 Hello and welcome to the session. This is Professor Farhad. In this session we would look at financial assets. This topic is covered in essential of investment course, CPA exam, BEC section, the CFA exam. As always I would like to remind you to connect with me on LinkedIn if you haven't done so. YouTube is where you would need to subscribe. I have 1700 plus accounting, auditing, tax, finance, as well as Excel tutorial. If you like my lectures, please like them, share them, put them in playlists. If they benefit you, it means they might benefit other people. Share the wealth, subscribe to YouTube. Connect with me on Instagram or on my website farhadlectures.com. You will find additional resources to supplement your accounting as well as your finance education. Whether you are studying for your CPA exam or taking accounting courses, my website should help you tremendously. Let's talk about the three broad types of financial assets. Remember, in the prior session we differentiated between financial and real assets. So in finance we study financial assets because we cannot really study real assets. I mean we do cover real assets briefly but we really look at financial assets. And what are financial assets? Financial assets can be broken down broadly into three categories. One is fixed income or debt securities. And what are we talking about when we say fixed income or debt securities? Basically you are a lender. You lend money to someone else like you buy a bond or you buy an annuity. And we'll talk about those a little bit shortly. We have equity investments. Here we are talking about stocks. Here you become an owner, an owner of the company. And we have a third category called derivative securities. Also we would look at derivative securities shortly in this briefly, not shortly. We're going to look at everything shortly also briefly. Then we're going to look at all these three broad categories later on much, much more in details. Starting with fixed income or debt securities. Again, debt securities are basically you are lending. You are buying bonds, you are buying annuities, you are lending money. What do you get in return when you lend money? You're going to get, you're going to get a promise, a fixed income stream. Generally speaking, when you buy a bond you will get some income, fixed income. For example, the interest payment. Or sometime you may get a stream of income that's determined according to a specified formula using some benchmark like US Treasury. They would say we're going to pay you US Treasury rate plus 2%. So what's going to happen is the US Treasury rate goes up. Your rate goes up as the rate of return goes up. As the US Treasury rate goes down, your rate goes down. So what happened here is your income from that fixed income is determined by some formula. Or sometime we could use LIBOR and for some, for some you might have the income level. For example, if the company makes more profit, but that's very rare, you may make a little bit more than your fixed income, but that's rare. But generally speaking, it's either fixed or based on some formula. Unless the company is in a bankruptcy status, you always get the same amount of money. Therefore, the health of the company is very important to that investment. So if you buy a bond, what's going to happen is the condition of your investment is based on the financial condition of the issuer. Because if they cannot pay off the debt, then your bond is no good. So that's why their health is important. The health of the issuer, the issuer of the fund. Now we might have a lot of different type of debt investments. So they come in tremendous flavors. They vary in maturities and payment provisions. Starting with money market. Money market refer to fixed income securities that are short term, highly marketable and generally very low risk. We're talking here about US Treasury bill or bank certificate of deposit. And here we're not talking about your regular bank certificate. We're talking about millions of dollars in bank certificate that is negotiable. It means they can sell them. So what is a money market? Simply put, when you often time you might have a money market account without even knowing, simply put you put your money in the bank. And as a result, that money will be invested in a fixed income securities like they will put it in US Treasury bill. US Treasury bill is short term. It means it's going to mature shortly, highly marketable. They can easily sell it and there is no risk. This is what we mean by money market. So money market is a form of fixed income, fixed income. Also we have fixed income capital market and do not worry. We're going to talk about the money market later on much, much more in details. And the fixed income capital market. So we have money market and we have capital market include long term securities here. Here we are talking about Treasury bond. Also bond long term in contrast to US Treasury bills. Bills are short term bonds are long term. We're talking about bonds that are issued by state and local municipalities. When the state government or the local government or the county, they want to raise money, they will issue bonds. We're talking about corporation, corporate bond and all these bonds are generally speaking, especially corporate bond as well as government bond. They are rated. It means they have a level of security. They have a level of security. Obviously government bond. Usually they are more secure than corporate bond and with the corporate bonds and we're going to talk about this later. We're going to have AAA bond, AA bond, so on and so forth. So safety is important. So they vary in terms of safety. We have very safe, for example, Treasury securities, US government relatively safe, not relatively generally speaking safe and we have high yield or junk bond which are not as safe. So what happened? Investors can choose between whether they want to lend money to the US government and earn a low return, but with safety or do they want to buy corporate bond that are junk in nature? It means they are below grade level. They are risky. They will have more return, but they are taken more risk and always when we are involving bond, when we are dealing with bond, there's always what's called a bond indenture or bond covenants and those are agreements between the lender and the lender and the borrower to protect the lender because when the lender lend you money, they want to make sure they are protected. Like when the bank lend money to a company, they want to make sure in case something happened, in case they default, the bank can reserve some of their assets to sell and obtain their money back. So there's always some sort of an agreement between the buyer and the lender. So this is the first type of financial investments, which is investing in fixed income and do not worry. We're going to talk about all these topics much, much more in details. Equity, equity investments think about stocks and when we think about stocks, you are simply an owner of the company. So when you buy a stock, a share in a company like an Amazon and Apple, you basically become an owner. You are not promised any payment. So when you buy a stock, it's in contrast to bond or in the fixed investment, fixed income investment and fixed income, even the term itself tells you, you qualify or you're going to get some sort of an income. With equity, you are not promised anything. Now, yes, bonds, sorry, stocks pay dividend, but nothing is guaranteed. The dividend is only paid if the company makes a profit. The board of directors decides to distribute the profit to the shareholders. Otherwise, you don't get anything. So you may get dividend, but it's not guaranteed. And the other right you have is to vote. And in case of liquidation, you have a prorated ownership in the real assets of the firm. So if the company went belly up, whatever is left is sold and distributed in a proportionate manner to the shareholders. So if they have a million dollars left, you own 5%, you may get 5% of the million dollars. It doesn't matter how much you invest it in case they liquidate, whatever is left is yours. You generally speak and nothing is left for the equity shareholders. Here we have to understand that when you buy equity, your investment performance is tied directly, like 100% directly to the performance of the company, to the performance of the real assets of the company. So of the real assets, they are generating income, their equipment, their manufacturing facilities, they're generating good product, the salespeople are selling the product, they're making profit. The performance of the equity security of your equity investment is tied to that. So equity investment, because they are tied to that, they are riskier than relatively speaking to that. Because under that, whether the company is doing well or not doing well, they always, in quote, guarantee an income for you, that's why it's called fixed income under equity, you become an owner. As an owner, if the company makes a profit, the company decides to pay the dividend, who decides, usually the board of directors, then it's not a big deal we can give you some money. The third category, the third major category is derivative securities. And here we are talking about options, we're talking about forward swaps, and we're going to be talking about those much, much in details later on options and forward contract provided paid off that are determined, derived, that's why they're called derivative securities by the price of other assets such as bonds or stocks. So let's assume you want to buy Tesla stock, you want to buy the company Tesla, you want to buy some stocks. Let's assume Tesla is trading at $900 a day. But guess what, you are not ready to buy Tesla now, but you are bullish, you are optimistic about Tesla. What you can do, you can buy a call option. Okay, what is a call option? For example, you'll pay someone today $30, I just make this up, you pay someone today $30 to buy Tesla at $1,000 in the next six months. So here's what happened, you paid someone today $30, that individual took the $30 and they tell you no problem between today and the next six months. And anytime you want to buy Tesla, you can buy it for $1,000. Obviously, today your option is worthless because you can buy Tesla for $900. Why did you do so? Why did you, why did you buy this option? The reason you bought this option because you think Tesla, it's going to go above $1,000 in the next six months. Now, the other party, they think it's not going to go and they're going to say we're going to take the $30 and we're never going to see this individual again and basically made $30. You are thinking guess what, Tesla is going to go up below $1,000 and simply put, once it goes below $1,000, now you have a profit. Well, technically, you don't have a profit unless it goes below $1,030 because you already paid $30. So, they are required to deliver it for $1,000 and you're hoping that it's going to go above $1,030 and this is what you have a call option, the right to buy the stock. You don't buy the stock itself, you buy the right, you buy the right, you buy the right to buy the stock. Now, this is one use of call option. You can have call option, you can have put option, we're going to talk about all of those, you can have a future contract. But generally speaking, the reason companies use derivative securities, the main reason is to hedge. Hedge the risk or transfer them to another party. For example, here what I'm doing is when I'm buying Tesla this way, I'm not really hedging any risk. I'm basically making a speculative call. But let's assume on the other hand, I have Tesla stock, okay? I have Tesla stock and I purchase Tesla at, let's assume I purchase Tesla at $900. This is what I, this is the buy. Today Tesla is $900. So, I have a profit of $200. Right now I have a profit of $200. But here we go. I'm not sure what to do. Should I sell Tesla today? Should I wait and maybe make more profit? I'm not sure. What can I do? I can hedge my risk. What's hedge? It means protect my risk because Tesla could go down below $700 or Tesla keep on climbing. So, what I do is I sell rather than a call option, I'm sorry, rather than buy a call option, I will buy a put option. What is a put option? The put option gives me the right to sell Tesla at $850 in the next six months. So, what happened is this? I'll pay someone, again, let's assume $30. I'll tell someone, look, I'll pay you $30 and I have the right to sell you Tesla at $850 for the next six months. Why? If they buy Tesla from me at $850, it's guaranteed. It doesn't matter. If Tesla goes down to $500, I could still sell it at $850. Now, the individual that sell the put, they think Tesla is going to go to $1,000. And what's going to happen? If Tesla goes to $1,000, they don't have to buy it from you. So, they will pocket the $30. So, you're hedging your risk. So, generally speaking, derivatives are not generally speaking. One use of derivatives is to hedge your risk or transfer them to another party. For example, you could also have, you could hedge your interest rate risk. We'll talk about that later. You could have a cash flow hedge, foreign currency hedge. That's very common when you buy and sell in foreign currency. When you have a payable or a receivable, you're going to be receiving money or paying money in foreign currency. You don't want to take your chances until that payment date to find out what the foreign currency is trading at. You want to buy maybe a call or a put option to lock in your prices. This way, if the foreign currency goes up in value or go down in value, you are protected. So, that's one use of derivative securities. Don't worry. This is just a general idea. We'll talk about derivatives much more in details later on. Also, derivative securities can be used for speculative position. For example, you remember I wanted to buy Tesla? That's speculative. I could lose all my money speculating if I make the wrong choice. If I make the wrong choice, I could really blow myself up. And on a regular basis, investment firms or hedge firms, they call hedge, hedge, hedge investment firms, they blow up. Basically, they go bankrupt because they took the wrong position. So, that's very common. Also, investors, another thing that they can do, they can invest directly in some real assets. We're talking about financial asset. Just want to let you know that you could also invest in real assets like commodities. For example, commodities are usually traded on the Chicago Mercantile Exchange as well as other exchanges. Here we're talking about corn, wheat, natural gas, gold, silver, coffee, and oil as well. For example, if Starbucks wants to buy coffee, they can buy actual contract of coffee, actual coffee. Somebody will deliver them the actual coffee into the future for a certain price. So, they're buying actually coffee as a real asset because they're going to take this coffee and turn it into their product and sell the product itself. So, you can invest in real asset as well. But generally speaking, we're talking about financial assets in this session. In the next session, we'll look at the role that the financial market play in the economy overall. As always, I would like to remind you to like my lectures, share them, visit my website forhatlectures.com. If you are studying for your CPA exam or you'd like to supplement your accounting or finance courses, I strongly suggest you give it a shot, stay safe, especially during those coronavirus days. Good luck and study.