Assets Traded in Organized Markets

Fixed Income

Fixed-income investments include promises to repay borrowed money and a variety of other instruments with payment schedules. People, companies, and governments create fixed-income instruments when they borrow money. While there is no consensus definition on the exact cut-offs, fixed-income securities are often classified based on maturity date as short-term (less than one or two years), intermediate-term (two to five years), and long-term (greater than five years). Fixed-income investments include:

• Notes: Fixed-income instruments, usually with a maturity of ten years or less.
• Bonds: Fixed-income instruments, usually with a maturity of more than ten years.
• Convertible bonds: Can be converted into the issuing corporation’s stock by the holder after a specified amount of time.
• Bills/Securities of Deposit/Commercial Paper: Short-term securities, usually maturing in a year or less, issued by governments, banks, and corporations.
• Repurchase Agreements: Short-term lending instruments in which the borrower sells an instrument and promises to buy it back at a higher price.
• Money Market Instruments: Debt instruments maturing in one year or less, purchased by money market funds and corporations seeking a return on short-term cash balances.

Equities

Equities represent ownership rights in companies and include:

• Common Stock: Shareholders hold several rights, including the potential to receive dividends when declared by the board of directors, voting rights to elect the company’s board, and a share of the assets if the company undergoes liquidation.
• Preferred Stock: Shareholders usually lack voting rights but typically hold the privilege to receive regular dividends and hold priority over common shareholders in terms of liquidation proceeds. Cumulative preferred equity, a subtype of preferred shares, mandates that the company must settle any missed preferred dividends before distributing dividends to common shareholders.
• Warrants: These are securities offered by a corporation, granting the holder the choice to purchase a company’s securities, often common stock, at the exercise price at any point before the warrant expires.

Pooled Investments

Pooled investments represent indirect ownership of assets held by an entity by purchasing shares, units, depository receipts, or limited partnership interests. Pooled investments are typically used to gain access to skilled investment management and/or to diversify an investor’s portfolio efficiently. Pooled investments are made up of two types of investment vehicles: open-ended and closed-ended funds.

Open-ended funds create and redeem shares based on the fund’s net asset value, allowing direct trading with investors. In contrast, closed-ended funds issue shares through primary market offerings, which are then traded in the secondary market. Closed-ended fund shares don’t offer redemptions at their net asset value, causing them to trade at a discount or premium to NAV. Types of pooled investments include:

• Mutual Funds: These are open-ended and closed-ended investment vehicles that pool money from many investors for investment in a portfolio of securities.
• Exchange-traded funds (ETFs): These are open-ended funds that trade on secondary markets. ETFs typically avoid substantial discounts or premiums because authorized participants can directly trade with the fund, capitalizing on NAV and market price disparities.
• Asset-backed Securities: These are securities whose values and income payments are derived from a pool of assets, such as mortgage bonds, credit card debt, or car loans.
• Hedge Funds: These are typically structured as limited partnerships, with managers as general partners and qualified investors as limited partners. These funds employ diverse strategies and adhere to varying regulatory rules based on the jurisdiction. Most hedge funds commonly use leverage to enhance returns and implement a fee structure that includes a performance fee when they achieve positive returns alongside the standard management fee.

Currencies

There are approximately 175 currencies worldwide, some of which are considered reserve currencies – currencies held by banks and other monetary authorities in large quantities. Primary reserve currencies include the US dollar and the euro. Secondary reserve currencies include the British pound, the Japanese yen, and the Swiss franc.

Contracts

Contracts are agreements to trade other assets in the future, many of which are derivatives. Derivative contracts are assets that derive their value from the prices of underlying assets. Derivatives are classified by the nature of their underlying assets. For instance, a contract based on the price of gold would be considered a physical derivative. In contrast, a contract based on Costco’s stock price or the S&P 500 would be considered a financial derivative – or, more specifically, an equity derivative. Types of contracts include:

• Forward Contracts: These are agreements to trade the underlying asset in the future at a price agreed upon today, often used by traders to hedge the risk of adverse price movements. There are two primary issues with trading in forwards: counterparty risk and limited liquidity. Counterparty risk describes the risk that the other party will fail to honor the terms of the contract. Forward contracts have limited liquidity because the other party’s consent is needed before the contract can be traded.
• Futures Contracts: Similar to forward contracts but offer more security. In a futures contract, the buyer receives the physical delivery or its cash equivalent on the specified date, while the seller delivers the asset or its cash equivalent. These contracts are safer because clearinghouses prevent default risk. They are also standardized, allowing traders to eliminate obligations by taking an offsetting position, such as a buyer selling the same futures contract or a seller buying the same futures contract.
• Swap Contracts: These are agreements to exchange payments of periodic cash flows that depend on future asset prices or interest rates. Variable payments are based on a pre-determined variable interest rate like the London Interbank Offered Rate (Libor). Commonly used swaps include interest rate swaps, commodity swaps, currency swaps, and equity swaps.
• Option Contracts: Call options (put options) allow the buyer to purchase (sell) an underlying instrument at a set strike price before a specified date. If the market price of the underlying security rises above the strike price, the call holder can exercise the option at a profit. Conversely, if the underlying security price falls below the strike price, the putholder profits from exercising the option. European-style contracts allow the holder to exercise only on the maturity date, while American-style contracts allow the holder to exercise the options early.
• Credit Default Swaps: Insurance contracts that promise payment of principal if a company defaults on its bonds. A company’s bondholders may invest in related credit default swaps to hedge against the company’s risk of default. Alternatively, well-informed traders may choose to invest in a company’s credit default swaps without bond exposure to essentially bet on the company’s default.

Commodities

Commodities encompass precious metals, energy products, industrial metals, agricultural products, and carbon credits. You can access commodities directly through spot markets or indirectly via forward and futures markets. In the commodity spot markets, producers and processors of industrial metals and agricultural products are the main participants. They often possess valuable information and affordable storage options.

In contrast, information-motivated traders frequently engage in commodities forward or futures markets. They aim to capitalize on future price changes without the burden of storing the actual assets.

Real Assets

Real assets are investments in tangible properties, usually held by operating companies. Investors find real assets attractive due to their potential income and tax benefits and low correlation to other asset classes. However, direct investments in real assets are usually quite costly as investors must either maintain the property themselves or hire a manager to do it for them. No two real assets are exactly the same, making real assets difficult to value and trade.

These challenges benefit information-driven traders who seek underpriced assets from less-informed sellers. Yet, the extra expenses associated with discovering and handling undervalued assets might diminish or even negate the excess returns they earn.

Real estate investment trusts (REITs) and master limited partnerships (MLPs) are financial intermediaries that package real assets into securities. They then pass on most of their net income, minus management fees, to investors. These investment options provide a way for investors to indirectly access real assets, avoiding the limitations of direct investments.

Question 1

Louis Reed, a wheat farmer, wants to protect himself against the risk of falling wheat prices without sacrificing all the upside if wheat prices spike. What will Reed most likely do to achieve this goal?

1. Buy put options.
2. Buy call options.
3. Sell futures contracts.

Solution

The correct answer is A.

Selling futures contracts can hedge against falling wheat prices, but it forces Louis Reed to sell at the agreed-upon price even if market prices rise. Buying call options lets him benefit from rising wheat prices, but he remains exposed to price drops. Purchasing put options enables Reed to sell his wheat at a predetermined price, but he’s not obliged to do so if market prices surpass the strike price at maturity.

Question 2

Short Term Capital Management (STCM) generates extraordinary returns by identifying small market inefficiencies and employing a high amount of leverage. Since the fund’s inception, STCM’s managers have become incredibly wealthy due in large part to the performance-based fees charged to fund investors. STCM is most likely a:

1. Hedge fund.
2. Mutual fund.
3. Exchange-traded fund.

Solution

The correct answer is A.

Hedge funds commonly use high leverage and typically impose performance-based fees. In contrast, mutual funds and ETFs are generally unleveraged and charge a management fee as a percentage of total assets.