Global Financial Instruments III

Summary

This script delves into the intricacies of equity, explaining how buying stock makes one a partial owner with limited liability. It contrasts preferred and common stock, highlighting their differences in dividend priority and voting rights. The lecture then transitions into financial indices, illustrating their significance in reflecting market trends and as benchmarks for fund managers. Finally, it touches on derivatives, using call options and forward contracts to demonstrate how their values are derived from underlying assets, setting the stage for further exploration into option pricing.

Takeaways

• 📈 When you buy stock in a company, you become a part owner with limited liability, meaning your financial risk is capped at the amount you invested.
• 🏦 There are two main types of stock: preferred and common. Preferred stockholders have priority over common stockholders in dividend payments and in asset distribution during liquidation.
• 💲 Preferred stock typically carries a fixed dividend, making it less volatile than common stock, which may not pay dividends, especially for rapidly growing companies.
• 🗳️ Common stockholders have voting rights, allowing them to participate in the company's decision-making by electing board members, a privilege not extended to preferred stockholders.
• 📊 Stock market indices, like the Dow Jones Industrial Average or the S&P 500, provide a snapshot of market performance but can be misleading if not broad enough to represent the entire market.
• 🌍 International indices, such as Germany's DAX or Japan's Nikkei, offer insights into global market trends and are crucial for investors with a global outlook.
• 📊 The S&P 500 index, comprising 500 of the largest U.S. companies, represents approximately 90% of the U.S. stock market's value, making it a significant benchmark.
• 💼 Professional money managers often use indices as benchmarks to evaluate their performance, with mutual and pension fund managers being compensated based on how their funds perform relative to these indices.
• 📋 Derivative securities, such as options, forwards, and futures, derive their value from an underlying asset, unlike primitive securities like stocks and bonds.
• 🔄 A call option gives the owner the right, but not the obligation, to buy an asset at a predetermined price before a certain date, with the option's value tied to the asset's market price.
• 🌾 Forward and futures contracts are agreements to buy or sell an asset at a fixed price in the future, with the value of these contracts depending on the asset's future market price.

Q & A

What is the significance of buying stock in a company?

Buying stock in a company makes you a part owner of that company and grants you limited liability, meaning your financial risk is limited to the amount you invested.

What is the difference between preferred stock and common stock?

Preferred stock has priority over common stock in terms of dividend payments and asset distribution in case of liquidation. It usually carries a fixed dividend but no voting rights. Common stockholders, on the other hand, do not have dividend guarantees, can vote on company matters, and may receive dividends at the discretion of the company's management.

Why might a company choose not to pay dividends?

A company might choose not to pay dividends if it is still growing rapidly and prefers to reinvest earnings back into the business to fuel further expansion.

How does the volatility of preferred stock compare to common stock?

Preferred stock is generally less volatile than common stock due to its fixed dividend and priority in dividend payments and asset distribution.

What is an index and how is it used in the financial market?

An index is an average price of a subset of securities that it follows, used to gauge the performance of a segment of the market. It helps investors understand market trends and serves as a benchmark for the performance of investment funds.

Why is the S&P 500 considered a broader index than the Dow Jones Industrial Average?

The S&P 500 is considered a broader index because it includes 500 different companies, representing about 90% of the value of the U.S. stock market, compared to the Dow Jones Industrial Average which only includes 30 blue-chip companies.

What is the role of indices in the management of mutual funds and pension funds?

Indices serve as benchmarks to evaluate the performance of mutual fund and pension fund managers. If a fund outperforms its benchmark index, it may indicate good management; if it underperforms, it may suggest poor management.

What is a derivative security and how does its value relate to an underlying asset?

A derivative security is a financial instrument that derives its value from an underlying asset, such as a stock or commodity. Its value is dependent on the price movements of the underlying asset.

Can you explain how a call option works with an example?

A call option gives the owner the right to buy an underlying asset, like a stock, at a predetermined price, known as the strike price, before or at the option's expiration date. For example, if you buy a call option to purchase Amazon stock at $1870 per share with an expiration date in the future, and the stock price rises above $1870, you can exercise the option to buy at the lower strike price, making a profit.

What is the difference between a forward contract and a futures contract?

A forward contract is a private agreement between two parties to exchange an asset at a fixed price on a future date. A futures contract is similar but standardized and traded on an exchange, which allows for easier buying and selling by multiple parties.