for transferring wealth from the unsophisticated to the sophisticated. However, you can effectively use options to eliminate risk and inexpensively lever your investments.

Looking at futures and comparing them to options, what is the difference? First, options give you the right to purchase a given number of shares of stock or some other asset, while a futures contract requires its holder to buy or sell the asset. In effect, you exercise an option only if its in your best interests, but with a futures contract, you have to buy or sell the asset at the predetermined price regardless of which way its price has

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gone. Also, with an option, in the worst case scenario, the most you can lose is what you paid for the option, or 100 percent of your investment. Thats not the case with a futures contract. You may put down only a small initial margin, but prices may go in the wrong direction as they did with Nick Leeson and the Japanese Yen. In that case, you can lose much more than you initially invested in fact, the skys the limit.

Mutual Funds

Mutual funds arent just another category of investments. They are a way of holding securities such as stocks and bonds. Mutual funds pool your money with that of other investors and invest it in stocks, bonds, and various short-term securities. Professional managers tend to these funds, trying to make them grow as much as possible. Mutual funds let you diversify even with small amounts of money. In fact, your investment may be only $1,000, or even less, and with that investment you could own a fraction (a very small fraction) of up to 1,000 different stocks. Your shares in the mutual fund give you an ownership claim to a proportion of the mutual funds portfolio. In effect, investors buy mutual fund shares, the mutual fund managers take this money and buy securities, and the mutual fund shareholders then own a portion of this portfolio. Mutual fund shareholders dont directly own the funds securities. Rather, they own a portion of the overall value of the fund itself.

When you own shares in a mutual fund, you make money in three ways. 1. As the value of all the securities in the mutual fund increases, the value of each mutual fund share also goes up. 2. Most mutual funds pay dividends to shareholders. If a fund receives interest or dividends from its holdings, this income is passed on to shareholders in the form of dividends. 3. If the fund sells a security for more than it originally paid for it, the shareholder receives this gain in the form of a capital gains distribution, generally paid annually. The shareholder, of course, can elect to have these dividends and capital gains reinvested back into the fund or receive these earnings in the form of a check from the fund.

By far the most popular form of investment companies are open-end investment companies or, as they are commonly called, mutual funds. These companies account

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for over 95 percent of all the money put into the various investment companies. The term open-end simply means that they can issue an unlimited number of ownership shares. That is, as many people who want to invest in the fund can, simply by buying ownership shares.

A share in an open-end mutual fund is not really like a share of stock. You cant trade it on one of the stock exchanges. You can only buy ownership shares in the mutual fund directly from the mutual fund itself. Companies will market their mutual funds directly to investors over the phone, by mail, or Internet, or from a local office. Others are sold indirectly through a broker who receives a commission. Later, when you want out, the mutual fund, or open-end investment company, will simply buy back your shares. No questions asked. Theres never a worry about finding a buyer.

The price that you pay when you buy your ownership shares and the price you receive when you sell your shares is based on the net asset value (NAV) of the mutual fund. Taking the total market value of all securities held by the mutual fund, subtracting out any liabilities, and dividing this result by the number of shares outstanding determines the net asset value.

net asset value (NAV) = total market value of all securities - liabilities total shares outstanding

For example, if the value of all the funds holdings is determined to be $850 million, the liabilities are $50 million, and there are $40 million shares outstanding, the net asset value would be

net asset value (NAV) = $850 million - $50 million = $20 per share 40 million shares

In effect, one share, which represents a one-forty-millionth ownership of the fund, can be bought or sold for $20. So, the value of the portfolio that the mutual fund holds determines the value of each share in the mutual fund.

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Mutual funds can either be load or no-load funds. A load is a sales commission on your ownership shares, so a load fund is one that charges a sales commission. Load funds are actually mutual funds that are sold through brokers, financial advisors, and financial planners who tack on the loads for themselves. These commissions can be quite large, typically in the four percent to six percent range, but in some cases they can run as high as 8.5 percent. In general, you pay the commission when you purchase ownership shares in the fund.

ETFs or Exchange Traded Funds ETFs or exchange-traded funds, first issued in 1993, are a hybrid between mutual funds and individually traded stocks or bonds. As the name implies, they are mutual funds that trade on an exchange just like individual securities and can be bought and sold throughout the trading day. In effect, whatever you can do with a stock, you can also do with an ETF. You can, for example, sell short or buy them on margin. This trading flexibility is the primary advantage that ETFs have over traditional mutual funds. They trade throughout the day, so you can buy and sell them when you want.

Because shares in ETFs trade throughout the day just like stocks, their prices can differ from their NAVs, although in most cases the price differences are quite small. Then, at the end of the trading day, ETFs calculate the value of their holdings to come up with new NAVs for their portfolios, as regular mutual funds do. You can track ETF prices online by name or symbol as you would a share of common stock. Or you can look in The Wall Street Journal under the heading of "Exchange-Traded Portfolios."

One advantage to ETFs is that they charge lower annual expenses than even the lowest cost mutual funds. To give you an idea, the annual expense ratio, or percent of total assets that go toward expenses, on SPDRs is just 0.12%. But, as with stocks, you pay a commission when you buy or sell them. Because you buy them from another investor, you also have the bid-ask spread to deal with. That is, you might be able to buy the ETF at $25.00, but be able to sell it for only $24.75. All this means that ETFs may be less expensive than regular mutual funds for those who trade infrequently, but they are more expensive than traditional mutual funds for those who trade frequently.

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Another advantage to ETFs is taxes. With a regular mutual fund, the mutual fund managers must occasionally sell holdings to meet the redemption demands of investors. These sales result in taxable capital-gains distributions being paid to shareholders. However, with ETFs, most trading is between shareholders, so the funds dont have to sell stocks to meet redemptions. This fact makes ETFs more tax-efficient than most mutual funds.

ETFs have been a huge success because they allow investors who think they know the future direction of a sector or industry to stake out an investment position in that sector or industry. They also allow investors to make their move during the markets trading hours. The table below lists the advantages and disadvantages to ETFs. Advantages and Disadvantages of ETFs Advantages of Exchange Traded Funds

ETFs trade on an exchange just like individual securities and can be bought and sold throughout the trading day.

ETFs can be sold short or bought on margin. ETFs allow you to take an instant position in a sector that you may not otherwise have access to, for example, Taiwanese technology companies.

ETFs have very low annual expenses. ETFs are more tax-efficient than most mutual funds.

Disadvantages of ETFs

Because ETFs trade like common stocks, you pay commissions. ETFs don't necessarily trade at their net asset value. You buy the ETF from another investor, so you also have the bid-ask spread. For example, you might be able to buy the ETF at $25.00, but only be able to sell it later for $24.75.

For investors who trade frequently, ETFs are more expensive than traditional mutual funds.

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