July 3rd, 2009 by Michael Denaro in Investing in Alternative Assets | No Comments »
Definition of Derivatives
Derivative – a security whose price is derived from one or more underlying assets.
The derivative security is a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes.
Most derivatives are characterized by high leverage.
Derivatives are generally used to hedge risk, but can also be used for speculative purposes.
Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset.
There are three major classes of derivatives:
- Futures/Forwards, which are contracts to buy or sell an asset at a specified future date.
- Options, which are contracts that give a holder the right to buy or sell an asset at a specified future date.
- Swaps, where the two parties agree to exchange cash flows or returns.
There are two major groups of derivative contracts in terms of trading:
- Over-the-counter (OTC) derivatives (swaps, forwards).
- Exchange-traded derivatives (ETD) (options, futures).
Benefits of Investing in Derivatives
- potential for large gains (through leverage)
- no need to own the underlying
- can limit losses on underlying (when combined with the underlying)
Negatives of Investment in Derivative Instruments
- potential for large losses (through leverage)
- counter-party risk
- zero-sum instrument (someone will always win while the counter-party will lose)
- some derivatives are very complex, requiring thorough understanding of the matter
- used mainly for hedging and for speculation, hence, of limited investments value to average investor
Useful Links for Investors in Derivatives
July 3rd, 2009 by Michael Denaro in Investing in Alternative Assets | No Comments »
Definition of Alternative Investments
An alternative investment is regarded as an investment product other than traditional investments such as stocks, bonds, and money markets.
Alternative investments include commodities, financial derivatives, hedge strategies (or absolute return strategies), real estate, private equity, venture capital and other assets. Alternative investments are often defined as “alternatives to conventional investments that are essentially listed securities, cash and bank deposits and lending”. It is often claimed that their other defining characteristic is a low correlation of returns with conventional investments. This means they can improve diversification, which is a key motive for investing in them.
Alternative investments are less accessible to small investors then securities because they are often illiquid, require large amounts to be invested, and may be barred by regulators from sale to the general public. Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals.
Many alternative investments also have high minimum investments and fee structures compared to mutual funds and ETFs. While they are subject to less regulation, they also have less opportunity to publish verifiable performance data and advertise to potential investors.
Alternative investments can improve both returns and diversification, but the risks are considerable. Their value may plummet as fashions change (collectibles), as the behaviour of markets changes in ways that makes particular strategies unprofitable, and from drivers unique to that type of asset. Without fundamental analysis, or much in the way of regulation, they also tend to be vulnerable to hype and manipulation.
While the small investor may be shut out of some alternative investment opportunities, real estate and commodities such as precious metals are widely available.
Benefits of Alternative Investments
- diversification (some have low correlation with traditional investments)
- potential for high return
Negatives of Investment in Alternative Assets
- potential for high losses
- usually require large investment (larger than required to invest in traditional vehicles)
Useful Links for Investors in Alternative Instruments
July 3rd, 2009 by Michael Denaro in Investing in Cash Market | No Comments »
Definition of Investing in Cash (Money) Market
A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. Money market securities consist of negotiable certificates of deposit (CDs), bankers acceptances, U.S. Treasury bills, commercial paper, municipal notes, federal funds and repurchase agreements (repos).
The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year.
The core of the money market consists of banks borrowing and lending to each other, using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked (i.e. priced over and above) to the London Interbank Offered Rate (LIBOR).
Where Money Market Securities are Traded
Most money market securities trade in very high denominations, limiting access for the individual investor. The money market is a dealer market, meaning that firms buy and sell securities in their own accounts, at their own risk. Deals are transacted over the phone or through electronic systems.
The easiest way to gain access to the money market is with a money market mutual funds, or through a money market bank account.
Benefits of Investing in Money Markets
Negatives of Investing in Money Markets
Useful Links for Money Market Investors
July 3rd, 2009 by Michael Denaro in Investing in Bond Market | No Comments »
Definition of Investment in Bonds
Bond – a debt security pursuant to which an investor loans money to an entity (corporate or governmental) for a defined period of time at a specified interest rate.
Bonds are commonly referred to as fixed-income securities.
Coupon rate may be fixed (usually) or variable (e.g. tied to LIBOR). Most bonds have a term of up to thirty years. Bonds can contain embedded options (e.g. call or put options), can be convertible into stock, and can contain other covenants.
Where Bonds are Traded
Bonds usually trade in over-the-counter markets.
Benefits of Investing in Bond Market
- bonds pay interest income
- have defined face value, coupon and maturity
- some bonds are very liquid
- bond can appreciate (depending on interest rates or due to changed credit rating)
- bonds can be putable
- treasuries are considered risk-free
- bonds are considered safer than stocks (bonds have a priority over shares during liquidation).
Negatives of Investing in Bonds
- bonds are subject to default
- bonds can depreciate (depending on interest rates or due to changed credit rating)
- some bonds can be callable (reinvestment risk)
- some bonds are illiquid
Useful Links for Bond Investors
July 3rd, 2009 by Michael Denaro in Investing in Stock Market | No Comments »
Definition of Investment in Stock Market
Stock, Share, Equity – a security representing ownership in a corporation a claim on a share of the corporation’s assets and earnings.
Common stock usually gives the owner a right to vote at shareholders’ meetings and to receive dividends. Preferred stock generally does not have voting rights, but has a priority over common shares when dividends are distributed or during liquidation.
Where Stocks are Traded
Stocks are traded on all stock exchanges. Main stock exchanges are: NYSE, AMEX, LSE, Toronto Stock Exchange, EuroNext, Tokyo Stock Exchange, Deutsche Borse etc.
Benefits of Investment in Stock Market
- high investment return potential
- allows voting on corporate matters
- possibility to receive dividends
- capital gains taxation
- wide universe of investment options
- investment liquidity
- well established market and rules
Negatives of Investments in Stock Market
- potential to lose the entire investment
- insider trading/window dressing + other ethical issues with management
- possible stock dilution
- dividends are taxed as income
- penny stock rules
- short sales are restricted
- some stocks are illiquid
- market panic can cause large swings in price
Useful Links for Stock Market Investors