Definition: Bonds are debt instruments issued by companies, governments, or other entities to raise capital. When you buy a bond, you are lending money to the issuer in exchange for periodic interest payments and the return of the principal amount at maturity.
- Interest Payments: Bonds typically pay interest to bondholders at regular intervals, usually semi-annually. This is known as the coupon payment.
- Principal Repayment: At the end of the bond’s term (maturity), the issuer repays the bond’s face value to the bondholder.
Types:
- Government Bonds: Issued by national governments (e.g., U.S. Treasury Bonds) and considered low-risk.
- Corporate Bonds: Issued by companies, offering higher yields but with higher risk.
- Municipal Bonds: Issued by state or local governments, often providing tax-exempt interest.
Risk: The main risk is the possibility of the issuer defaulting, which is assessed through credit ratings provided by agencies like Moody’s and Standard & Poor’s.
Mutual Funds
Definition: Mutual funds pool money from many investors to invest in a diversified portfolio of stocks, bonds, or other securities. They are managed by professional fund managers.
Diversification: Investing in a mutual fund allows individuals to own a variety of securities, which helps spread risk across different assets.
Types:
- Equity Funds: Focus on investing in stocks.
- Bond Funds: Invest primarily in bonds.
- Balanced Funds: Combine stocks and bonds to provide both growth and income.
- Money Market Funds: Invest in short-term, low-risk instruments.
Fees: Mutual funds charge management fees, which can affect overall returns. These fees are typically expressed as an expense ratio.
Exchange-Traded Funds (ETFs)
Definition: ETFs are investment funds traded on stock exchanges, similar to stocks. They aim to track the performance of a specific index, sector, or asset class.
Liquidity: ETFs can be bought and sold throughout the trading day, offering high liquidity and flexibility.
Lower Costs: ETFs generally have lower expense ratios compared to mutual funds because they are passively managed.
Types:
- Index ETFs: Track major indices like the S&P 500.
- Sector ETFs: Focus on specific sectors of the economy, such as technology or healthcare.
- Bond ETFs: Invest in a portfolio of bonds.
Advantages: ETFs offer diversification, lower costs, and the ability to trade like a stock.
Derivatives: Options and Futures
Options:
Definition: Options are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specified date.
Types:
- Call Options: Allow the holder to buy the underlying asset.
- Put Options: Allow the holder to sell the underlying asset.
Uses: Options can be used for hedging to protect against potential losses or for speculation to profit from price movements.
Risks: Options can be complex and involve significant risk, especially for sellers who may face unlimited losses.
Futures:
Definition: Futures are contracts to buy or sell an asset at a predetermined price on a future date.
Characteristics: Futures are standardized and traded on exchanges with margin requirements to cover potential losses.
Uses: Used for hedging against price changes in commodities, currencies, or financial instruments, or for speculation.
Risks: High leverage can lead to substantial gains or losses, making futures risky for inexperienced investors.
Fabozzi, F. J. (2019). Fixed income analysis (4th ed.). Wiley. ISBN 978-1119555641
Black, K., & Scwheser, J. (2022). Options, futures, and other derivatives (11th ed.). Pearson. ISBN 978-0136930860
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