A corporation can borrow money by issuing a bond. Bonds come in $1,000 denominations with a specific maturity date and interest rate (the coupon rate). For example, a 10-year bond with a coupon rate of 8% will pay $80 annually for each $1,000 of principal, which will be returned at maturity. Interest is typically paid twice a year in equal installments.
Credit rating agencies assign a bond a credit rating based on the issuer’s creditworthiness, just like you get a FICA score when you go to buy a house. A higher credit score means lower interest, and vice versa.
Bonds are classified by credit quality, term, and issuer.
Credit quality: high grade, investment grade, and low grade (often called high yield or junk).
Term: long term (30 years), intermediate term (5 or 10 years – often called notes), short-term (up to two years). Corporate borrowings for less than a year are called commercial paper.
Issuer: corporations, municipalities (states, cities, counties), the US Government, GNMA/FNMA (US Government-backed institutions chartered to support mortgage lending); foreign governments can all issue bonds. Banks can pool mortgages together and issue CMOs – collateralized mortgage obligations. Short-term US Government bonds are called Treasury Bills and are issued in $10,000 denominations.
Corporate and municipal bonds can be insured by a private insurer. Corporate bonds can also be called, i.e. redeemed prior to maturity at face value. Convertible bonds can be converted into shares of stock under certain conditions.
An option is a contract to buy or sell a stock at a predetermined price (strike price) by a certain date (expiration date). The right to buy is called a call. The right to sell is called a put. Options are speculative vehicles that let investors bet on future stock prices without necessarily buying/holding the underlying stock.
How would you trade oil? You don’t buy a couple barrels and have them delivered to your front door by FedEx, do you? Futures allow you to trade certain assets – commodities (oil, gold, wheat, oranges, pork bellies), currencies (US dollar, Euro, yen), and financial indices (S&P 500). They are contracts to buy or sell an asset at a predetermined future date and price.
Wall Street is constantly coming up with new tradable financial vehicles called derivatives because they are derived from – you guessed it! – stocks and bonds. These instruments are too complex and numerous to cover here and not something a beginner trader should attempt to handle on their own.
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