Introduction
The movement in prices of securities reflects the general state of economic activities in a country. If prices fluctuate so drastically, it means that the level of inflation is likely to be high. In fairly stable economies, prices of securities remain fairly stable over a reasonable period. On the other hand, in less stable economies, prices of securities are likely to change more drastically. Investors usually analyze changes in prices of various securities before deciding on which one to invest in. This analysis helps in assessing the nature and degree of risk associated with various securities. Generally, Investors differ in risk preference and this guides them towards making unique investment decisions.
Preference shares
Australand Assets Trust Company deals with the real estate business. This business involves the construction and sale of industrial and commercial properties. It also involves the construction and sale of apartments and other residential homes. Australand Assets Trust Company operates in the real estate industry and its ASX code is, AAZ. This company engages in cross-border trading and hence it is likely to expose itself to foreign currency exchange risk. Payments for services rendered abroad are mostly made in foreign currencies and this may cause heavy financial losses due to fluctuation in exchange rates (Brealey and Myers, 2003). To cushion an investor from such losses, an investor should invest in preference shares that guarantee a fixed rate of dividend.
In addition, the value of real properties fluctuates more often and this increases the level of risk to the investor. It is therefore prudent that the investor purchases preference shares to avoid losing money in case of price fall of real assets.
Ordinary shares
An investor can purchase ordinary shares of Abm Resources Nl which deals with minerals exploration. This company operates in the materials industry and its ASX code is ABU. The value of a mineral is likely to remain fairly stable over a longer period. Usually, exploration of minerals takes a fairly long time and therefore, an investor will be exposed to less risk of financial loss. In addition, the value of the company increases in the event of prospects of valuable minerals. This means that an investor is likely to earn more returns from the residue of the company’s profits.
Convertible notes
An investor can acquire convertible notes of Asian Masters Fund Limited which offers a wide range of financial services to its customers. This company operates in the industry of Diversified Financials and its ASX code is AUF. In addition, this company faces a great risk of customers’ defaulting in repayment of loans. In most cases, the absolute ability of a lender to pay back the principal together with the interest of borrowed money is difficult to ascertain and therefore a company loses money in case of insolvency of its customers. To mitigate this risk, an investor should invest in convertible notes which offer recovery of the principal amount plus the interest thereon at the end of the contract period. It is also possible to invest in convertible notes in reasonably shorter periods before the company’s financial position deteriorates.
Futures and Options
An investor can purchase options and futures of Aed Oil Limited which deals with the exploration and development of oil and gas. Aed Oil Limited operates in the energy sector and has ASX code as AED. This Company faces the risk of foreign currency exchange loss as well as production risks. Payments received from overseas are usually in form of foreign currencies which are likely to be affected by the exchange rates fluctuation. In addition, the company faces the risk of depletion of oil and gas deposits resulting in to decrease in supplies.
Characteristics of four types of securities
Ordinary shares
Ordinary shares give shareholders voting rights in the operational and financial decisions of a company. This means that ordinary shareholders have the power and authority to run an organization daily. Ordinary shares do not contain a fixed rate of return and therefore ordinary shareholders receive their dividends based on certain estimates as decided by the management of the company. In the case of liquidation of a company, holders of ordinary shares rank last in the distribution of liquidation proceeds. Therefore, holders of ordinary shares get their returns after all other investors have received theirs and in case the proceeds are not adequate to pay all the debts, they suffer the risk of losing the entire value of their investment. Ordinary shareholders are also exposed to the risk of losing the value of an investment in case a company suffers financial difficulties such as bankruptcy.
Ordinary shares do not have a maturity date therefore investors are entitled to returns for as long as a company remains in existence. Ordinary shareholders also benefit from dividends as well as capital gains arising from an appreciation of stocks.
Preference shares
Preference shares may be both redeemable and irredeemable.
Redeemable preference shares
These shares contain fixed rates of return which are usually expressed as a percentage of the par value of a share. Redeemable preference shares are bought back by the issuing company upon maturity. On maturity, shareholders receive returns equivalent to the market value of the share. Shares may be redeemed at par, premium, or discount.
Preference shares have a maturity date expiry of which they are redeemed by the issuing company. This means that these shares are held by shareholders for a certain period. Holders of redeemable preference shares receive dividends before ordinary shareholders and also rank before ordinary shareholders in case of distribution of liquidation proceeds. This means that shareholders suffer less risk of loss of returns in case a company goes bankrupt. Redeemable preference shares do not contain voting rights and therefore shareholders do not take part in the decision-making of the company.
Irredeemable preference shares
Holders of this type of share receive a fixed rate of return in form of dividends. They also receive their returns before ordinary shareholders and still rank before ordinary shareholders in case of a company’s liquidation. Irredeemable preference shares do not have a maturity date and therefore shareholders are entitled to returns for as long as the company remains in existence.
Options and futures
They contain a contractual agreement that gives an investor the right to either buy or sell a specified amount of financial instruments at a specified price in the future. They also do not contain voting rights and therefore option and futures holders do not take part in the decision-making of a company. Options and futures have a contract period expiry of which the holder is free to exercise his rights.
Convertible notes
They are convertible into ordinary shares on maturity. They may have a fixed rate of interest which is payable to the note-holder on a periodical basis. They contain characteristics of both bonds and ordinary shares. Before conversion into ordinary shares, the note-holder is not entitled to any voting rights. They also contain contractual agreements which give rise to both obligations and rights to the contracting parties. Each party exercises rights as provided for in the contract.
The order of distribution of the company’s proceeds in case of bankruptcy
Businesses are exposed to different types of risks which are then extended to investors. Some of these risks include market and foreign currency exchange risks which expose investors to the risk of losing either part or entire value of investment (Peirson and Bird, 1972). To mitigate these risks, an investor should hold a well-balanced portfolio of securities and also keep abreast with the market behavior.
Prices of securities keep on fluctuating and this makes it difficult for investors to predict the future value of investments. Price fluctuation is caused by factors such as the prospects of a company and the efficiency of management. Investors who invest in relatively riskier securities should be rewarded with high returns to compensate them in case of financial losses. On the other hand, less risky securities should carry a rate of return that is relatively lower than that risky one (Ross et al., 2004).
In the event of bankruptcy, the distribution of liquidation proceeds follows a prescribed procedure. The first beneficiary will be convertible notes because they contain a contractual agreement whereby the issuing company has a contractual obligation to pay periodical interests to the note-holder.
The second beneficiary will be holders of options and futures because they contain a binding agreement whereby the holder has a right to either sell or buy a specified amount of securities at a specified price in the future.
Preference shares will be third in the ranking because they contain a fixed rate of return. Last in distribution order will be ordinary shares because they do not contain a fixed rate of return nor do they contain any contractual obligation to pay returns to the shareholder. Since holders of ordinary shares are considered as the owners of the company they rank last in the distribution of liquidation proceeds.
Factors that influence the choice of investment
Investors consider the rate of return of a security and the nature of payment of those returns. For instance, if an investor prefers receiving regular payments, then, the suitable choice of investment is security bearing a fixed rate of return such as bonds and notes payable. On the other hand, if the investor’s preference is to receive capital gains then, the best choice will be the ordinary and preference shares.
Another factor to be considered is the liquidity position of an investor. Investors with a weak financial position prefer returns in form of cash and have less preference for possible future capital gains which arise as a result of holding long-term securities. This class of investors prefers investing in short-term securities such as notes (Schlosser, 2002). On the other hand, financial strong investors have less preference for cash returns and therefore, they are likely to invest in ordinary shares which offer returns in the long term.
Investors consider the degree of risk which is associated with certain securities. All rational investors aim at investing in securities bearing the lowest possible risk. Generally, investors have more confidence in investing in securities bearing low risks because this assures them of receiving expected returns.
Investors consider the maturity date of securities. If an investor intends to invest on a short-term basis then, the most likely choice is short-term securities such as notes payable. On the other hand, if an investor intends to invest on a long-term basis then, the preferred choice is long-term securities such as ordinary shares, bonds, and preference shares. The selection of suitable security is critical because sometimes investors borrow money from financial institutions and use the proceeds to acquire securities.
Investment which covers one month is short-term in nature and therefore to recover the value of the investment after one month, the suitable choice is a convertible note. This is because it is possible to enter into a contract with the selling company for one month and then recover the principal plus interest thereon. However, it is not possible to invest in other securities because they cover a relatively long period. For instance, ordinary shares and preference shares are long-term investments and therefore it is not appropriate to invest in those securities for one month.
Conclusion
Investment in securities requires a critical analysis of risk and returns. Ideally, it is impractical to have risk-free securities due to future uncertainties which characterize all business organizations. However, investors should aim at investing in securities with the lowest possible risks and offer the highest returns. It is also important that investors hold a well-balanced portfolio of securities and also use different hedging techniques to reduce risks.
References
BREALEY, R. A. & MYERS, S. C. 2003. Principles of corporate finance, Boston, Mass., McGraw-Hill/Irwin.PEIRSON, C. G. & BIRD, R. G. 1972. Business finance, Sydney, New York,, McGraw-Hill (Australia).
ROSS, S. A., WESTERFIELD, R. & JORDAN, B. D. 2004. Essentials of corporate finance, Boston, Mass., McGraw-Hill/Irwin.
SCHLOSSER, M. 2002. Business finance : applications, models, and cases, Harlow, England ; New York, N.Y., FT/Prentice Hall.