Book 3 Pages 1-51 Flashcards
what are the different maturities of T-bills?
4, 8, 13, 26, 52
what is the minimum purchase amount in regards to T-bills?
$100
The Bank Discount rate is the rate at which a Bill is quoted in the secondary market and is based on the par value, amount of the discount and a 360-day year.
The Coupon Equivalent also called the Bond Equivalent, or the Investment Yield, is the bill’s yield based on the purchase price, discount, and a 365- or 366-day year. The Coupon Equivalent can be used to compare the yield on a discount bill to the yield on a nominal coupon bond that pays semiannual interest.
Example:
- 07/01/19
- 4 Weeks
- Bank Discount = 2.13
- Coupon Equivalent Yield = 2.17
do T-bills have default risk?
no
are T-bills subject to original issue discount rules?
no
when is interest income paid under T-bills?
at maturity
is interest income taxed at the federal level in regards to T-bills?
Yes
is interest income taxed at the state level in regards to T-bills?
no
publicly traded, short term, unsecured promissory notes issued by companies to raise cash to finance accounts receivable and inventories
commercial paper
However, investors need to be aware that these notes are not FDIC-insured. They are backed solely by the financial strength of the issuer in the same manner as any other type of corporate bond or debenture. Standard &Poor’s and Moody’s both rate commercial paper on a regular basis using the same rating system as for corporate bonds, with AAA and Aaa being their highest respective ratings. As with any other type of debt investment, commercial paper offerings with lower ratings pay correspondingly higher rates of interest. But there is no junk market available, as commercial paper can only be offered by investment-grade companies.
true or false? commercial paper is issued in denominations of $100k
true
what is the average maturity length of commercial paper?
Example 2 -
- Let us calculate the bond equivalent yield of the following commercial paper.
Face value=$600,000
- Maturity period=90 days
- Net amount realized=$595,000
30 days
Common measures of return on money market instruments such as bank discount yield and money market yield can’t be directly compared with capital market instruments such as bonds. This is because they are either calculated with reference to the face value i.e. the maturity value instead of the initial value and/or they are based on a 360-day year. The bond equivalent yield addresses both theses weaknesses and enables comparison.
Bond Equivalent Yield
- To compare the return on discounted securities with other investments in relative terms, analysts use the bond equivalent yield formula.
Example
- Bond Equivalent Yield = [($600,000 - $595,000)/$595,000] x (360/90)
- 3.3613%
Maturities on commercial paper rarely range longer than 270 days. Commercial paper is usually issued at a discount from face value and reflects prevailing market interest rates.
A major benefit of commercial paper is that it does not need to be registered with the Securities and Exchange Commission (SEC) as long as it matures before nine months, or 270 days, making it a very cost-effective means of financing. The proceeds from this type of financing can only be used on current assets, or inventories, and are not allowed to be used on fixed assets, such as a new plant, without SEC involvement.
Financial Crisis -
- The commercial paper market played a big role in the financial crisis that began in 2007. As investors began to doubt the financial health and liquidity of firms such as Lehman Brothers, the commercial paper market froze, and firms were no longer able to access easy and affordable funding. Another effect of the commercial paper market freezing was some money market funds - substantial investors in commercial paper - “breaking the buck.” This meant that the affected funds had net asset values under $1, reflecting the diminishing value of their outstanding commercial paper issued by firms of suspect financial health.
what is the maturity range for commercial paper?
1 to 270 days
true or false? commercial paper has a high default risk
false, it is low
true or false? commercial paper usually has higher yields than T-bills and CDs
true
true or false? commercial paper interest income is taxed at federal but not state levels
false, it is taxed at both
when is commercial paper interest income taxed?
in the year it is earned
deposits placed with commercial banks at a specified interest rate for specified time period
CDs
Do CDs have high or low default risk?
low
is interest income from CDs taxed at state, federal, or both levels?
both levels
are money market accounts subject to a limited amount of withdrawals per month?
yes
Because money market accounts fall under Federal Reserve Regulation D, banks may limit the number of withdrawals you can make in any one statement cycle – typically up to six withdrawals per month.
when is money market interest income taxed?
in the year earned
The IRS requires that you report the interest on your money market account in the year that you earn it, regardless of whether or not you take the money out of the account. If you have a money market deposit account, the income counts as interest income, even if you have the account at a credit union and the payments are called dividends. If you have a money market mutual fund, the payments count as dividend income, but are still reported as taxable income in the year you earn them.
When people discuss money market accounts, they often confuse money market deposit accounts, which are interest-bearing savings accounts, with money market mutual funds, which invest in short-term notes. Your interest payments are taxed in the same year regardless of whether you have a money market deposit account or a money market mutual fund.
true or false? interest income from a money market account is taxed at federal and state levels
true
used by securities dealers to finance large inventories of marketable securities
Example
repurchase agreements
Example
Who?
- Cash Providers
- Money Market Mutual Funds
- Insurance Companies
- Corporations
- Municipalities
- Central Banks
- Securities Lenders
- Commercial Banks
- Securities Providers
- Securities Lenders
- Hedge Funds
- Levered Accounts
- Central Banks
- Commercial Banks
- Insurance Companies
Why?
- secure, collateralized nature of the transaction, coupled with flexibility of liquidity and collateral, repos provide an efficient solution, pairing conservative short-term lenders (i.e. investors and money market funds) with borrowers in need of short-term financing (repo dealers)
Parties
- Investor = Money Market Fund
- The investor has funds that he is willing to lend
- Currency, size, collateral, and pricing must be negotiated
- Custodian =
- Provides two accounts = collateral account and cash account
- Securities Margin posted = Each transaction is secured with collateral that is worth more than the notional amount, acting as a buffer for the lender against short-term variations in the collateral’s value.
- Rep Dealer =
- Posts collateral with haircut
- Maturity Date
- The principal amount, plus interest, is transferred from the repo dealer’s cash account to the investor’s cash account
- Upon receipt of the cash, the custodian will release the collateral from the investor’s account back to the repo
- On instruction from the investor, the custodian will then send the cash and interest to the investor’s bank account
true or false? repurchase agreements have a short term to maturity
true
true or false? repurchase agreements have high risk
false
under a repurchase agreement, the repurchase price is ___ than the selling price
greater
Repo Trade Date
- Investor transfers money into its cash account at the custodian
- $100 cash to Repo Dealer’s Cash Account
- Rep dealers deliver eligible collateral (including haircut) to the collateral account at the custodian
- $102 collateral to Investor’s Collateral Account
Repo Maturity Date
- Investor receives - The principal amount, plus interest, is transferred from the repo dealer’s cash account to the investor’s cash account
- Repo Dealer - Upon receipt of the cash, the custodian will release the collateral from the investor’s account back to the repo
securities that act as a line of credit issued from a bank
banker’s acceptance
Banker’s acceptances can be created as letters of credit, documentary drafts and other financial transactions. If you are trying to obtain an acceptance, approach a bank with which you have a good working relationship. You need to be able to prove, or offer collateral against, your ability to repay the bank at a future date. Many, but not all banks offer acceptances. A banker’s acceptance operates much like a short-term, fixed-rate loan. You go through a credit check and possibly additional underwriting processes. You are also charged a percentage of the total acceptance to purchase it.
If you are looking to purchase a banker’s acceptance for a short-term investment, there is a relatively liquid secondary market for partially aged banker’s acceptances. They are normally sold at prices near or below the London Interbank Offer Rate, or LIBOR.
calculate the dollar interest based on the below info: Assume a portfolio manager use a repurchase agreement to finance a $5million position. Assuming the repo term is one day and the repo rate is 4%
$5million * 4% * (1/360) = $555.55
debt security obligating the issuer to make payments of interest and principal on specified dates to the owner
individual bonds
if the market interest rate is greater than a bonds coupon rate the bond will be issued at a ___
discount
if the market interest rate is less than a bonds coupon rate the bond will be issued at a ___
premium
A 5% coupon bond will pay $___ per $1,000 bond
$50
true or false? zero coupon bonds sell at a discount
true
do zero coupon bonds have reinvestment rate risk?
no
bonds registered with the issuing company and payments are made to the owner of record
registered bonds
unregistered bonds in which payments are made to the bondholder
bearer bonds
record of ownership held electronically in a central depository allowing for greater efficiency in bond transactions
book-entry form
established and funded each year by the bond issuer to accumulate sufficient funds to pay off the debt upon maturity, held by a trustee
sinking funds
issued in terms up to 10 years and have a $100 minimum purchase
treasury notes
issued in terms of 30 years and have $100 minimum purchase
treasury bonds
are treasury notes/bonds exempt from state income tax?
yes
marketable securities whose principal is adjusted by changes in the CPI (consumer price index)
treasury inflation protected securities (TIPS)
what are the different maturities available under TIPS?
5, 10, 30 years
Suppose an investor owns $1,000 in TIPS at the end of the year, with a coupon rate of 1%. If there is no inflation as measured by the CPI, the investor will receive $10 in coupon payments for that year. If inflation rises by 2%, however, the $1,000 principal will be adjusted upward by 2% to $1,020. The coupon rate will remain the same at 1%, but it will be multiplied by the adjusted principal amount of $1,020 to arrive at an interest payment of $10.20 for the year.
Conversely, if inflation were negative, known as deflation, with prices falling 5%, the principal would be adjusted downward to $950. The resulting interest payment would be $9.50 over the year. However, at maturity, the investor would receive no less than the principal amount invested of $1,000 or an adjusted higher principal, if applicable.
calculate the semiannual inflation rate based off the below info: a TIPS has a 4.5% coupon rate and the annual inflation rate is 4%. On January 1st an investor purchases $100,000 of par value.
$4% / 2 = 2%
calculate the inflation adjusted principal at the end of a 6 month period: a TIPS has a 4.5% coupon rate and the annual inflation rate is 4%. On January 1st an investor purchases $100,000 of par value.
$100k x [1 + (4%/2)] = $102,000
calculate the inflation adjusted coupon payment at the end of a 6 month period: a TIPS has a 4.5% coupon rate and the annual inflation rate is 4%. On January 1st an investor purchases $100,000 of par value.
$100k x [1 + (4%/2)] = $102,000 $102,000 * (4.5% / 2) = $2,295
does TIPS interest income get taxed at the state level?
no
does TIPS increase in principal get taxed at the state level?
no
does TIPS increase in principal get taxed at the federal level?
yes
permit investors to hold and trade the individual interest and principal components of eligible treasury notes and bonds as separate securities
treasury strips (Separate trading of registered interest and principal of securities)
true or false? Savings EE bonds must be held for at least 12 months
true
what is the penalty for redeeming Savings EE bonds within 5 years of issue?
3 month interest penalty
true or false? Savings EE bonds are subject to state income tax
false
is interest tax deferred under a Savings EE bond?
yes
Minimum term of ownership: 1 year
Interest-earning period: 30 years
Early redemption penalties:
Before 5 years, forfeit interest from previous 3 months
- After 5 years, no penalty
Savings bonds are exempt from taxation by any State or political subdivision of a State, except for estate or inheritance taxes.
Interest earnings are subject to Federal income tax.
Interest earnings may be excluded from Federal income tax when bonds are used to finance education (see education tax exclusions). Restrictions apply.
is interest income from Series HH bonds taxed at state levels?
no
Interest earnings are exempt from state and local income taxes but are subject to federal, state, and local estate, inheritance, gift, and other excise taxes.
Interest earnings are subject to federal income tax.
true or false? Series HH bonds have been discontinued
true
offer a fixed interest rate that can earn interest up to 20 years
Series HH bonds
represents an ownership claim on a pool of mortgages, most commonly on residential property
mortgage backed securities
mortgage backed securities that have no default and are government backed
Ginnie Mae (GNMA)
For the most part, the government-backed mortgage guarantee companies have assumed the nicknames they picked up many years ago. Ginnie Mae is a corporation entirely owned by the Federal Housing Administration. The GNMA is in all respects a federal government agency.
Ginnie Mae provides a government guarantee on mortgage-backed securities that are backed by pools of home loans originated through a government program. The home loans behind a GNMA MBS bond will be FHA, VA, Public and Indian Housing and Rural Development Agency program home loans. Fannie Mae mortgage securities are backed by pools of conventional loans, which are home loans originated by a bank or lender and not under any specific government program. The loans in a Fannie Mae pool must meet the lending standards set by Fannie.
The Government National Mortgage Association (GNMA or Ginnie Mae) issues agency bonds backed by the full faith and credit of the U.S. government. GNMA guarantees principal and interest on mortgage-backed securities (MBS) backed by loans insured by the Federal Housing Administration and the Department of Veterans Affairs. New GNMAs are issued in $25,000 minimum denominations.
Credit rating
GNMA securities, like U.S. Treasuries, are guaranteed and backed by the full faith and credit of the U.S. government and generally are considered to be of the highest credit quality.
Taxability
The interest income on GNMAs generally is subject to federal and state taxes.
GNMA securities may subject investors to capital gains taxes when sold or redeemed. Investors should consult a tax professional for additional information.
Liquidity
Vanguard Brokerage Services ® does not make a market in GNMA bonds. If you want to sell your GNMAs prior to maturity, Vanguard Brokerage can provide access to a secondary over-the-counter market. The secondary market generally provides liquidity for GNMA bonds, but liquidity will vary depending on a bond’s features, lot size, and other market conditions. It may be difficult to sell GNMAs that have experienced significant principal pay-down.
Risks
GNMA prices can rise or fall depending on interest rates. If interest rates rise, the market price of outstanding GNMA bonds generally will decline. Changes in interest rates have an additional impact on MBS because they affect mortgage prepayment rates. The prepayment rate for a mortgage pool affects the average life and yield. Prepayments often speed up as interest rates decline because mortgage holders are able to refinance at lower rates. Rising interest rates tend to slow loan prepayments.
Principal may be returned to bondholders sooner than expected if mortgage holders prepay their loans. Bondholders then may have to reinvest the returned principal at a lower interest rate.
Principal may be returned to bondholders later than expected if mortgage holders delay the prepayment of their loans. Bondholders then could miss an opportunity to reinvest the returned principal at a higher interest rate.
All bonds carry the credit risk that the issuer will default or be unable to make timely payments of interest and principal. However, GNMAs generally carry minimal credit risk because they are backed by the U.S. government.
GNMAs sold prior to maturity may be subject to substantial gain or loss. The secondary market may also be limited.
what risks are mortgage backed securities subject to?
interest rate risk prepayment risk reinvestment rate risk
mortgage derivatives created by private investment firms
collateralized mortgage obligations (CMO)
A collateralized mortgage obligation (CMO) refers to a type of mortgage-backed security that contains a pool of mortgages bundled together and sold as an investment. Organized by maturity and level of risk, CMOs receive cash flows as borrowers repay the mortgages that act as collateral on these securities. In turn, CMOs distribute principal and interest payments to their investors based on predetermined rules and agreements.
Investors in CMOs, sometimes referred to as Real Estate Mortgage Investment Conduits (REMICs), want to obtain access to mortgage cash flows without having to originate or purchase a set of mortgages. Organizations that purchase CMOs include hedge funds, banks, insurance companies, and mutual funds.
what are the three types of payments received under a mortgage backed security?
scheduled interest scheduled principal unscheduled principal
what risks are collateralized mortgage obligations subject to?
- market risk
- prepayment risk
- liquidity risk
- interest rate risk
SEC = CMOs are often highly sensitive to changes in interest rates and any resulting change in the rate at which homeowners sell their properties, refinance, or otherwise pre-pay their loans. Investors in these securities may not only be subjected to this prepayment risk, but also exposed to significant market and liquidity risks
bonds that are repaid from the revenue generated from the financed project
revenue bonds
bonds that are backed by the full faith and credit of the municipality issuing the debt
general obligation bonds
issued to finance community capital improvements
general obligation bonds
issued by municipalities to finance specific projects
revenue bonds
true or false? revenue bonds are less risky than general obligation bonds
false, revenue bonds are more risky
bonds where more than 10% of the proceeds of the issue are used for private business and more than 10% of the payment of the principal and interest is secured by an interest in property to be used for private business or derived from payments for property used for private business
Secondly, a municipal bond will be classified as a private activity bond if the amount of proceeds of the issue used to make loans to non-governmental borrowers exceeds 5 percent of the proceeds or $5 million, whichever is lesser.
Private activity bonds
- Private activity bonds are municipal bonds which are used to attract private investment for projects that have some public benefit; however, there are strict rules as to which projects qualify. Qualified projects that may be financed by private activity bonds include funding and refinancing student loans, airports, private universities, hospitals, affordable rental housing, mortgage provision for first-time lower-income borrowers, etc. In no event may proceeds of a private activity bond be used to finance an airplane, certain health club facilities, a gambling facility, stadium, golf course, oil refinery, or a liquor store. This type of bond results in reduced financing costs because of the exception of federal tax.
- States and cities, through private activity bonds, are able to borrow on behalf of private companies and nonprofits, lowering borrowing costs for entities that might otherwise turn to corporate bonds or bank loans. Private activity bonds are issued to attract businesses and labor to a region in order to derive a public benefit, which would qualify the bond for tax-exempt status. These bonds pay taxable interest unless specifically exempted by the federal government.
a specified series of bonds that mature each year until the final year of maturity
Serial Bonds
The Differences Between Sinking Funds and Serial Bond Issues
In a sinking fund, the issuer makes periodic payment to the bond issue’s trustee, and the trustee purchases bonds in the open market and retires the bonds. The trustee represents the interests of the bondholders and must use the sinking fund payments to buy bonds and retire them. Instead of retiring bonds according to a specific schedule, the trustee purchases bond from any bondholder who is willing to sell his holdings. Both sinking funds and serial bond issues reduce the total dollar amount of bonds outstanding over time.
what is the tax equivalent yield of the following municipal bond: yield of muni bond = 5% and the tax payer is in the 25% tax bracket
5% / (1 - 25%) = 6.67%
a legal document that sets forth repayment schedule, redemption rights, and amount of issue
indenture agreement
bonds that have a legal claim to specific assets in the event of default, insolvency, or liquidation
Secured bonds
true or false? secured bonds generally have lower yields than unsecured bonds
true
bonds that are backed by real estate, land, or property
mortgage bonds
bonds secured by stocks and bonds of other companies held in trust
collateral trust bonds
bonds not backed by collateral
debentures
true or false? subordinate debentures have high yield than secured bonds and regular debentures
true
bonds that have a high probability of payment of interest and repayment of principal
investment grade bonds
what agencies rate bonds?
standard and poors Fitch Moody’s
Moodys is the weird one
- Aaa
Aa1
Aa2
Aa3
A1
A2
A3
Baa1
Baa2
Baa3
Fitch and Standard & Poor
- AAA
AA+
AA
AA-
A+
AA
A-
BBB+
BBB
BBB-
what ratings are considered investment grade?
BBB- = Standard & Poor + Fitch - Last Investment Grade
BB+ = Standard & Poor + Fitche - Non Investment Grade
Bbb3 = Fitch - Last Investment Grade
Bb1 = Fitch - Non Investment Grade
bonds that have a significant risk of defaul
non-investment grade bonds
what ratings are considered non-investment graded?`
anything BB+ or lower
what other names do non-investment grade bonds go by?
junk or high yield
what is the lowest bond rating by Standard and Poor’s?
D
allows the issuer to redeem a bond issue before its maturity date, either in whole or in part
callable bond
corporate bonds that may be exchanged for a fixed number of shares of the issuing company’s common stock
convertible bond
true or false? convertible bonds usually have a lower yield than regular bonds
true
the price that is paid for each share of common stock that is acquired through the conversion of the security
conversion price
the number of shares of the issuing company’s common stock that can be acquired by exchanging the convertible security
conversion ratio
FIRST example, Twitter (TWTR) issued a convertible bond, raising $1.8 billion in September 2014. The notes were in two tranches, a five-year due in 2019 with a 0.25% interest rate, and a seven-year due in 2021 at 1%. The conversion rate is 12.8793 shares per $1,000, is about $77.64 per share. The price of the stock has ranged between $35 and $56 over the last year. To make a profit on the conversion, one would have to see the stock more than double from the $35 to $40 range. The stock certainly could double in short order, but clearly, it’s a volatile ride. And given a low-interest rate environment, the principal protection isn’t worth as much as it might otherwise be.
SECOND Example
- Suppose that TSJ Sports issues $10 million in three-year convertible bonds with a 5% yield and a 25% premium. This means TSJ will have to pay $500,000 in interest annually, or a total $1.5 million over the life of the converts.
- If TSJ’s stock was trading at $40 at the time of the convertible bonds issue, investors would have the option of converting those bonds for shares at a price of $50—$40 x 1.25 = $50.
- So, if the stock was trading at $55 by the bond’s expiration date, that $5 difference per share is profit for the investor. However, there is usually a cap on the amount the stock can appreciate through the issuer’s callable provision. For instance, TSJ executives won’t allow the share price to surge to $100 without calling their bonds and capping investors’ profits.
- Alternatively, if the stock price tanks to $25, the convert holders would still be paid the face value of the $1,000 bond at maturity. This means while convertible bonds limit the risk if the stock price plummets, they also limit exposure to upside price movement if the common stock soars.
how do you calculate the conversion ratio?
par value of convertible security / conversion price
Convertible Bonds
- A stock trading for $40 has a conversion ratio equal to $1,000 divided by $40, or 25.
Convertible Preferred
- For example, if a company issues convertible preferred with a 5% dividend and a conversion ratio of five, it means the investor gets five common shares for each share of preferred shares. If the preferred stock is trading at $100, the conversion break-even price on common shares can be determined by dividing the price by the conversion ratio, which is $20.
represents the cost of each share of stock obtained through the conversion
market conversion price
calculate the market conversion price based off the following info: if the market price of the convertible bond is $1,100 and 50 shares of common stock can be obtained
$1,100 / 50 = $22
represents the value of the bond if it were converted based on current market conditions
What is the floor value?
conversion value
Floor Value
- Bond Floor of Convertible Bond vs. Comparable Bond
- To find the bond floor, calculate the present value (PV) of the coupon and principal payments discounted at the straight bond interest rate.
- Even if stock drops, conertible bond should trade for a minimum of x price.
For example
- assume a convertible bond with a $1,000 par value has a coupon rateof 3.5% to be paid annually.
- The bond matures in 10 years. A comparable straight bond has the same face value, credit rating, interest payment schedule, and maturity date of the convertible bond, but has a coupon rate of 5%.
- To find the bond floor, calculate the present value (PV) of the coupon and principal payments discounted at the straight bond interest rate.
stock price $30.00 per sharestock
dividend $0.50 per share
convertible market price $1,000
coupon rate 7.00%
maturity20 years
conversion price $36.37
Conversion ratio= number of shares for which one bond may be exchanged= par / conversion price = $1,000 / $36.37 = 27.50 sharesd
Conversion Value = equity value or stock value of the convertible= stock price x conversion ratio= $30.00 x 27.50 = $825.00
Conversion premium= (convertible price – conversion value) / conversion value= ($1,000 – $825.00) / $825.00 = 21.21%
$70 x $15 = $1,050
true or false? you have pay taxes on the conversion of a security into common stock
false
true or false? corporate bonds offer high yields than government bonds
true
true or false? Yankee bonds are traded in the United States on exchanges or OTC markets
true
A Yankee bond is a bond issued by a foreign entity, such as a bank or company, but is issued and traded in the United States and denominated in U.S. dollars. Yankee bonds are governed by the Securities Act of 1933, which requires the bonds to be registered with the Securities and Exchange Commission (SEC) prior to being offered for sale.
Foreign issuers usually favor issuing Yankee bonds when there is a low-interest rate environment in the United States, since that means the issuer is able to offer the bond with lower interest payments.
true or false? Eurodollar bonds are traded in the United States
false
true or false? Eurodollar bonds are registered with the SEC?
false
true or false? Yankee bonds are registered with the SEC
True
true or false? Foreign pay bonds are registered with the SEC
False
True or false? Foreign pay bonds are issued and traded overseas
true
are foreign pay bonds subject to exchange rate risk?
Yes
true or false? if the exchange rate goes from 1.50 per 1.00 to 1.40 per 1.00 you will lose principal on a foreign pay bond
true
a promise to pay a certain sum of money at a prescribed time or to make a series of payments over a certain period
promissory notes
type of investment that has a guaranteed rate of return for a fixed time period and is primarily sold to pension plans
Guaranteed Investment Contract
true or false? guaranteed investment contracts have low default risk
true
states that one share of common stock permits one vote for each vacant position on the board of directors
statutory
states that a shareholder can cast votes equal to the number of vacant positions on the board of directors multiplied by the number of shares owned
cumulative
give an example of statutory voting
shareholder has 100 shares, there are two vacant positions…. this means the shareholder can put 100 votes towards each vacant position
For example, if the election is for four directors and you hold 500 shares (with one vote per share), under the regular method you could vote a maximum of 500 shares for each one candidate (giving you 2,000 votes total—500 votes per each of the four candidates). With cumulative voting, you are afforded the 2,000 votes from the start and could choose to vote all 2,000 votes for one candidate, 1,000 each to two candidates, or otherwise divide your votes whichever way you wanted.
Cumulative voting can be beneficial to minority voters because they can use all of their votes for a single candidate, improving the chance that they can get at least one sympathetic member on the board; statutory voting ensures that their votes get spread out amongst several candidates, making it less likely that any one of them is elected.
give an example of cumulative voting
shareholder has 300 shares, there are three positions vacant…this means the shareholder can cast 300 total votes combined between the 3 vacant spots
true or false? cumulative voting protects minority shareholders
true
entitles existing common stockholders the right to maintain ownership percentage
preemptive right
allows stockholders to purchase common stock below the current market price
rights offering
stock held by brokers on behalf of investors
street name stock
the date the board of directors approves and declares that a dividend will be paid
declaration date
the date on which the stock begins trading without the dividend; investors who held the stock on the day before this date will receive the dividend
ex-dividend date. Now…generally 1 day before the Record Date. THUS…NEED TO BUY THE STOCK TWO DAYS BEFORE RECORD DATE TO GET DIVIDEND
Apple:
Declaration Date = Tuesday, 4/30/2019
Ex-Dividend Date = Friday, 5/10/19
Record Date = Monday, 5/13/2019
As mentioned above, the legal definitions are pretty straightforward: the ex-date is one day prior to the record date. So if you want the dividend, you need to be an owner the day before the ex-date. Many people use the term “trading ex” which means the time has already passed to get the dividend.
So if a stock is “trading ex,” that means you can buy it but will not get that current period dividend. And the stock may be trading lower (hypothetically by the amount of the dividend) on the ex-date.
the date by which stock trades must be settled for shareholders to receive the dividend
record date
when is the record date for common stock?
two business days after the ex-dividend date
the date the company actually pays the dividend to the shareholders
payable date
true or false? the corporation paying the dividend receives a tax deduction
false
if a company is worth $11million with 1 million shares outstanding and issues a 10% stock dividend, what will the stock price of the company be?
1 million x 10% = 100,000 new shares $11 million / 1.1 million shares = $10 per share
true or false? stock dividends (different than regular dividends) received by the investor are taxable
false
commonly used to reduce the market price per share of the stock
stock splits
if an investor owns 100 shares of a company that trades at $150 per share and the company declares a 3 to 1 stock split how many shares will the investor own and at what price?
300 shares at $50 per share ($150/3 = $50) (100 x 3 = 300)
used to reduce the total number of shares outstanding
reverse stock split
an investor owns 500 shares of stock with a price of $2 per share. The company declares a reverse stock split of 5 for 1, how many shares will the investor own and at what price?
100 shares at $10 (500/5 = 100) ($2 x 5 = $10)
true or false? Blue chip stocks are represented by the DJIA
true
issued by highly regarded, cash flow stable companies
blue-chip stocks
true or false? blue chip stocks usually don’t pay dividends
false, they usually do
issued by companies with sales, earnings, and market share growth rates exceeding those typical of the industry
growth stocks
true or false? growth stocks usually pay a dividend
false, they don’t usually pay dividends
true or false? growth stocks usually have high price to earnings ratios
true
stocks that tend to prosper during economic expansion and perform poorly during contractions
cyclical stocks
Include
- restaurants,
- hotel chains,
- airlines,
- furniture,
- high-end clothing retailers, and
- automobile manufacturers.
These are also goods and services people tend to forgo when times are tough. When people stop or hold off buying because of a reduction in purchasing power, company revenues may start to fall. This, in turn, puts pressure on stock prices, which also start to drop. In the event of a long downturn, some of these companies may even go out of business.
what industries will you typically find cyclical stocks in?
automobile, construction, air travel
Cyclical stocks are known for following the cycles of an economy through expansion, peak, recession, and recovery.
Cyclical stocks typically refer to companies that sell discretionary items consumers can afford to buy more of in a booming economy. Alternatively, cyclical stocks are also companies that consumers choose to spend less with and cut back on during a recession
Durable goods companies are involved in the manufacture or distribution of physical goods that have an expected life span of more than three years. Companies that operate in this segment include automakers such as Ford Motor Company, appliance manufacturers such as Whirlpool Corporation, and furniture makers such as Ethan Allen Interiors Inc. The measure of durable goods orders is an indicator of future economic performance. When durable goods orders are up in a particular month, it may be an indication of stronger economic activity in the ensuing months.
Nondurable goods companies produce or distribute soft goods that have an expected life span of fewer than three years. Examples of companies operating in this segment are sports apparel manufacturer Nike Inc. and retail stores such as Nordstrom Inc. and Target Inc.
Services is a separate category of cyclical stocks because these companies do not manufacture or distribute physical goods. Instead, they provide services that facilitate travel, entertainment, and other leisure activities for consumers. Walt Disney Company (DIS) is one of the best-known companies operating in this space, but it is joined by many companies operating in the new digital area of streaming media, such as Netflix Inc. and Time Warner Inc.
stocks currently trading at prices that are low considering their historical earnings and asset values
value stocks
true or false? value stocks usually have low price to earnings ratios
true
stocks relatively unaffected by economic fluctuations
defensive stocks
stocks affected by changes in market interest rates
interest sensitive stocks
what industries are you most likely to find interest sensitive stocks?
insurance financials construction real estate
preferred stock is an example of a ____, there is no fixed maturity date
perpetuity
true or false? preferred stock usually has a fixed dividend
true
a hybrid security with features of both equity and debt securities
preferred stock
what is the value of the dividend that would be paid under the following preferred stock: A $100 par 5.5% issue
$5.50 annually per share
states that unpaid preferred stock dividends from prior years must be paid before dividends are paid to common stockholders
cumulative preferred
states that shareholders are not paid missed dividends
straight preferred
A straight preferred security is “just a piece of paper” that agrees to pay some dividend at some point. But if it ever misses paying that dividend then…oh well, gee whiz, we didn’t pay it. Bummer days for you. This kind of preferred stock is called non-cumulative (think: suckers!), and it means it will have to pay a higher dividend to compete against securities of similar risk cumulative preferred securities.
states that shareholders are paid a regular fixed dividend plus an additional dividend if common stock dividend exceeds a specified amount
participating preferred
For example
-
Company A has one series of non-participating preferred stock with a liquidation preference of $6 million representing 50% of the capital stock of Company A.
- If Company A were to be sold for $10 million, the investors would receive $6 million (as the $6 million investment amount is greater than the preferred’s 50% share of the $10 million sale proceeds) and the remaining $4 million of proceeds would be distributed to management.
-
Company B also has one series of preferred stock with a liquidation preference of $6 million representing 50% of the capital stock of Company B, but its preferred stock is participating.
- Upon the same $10 million sale event, the investors would receive $8 million (the $6 million liquidation preference plus 50% of residual $4 million of sale proceeds) and the remaining $2 million of the proceeds would be distributed management. Thus, in the same $10 million sale, the different between participating vs. non-participating preferred resulted in a $2 million shift in economics away from management to the investors, which represents one-half of the return that management would have received had the preferred stock been structured as non-participating.
stock issued with the right to convert the preferred shares into a specified number of common shares
convertible preferred
stock issued that gives the company to repurchase preferred shares from investors at a stated call price after a specified date
callable preferred
trust receipts issued by a US bank for shares of a foreign company purchased and held by a foreign branch of the bank
ADR (american depository receipts)
true or false? exchange rate risk is completely eliminated with ADR’s
false
ADRs may be listed on a major exchange such as the New York Stock Exchange or may be traded over the counter (OTC). Those that are listed can be traded, settled, and held as if they were ordinary shares of U.S.-based companies.
American Depository Receipts (ADRs) offer U.S. investors a means to gain investment exposure to non-U.S. stocks without the complexities of dealing in foreign stock markets. They represent some of the most familiar companies in global business, including household names such as Nokia, Royal Dutch Petroleum (maker of Shell gasoline), and Unilever. These and many other companies based outside the U.S. list their shares on U.S. exchanges through ADRs.
In addition to ADRs, Global Depositary Receipts (GDRs) give issuers exposure to the global markets outside their home market. GDRs are offered to investors in 2 or more markets and are most commonly used to raise capital in Europe and the United States. Both ADRs and GDRs are usually denominated in U.S. dollars, but may also be denominated in euros.
corporation or trust that pools investors’ money and uses proceeds to invest in a portfolio of securities
investment companies
to be classified as a regulated investment company what four characteristics must be present?
- at least 90% of income derived from interest, dividends, and capital gains
- at least 90% of taxable income distributed to shareholders
- Should the RIC not distribute this share of income, it may be subject to an excise tax by the IRS
- No more than 25% of the company’s total assets may be invested in securities of a single issuer unless the investments are government securities or the securities of other RICs.
- Finally, to qualify as a regulated investment company, at least 50% of a company’s total assets must be in the form of cash, cash equivalents or securities
For example, it may take the form of a
- mutual fund or exchange-traded fund (ETF),
- a real estate investment trust (REIT), or
- a unit investment trust (UIT)
true or false? unit investment trust (UIT’s) are self liquidating
true
true or false? unit investment trusts are actively managed
false
true or false? shares of a close end investment company are traded in the secondary market
true
true or false? close end investment companies usually have a fixed capitalization
true
true or false? open end investment companies are mutual funds
true
true or false? mutual funds are not traded in the secondary market
False - although not on an exchange
After the initial sales of a new issue have been completed in the underwriting process, the bonds may continue to be bought and sold throughout the life of the security in what is generally called the secondary market. There is no central exchange for municipal securities. Instead, the secondary market for municipal securities historically has been an over-the-counter, dealer market.
true or false? mutual funds have a fixed market cap
false, it varies
funds that focus on capital appreciation
aggressive growth stock funds
true or false? aggressive growth stock funds have higher risk
true
true or false? aggressive growth stock funds have lower turnover
false
____ funds are similar to aggressive growth funds but have less volatile stocks
growth
funds that focus on capital appreciation and current income
growth and income funds
funds that invest in domestic and foreign securities
global fund
funds that invest in companies outside the US
international funds
funds that invest in foreign markets of developing countries
emerging markets fund
bond funds that focus on tax-free income
municipal funds
investment in junk bonds or higher level income bonds
high yield funds
funds that invest in a fixed percentage of stock and bonds or money market securities
balanced funds
true or false? money market funds are used as an emergency fund
true
if a client is concerned with maximizing current income which type of fund suits them?
corporate bond fund
if a client is concerned with growth what type of fund suits them?
stock fund
if a client is concerned with income (current or not) what type of fund suits them?
bond fund
if a client is concerned with immediate liquidity what type of fund suits them?
money market fund
if a client is concerned with tax relief what type of fund suits them?
muni bond fund
a sales charge that is deducted from the initial investment
A sales charge is a commission paid by an investor on his or her investment in a mutual fund. The sales charge is paid to a financial intermediary (broker, financial planner, investment adviser, distributor, etc.). Sales charges are expressed as a percentage of the investment value.
Class A shares are front-end load funds that carry an upfront sales charge on the total amount of the investment. The charge is used to pay for the services of an investment advisor and ranges from 5% to 8%. Investors who invest large amounts of money can benefit from breakout discounts that reduce the sales charge.
Eventually, after a seven or eight year holding period, the investor can exchange the class B shares for class A shares. Class B shares are appropriate for investors who lack adequate capital to invest in class A and qualify for breakout discounts but can hold class B shares for about seven years before exchanging them for class A shares.
Class C shares charge a level load of about 1% all through the investment holding period, making it the most expensive share class for investors who plan to hold the investment in the long term. They do not offer breakout discounts. Class C shares are most appropriate for investors who plan to hold the shares for the short term.
12b-1
Class A shares, which usually charge a front-end load but no back-end load, may come with a reduced 12b-1 expense but normally don’t come with the maximum 1% fee. Class B shares, which typically carry no front-end but charge a back-end load that decreases as time passes, often come with a 12b-1 fee. Class C shares usually have the greatest likelihood of carrying the maximum 1% 12b-1 fee. The presence of a 12b-1 fee frequently pushes the overall expense ratio on a fund to above 2%.
front-end sales charge
a sales charge that is deducted upon withdrawal from the fund
A back-end load is a fee (sales charge or load) that investors pay when selling mutual fund shares, and the fee amounts to a percentage of the value of the share being sold. A back-end load can be a flat fee or can gradually decrease over time, usually within five to 10 years. In the latter case, the fee percentage is highest in the first year and decreases yearly until the specified holding period ends, at which time it drops to zero.
back-end sales charge
fees for marketing and advertising expenses
12b-1 fees
Distribution [and/or Service] (12b-1) Fees
This category identifies so-called “12b-1 fees,” which are fees paid by the fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses. 12b-1 fees get their name from the SEC rule that authorizes a fund to pay them. The rule permits a fund to pay distribution fees out of fund assets only if the fund has adopted a plan (12b-1 plan) authorizing their payment.
“Distribution fees” include fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature.
Some 12b-1 plans also authorize and include “shareholder service fees,” which are fees paid to persons to respond to investor inquiries and provide investors with information about their investments. A fund may pay shareholder service fees without adopting a 12b-1 plan. If shareholder service fees are part of a fund’s 12b-1 plan, these fees will be included in this category of the fee table. If shareholder service fees are paid outside a 12b-1 plan, then they will be included in the “Other Expenses” category.
pays for general operating expenses of the mutual fund
admin and management fees
Annual Fund Operating Expenses - FROM SEC (https://www.sec.gov/files/ib_mutualfundfees.pdf)
-
Management Fees
- Management fees are fees that are paid out of fund assets to the fund’s investment adviser (or its affiliates) for managing the fund’s investment portfolio, and administrative fees payable to the investment adviser that are not included in the “Other Expenses” category (discussed below).
-
Distribution and/or 12b-1 Fees
- This category identifies so-called “12b-1 fees,” which are fees paid by the fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses.
- “Distribution fees” include fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. Under FINRA rules, however, 12b-1 fees that are used to pay marketing and distribution expenses (as opposed to shareholder service expenses) cannot exceed 0.75% of a fund’s average net assets per year.
- “Shareholder Service Fees” - A fund may pay shareholder service fees without adopting a 12b-1 plan. If shareholder service fees are part of a fund’s 12b-1 plan, these fees will be included in the “Shareholder Fees” category of the fee table. If shareholder service fees are paid outside a 12b-1 plan, then they will be included in the “Other Expenses” category, discussed below. FINRA imposes an annual 0.25% cap on shareholder service fees (regardless of whether these fees are authorized as part of a 12b-1 plan).
- This category identifies so-called “12b-1 fees,” which are fees paid by the fund out of fund assets to cover distribution expenses and sometimes shareholder service expenses.
-
Other Expenses
- Included in this category are expenses not included in the categories “Management Fees” or “Distribution [and/or Service] (12b-1) Fees.” Examples include: certain shareholder service expenses; custodial expenses; legal expenses; accounting expenses; transfer agent expenses; and other administrative expenses.
-
Total Annual Fund Operating Expenses
- This line of the fee table represents the total of a fund’s annual fund operating expenses, expressed as a percentage of the fund’s average net assets.
what type of share class has a front end load
Class A Shares
what type of share class has a back end load
Class B Shares
Mutual fund B shares do not require front-end sales charges, but carry a contingent deferred sales charge (CDSC) and have a higher 12b-1 fee (a 1% 12b-1 fee is common) than other mutual fund share classes. CDSCs are charges imposed on shareholders who sell their shares in the fund during the surrender period.
These CDSCs are not paid to advisors, but to the fund company to cover various costs, including the upfront commissions the fund pays to advisors (often as high as 4%). Investors do not see these upfront commissions charged by funds that are paid to the advisors who offer the fund shares for purchase.
Specific CDSCs are outlined in the mutual fund’s prospectus and the cost depends on how long the investor holds his/her shares. Many mutual fund B shares have a CDSC that is reduced to 0% by year six, while in year seven, the mutual fund Class B shares convert to Class A shares (which carry no surrender charges and have lower 12b-1 fees).
generally speaking B shares have a ___ 12b-1 fee than A shares
higher
The 12b-1 fee is divvied up into two distinct charges:
- a distribution/marketing fee (capped at 0.75%)
- a service fee (capped at 0.25%)
12b-1 fees are capped at 1% annually, with distribution/marketing fees and service fees limited to 0.75% and 0.25%, respectively. NOTE - different than Front End Load Fee.
A Shares
- “A share” mutual fund investors pay a separate upfront sales and marketing commission, so they are typically only face the service fee portion of the 12b-1 fee.
- Class A shares tend to have lower 12b-1 fees (marketing and distribution fees included in the fund’s expense ratio), so if you plan on holding these shares for several years, a front-end load might be beneficial in the long run.
- Class A shares, which usually charge a front-end load but no back-end load, may come with a reduced 12b-1 expense but normally don’t come with the maximum 1% fee.
C Shares
- “C share” mutual fund investors pay both the distribution/marketing fee and the service fee to compensate their fund managers.
- The presence of a 12b-1 fee frequently pushes the overall expense ratio on a fund to above 2%.
what share class has a back end load for the first year only?
Class C Shares
Class C shares are a type of level-load fund, which charges an annual fee. This class works well for individuals who will be redeeming shares in the short term.
Pros
- No Front-End Fees – Your entire initial investment contribution earns interest income.
- Small Back-End Load – The back-end load is typically only 1%.
- Opportunity to Avoid Back-End Load – The back-end load is normally removed after the shares have been held for one year.
Cons
- Back-End Load – A back-end load – although small – is typically charged if funds are withdrawn within the first year.
- Higher Expense Ratios – Although the expense ratios of Class C shares are lower than those of Class B shares, they are higher than those for Class A shares.
- No Conversion – Unlike Class B shares, Class C shares cannot be converted into Class A shares, removing the opportunity for lower expense ratios. As such, if you have a long time horizon, Class C shares are not optimal for you as the high management fees are continuous. That is, your investment returns will be reduced the longer you stay invested because the fees will add up considerably over time.
- No Discounts – Class C shares do not offer discounts on expenses when the account reaches certain levels.
if a fund has a turnover rate of 100% or more, the fund is generally holding its securities for ___ than a year
less
higher turnover results in ___ transaction costs
higher
higher turnover can lead to ___ taxable income for the investor
more
changes in fund’s investment style affect the investor’s asset allocation
style drift
calculate the investors adjusted basis and capital gain in the following scenario: tommy invested $10k into a mutual fund two years ago. He elected to reinvest all his capital gains and dividends. Last year he received dividends of $500 and cap gains of $200. This year he received $700 of dividends and $300 of cap gains. He sold his shares at the end of this year for $20,000
his adjusted basis = ($10k + 200 + 500 + 700 + 300) = $11,700 his capital gain from sale = $20k - $11,700 = $8,300
private partnerships that use advanced investment strategies in an effort to achieve higher returns
hedge funds
what risks are associated with hedge funds?
leverage short selling riskier investment options lack of transparency (don’t disclose a lot of info)
true or false? a hedge fund manager charges a performance based fee
true
Hedge fund fees are often higher than those of mutual funds and they frequently involve both a management fee and a performance fee. A commonly-quoted hedge fund fee is “two and twenty”—an annual two percent of assets fee plus 20 percent of the gains over some base return or “hurdle rate.”
High water marks refer to performance fee policies that specify that the fund manager will only be paid a percentage of the profits if the net value of the fund exceeds the previous highest value achieved by the fund. A fund must actually make up losses before it can charge an incentive. In other words, if a $1,000,000 investment loses 50% in the first year (leaving $500,000), then earns 100% the following year, it cannot charge an incentive fee the second year because the investment is only back to where it began. Some investors feel the high-water mark can lead to the manager taking on more risk, if he is in a position where he has to play catch-up. Others would not invest without it.
Hurdle rates, also referred to as minimum acceptable rates of return, are also used as a determining factor for hedge fund performance fees, by measuring fund performance against an external benchmark. Where hurdle rates are applied, performance fee percentages are not paid to the fund manager unless the rate of return on the fund meets or exceeds that benchmark rate. The rates used for comparison may be a pre-determined percentage, or some other financial industry measure such as the rate of return on US treasury bills, or other rates of return in the financial industry. Guaranteeing that performance fees will not be levied helps to reassure investors that they will be compensated somewhat if the return fails to exceed that of other investment options.
what is difference between the trading strategies of an investment company and a hedge fund?
hedge fund managers usually makes use of derivatives, leveraging, short selling
true or false? hedge funds generally do not have daily liguidity
TRUE
security whose value is derived from the value of an underlying secuirty or asset
derivative
contracts between two parties to make or take delivery of a specific commodity or financial asset of a specified quality at a future time, place, and unit price
Futures
futures that involve currency and interest rates
financial futures
futures that involve wheat, sugar, and lumber
agricultural futures
Futures are often used to trade agricultural commodities. Such commodities are divided into several groups:
- grains and oilseeds,
- Livestock,
- dairy,
- lumber,
- softs,
- biofuels.
The CME Group is used as the main supplier of market data for agricultural commodity futures on TradingView. It operates the biggest futures exchange in the world. Even though this market segment is often perceived as a whole, each product behaves differently. You may sort the futures using various metrics that will help you understand the product, its volatility and price dynamics.
futures that involve oil and gas
mineral futures
Despite using it every day, not many people know the differences between crude oil and gasoline. It is the raw material that is refined to produce gasoline, heating oil, diesel, jet fuel and many other petrochemicals. The fundamentals are different since it is a raw product.
Light Sweet Crude Oil is traded on the New York Mercantile Exchange (NYMEX). “Light Sweet” is the most popular grade of crude oil being traded. Another grade of oil is Brent Crude, which is primarily traded in London, and is seeing increased interest. Russia, Saudi Arabia, and the United States are the world’s three largest oil producers as of 2018.
When crude oil is refined or processed, it takes about three barrels of oil to produce two barrels of unleaded gas and one barrel of heating oil. This helps to put into perspective the production needs of crude, and why production/supply levels are watched so closely.
what are three examples of future contract exchanges?
New York Mercantile Exchange Chicago Mercantile Exchange Chicago Board of Trade
The New York Mercantile Exchange (NYMEX) is the world’s largest physical commodity futures exchange. Today, NYMEX is part of the Chicago Mercantile Exchange Group (CME Group). The CME Group is the world’s leading and most diverse derivatives marketplace, made up of four exchanges,
-
CME
- The CME trades futures, and in most cases options, in the sectors of agriculture, energy, stock indices, foreign exchange, interest rates, metals, real estate, and even weather.
- By 2010, the CME purchased a 90% interest in the Dow Jones stock and financial indexes. The CME grew again in 2012 with the purchase of the Kansas City Board of Trade, the dominant player in hard red winter wheat. And in late 2017, the Chicago Mercantile Exchange began trading in Bitcoin futures.
-
Chicago Board of Trade (CBOT)
- The CBOT originally traded only agricultural commodities such as wheat, corn and soybeans. Now, the CBOT offers options and futures contracts on a wide range of products including gold, silver, U.S. Treasury bonds and energy
-
NYMEX
- Futures and options on energy and precious metals have become great tools when companies try to manage risk by hedging their positions. The ease with which these instruments are traded is vital to hedging activities and gauging futures prices, making NYMEX a vital part of the trading and hedging worlds. Daily exchange volume of the CME Group is around 30 million contracts with NYMEX making up about 10% of that amount because of the physical commodities that are traded on that exchange.
-
Commodity Exchange, Inc. (COMEX)
- COMEX is the primary futures and options market for trading metals such as gold, silver, copper and aluminum. Formerly known as the Commodity Exchange Inc., COMEX merged with the New York Mercantile Exchange (NYMEX) in 1994 and became the division responsible for metals trading.
true or false? derivatives require a margin account
true
In the world of futures contracts, the margin rate is much lower. In a typical futures contract, the margin rate varies between 5 and 15% of the total contract value.
For example
- the buyer of a contract of wheat futures might only have to post $1,700 in margin.
- Assuming a total contract of $32,500 ($6.50 x 5,000 bushels) the futures margin would amount to around 5% of the contract value.
- Initial Futures Margin is the amount of money that is required to open a buy or sell position on a futures contract.
Initial margin is original margin, the amount posted when the original trade takes place.
what is the initial margin of a derivative equal to?
initial deposit
the current price of the commodity
spot rate
As an example of how spot contract works, say it’s the month of August and a wholesaler needs to make delivery of bananas, she will pay the spot price to the seller and have bananas delivered within 2 days. However, if the wholesaler needs the bananas to be available at its stores in late December, but believes the commodity will be more expensive during this winter period due to a higher demand and lower overall supply, she cannot make a spot purchase for this commodity since the risk of spoilage is high. Since the commodity wouldn’t be needed until December, a forward contract is a better fit for the banana investment.
maximum change in a commodity’s price that is permitted during the trading day
daily limit
It is often used in the derivatives market, especially for option or futures contracts, to harness the excessive volatility that can ensue in one trading session. Daily trading limits are imposed by securities exchanges to protect investors from extreme price movements and discourage potential manipulation within the markets.
Here’s a hypothetical example: suppose the daily trading limit for a particular commodity was $0.50 per bushel and the previous day’s settlement was $5.00. In this case, traders cannot sell for less than $4.50 or buy for more than $5.50 per bushel during the current session. If either of the daily trading limits were to be reached then this commodity would be deemed to be a ‘locked’ market. It would also be described as having gone ‘limit up’ or ‘limit down’ based on whether the upside or downside limit was reached.
the number of contracts outstanding for a particular futures contract
open interest
price specified in the contract for future delivery of the commodity
futures price
the required minimum balance of a derivative
maintenance margin
Securities margin is the money you borrow as a partial down payment, up to 50% of the purchase price, to buy and own a stock, bond, or ETF. This practice is often referred to as buying on margin.
Futures margin is the amount of money that you must deposit and keep on hand with your broker when you open a futures position. It is not a down payment and you do not own the underlying commodity.
Futures margin generally represents a smaller percentage of the notional value of the contract, typically 3-12% per futures contract as opposed to up to 50% of the face value of securities purchased on margin.
Initial margin is the amount of funds required by CME Clearing to initiate a futures position. While CME Clearing sets the margin amount, your broker may be required to collect additional funds for deposit.
Maintenance margin is the minimum amount that must be maintained at any given time in your account.
If the funds in your account drop below the maintenance margin level, a few things can happen:
You may receive a margin call where you will be required to add more funds immediately to bring the account back up to the initial margin level (DIFFERENT THAN SECURITIES MARGIN).
If you do not or can not meet the margin call, you may be able to reduce your position in accordance with the amount of funds remaining in your account.
Your position may be liquidated automatically once it drops below the maintenance margin level.
what is the purpose of hedging?
to reduce risk associated with fluctuating commodity prices
Most people would think that hedgers would initiate a hedge as soon as possible to make sure they don’t have any risk that prices could make a detrimental move before they have to buy or deliver a commodity. However, that is often far from the normal case.
Some companies don’t hedge or they rarely hedge. A good example of this is when the major airlines were caught sleeping when the price of oil climbed from $30 to nearly $150 a barrel. Many airlines suffered huge losses and some went bankrupt due to the high fuel costs.
If they had been hedging properly, a large portion of the losses could have been avoided. They still would have had to pay the higher fuel costs, but they would have made a substantial amount of profits on the futures positions. Most airlines are now very diligent about using a strict hedging program.
Farmers, for example, sometimes don’t hedge until the last minute. Grain prices often move higher in the June - July timeframe on weather threats. During this time, farmers watch prices move higher and higher, often getting greedy. Sometimes they wait too long to lock in the high prices and prices tumble. In essence, these hedgers turn into speculators.
give an example of a short hedge?
farmer is long in wheat, he could go short in a wheat futures contract
If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. As an example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells. If the price declines to $5, Company X will sell the silver for $5 but will recoup the difference
if September wheat contract is currently selling for $3.10 per bushel and a farmer locks in his future wheat price at $3.10 what happens in September of next year when the wheat price is $4 per bushel
the farmer is locked into his $3.10 price so he will lose $0.90 per bushel
how are gains or losses treated in regards to futures contracts?
For example, in February of this year, Bob bought a contract worth $20,000. If on December 31 (last day of the tax year) the fair market value of this contract is $26,000, Bob will….
60% long term and 40% short term regardless of holding period
Bob will recognize a $6000 capital gain on his 2015 tax return. This $6000 will be taxed on the 60/40 rate.
Futures traders benefit from a more favorable tax treatment than equity traders under Section 1256 of the Internal Revenue Code (IRC). 1256 states that any futures contract traded on a US exchange, foreign currency contract, dealer equities option, dealer securities futures contract, or index futures contract are taxed long-term capital gains rates of 60 percent and short-term capital gains rates of 40 percent—regardless of how long the trade was opened for.
Carry Back & Carry Forward
- Should a futures trader wish to carry back any losses under Section 1256, they are allowed to do so for up to three years, under the condition that the losses being carried back do not exceed the net gains of that previous year, nor can it increase an operating loss from that year.
- The loss is carried back to the earliest year first, and any remaining amounts are carried to the next two years.
- As usual, the 60/40 rule applies. Conversely, if any unabsorbed losses still remain after the carry-back, these losses can be carried forward.
the right to purchase the underlying security for a specified price within a specified period
call option
when the writer of the option owns the underlying security
covered call option
when the writer of the option does not own the underlying secuirty
naked call option
true or false? naked call options are not risky
fasle
the right to sell the underlying security for a specified price within a specified period
put option
purchase of a put index option, reflective of the portfolio, to protect an investor’s portfolio against a market downturn
portfolio insurance
options where the underlying security is a market index or average
index option
options where the underlying security is an individual stock
equity option
- A company issues a bond and attaches a warrant to the bond to make it more attractive to investors. If the issuer’s stock increases in price above the warrant’s stated price, the investor can redeem the warrant and buy the shares at the lower price.
- For example, if the warrant has a strike price of $20 per share and the market price of the stock rises to $25 per share, the investor can redeem the warrant and buy the shares for $20 per share.
- If the stock never rises above the strike price, the warrant expires, so it becomes worthless. There are complicated formulas for determining the value of warrants based on the strike price, the current market price, the time until expiration, and other factors.
one option contact covers ___ shares of the underlying security
100
the price per share cost of the option
premium
a call option trading for $4 would cost the investor ___
$400
the price at which the underlying security in an option can be bought or sold
exercise price
minimum price at which an option will trade
intrinsic value
Intrinsic value is the value any given option would have if it were exercised today. Basically, the intrinsic value is the amount by which the strike price of an option is in the money. It is the portion of an option’s price not lost due to the passage of time.
The time value of options is the amount by which the price of an option exceeds the intrinsic value. It is directly related to how much time an option has until it expires, as well as the volatility of the stock. The formula for calculating the time value of an option is:
Time Value = Option Price – Intrinsic Value
The actual derivation of the time value of an option is a fairly complex equation. As a general rule, an option will lose one-third of its value during the first half of its life and two-thirds during the second half of its life. This is an important concept for securities investors because the closer you get to expiration, the more of a move in the underlying security is needed to impact the price of the option. Time value is often referred to as extrinsic value.
true or false? intrinsic value can be less than zero
false
the difference between market price and the exercise price
intrinsic value
the intrinsic value of a call option = _______
greater of the market price minus the exercise price or zero
the intrinsic value of a put option = _____
greater of the exercise price minus the market price or zero
For example,
- let’s say General Electric (GE) stock is selling at $34.80.
- The GE 30 call option would have an intrinsic value of $4.80 ($34.80 – $30 = $4.80) because the option holder can exercise his option to buy GE shares at $30, then turn around and automatically sell them in the market for $34.80—a profit of $4.80.
- the GE 35 call option would have an intrinsic value of zero ($34.80 – $35 = -$0.20) because the intrinsic value cannot be negative.
In a different example,
- Intrinsic value also works the same way for a put option.
- For example, a GE 30 put option would have an intrinsic value of zero ($30 – $34.80 = -$4.80) because the intrinsic value cannot be negative. On the other hand, a GE 35 put option would have an intrinsic value of $0.20 ($35 – $34.80 = $0.20).
what is the intrinsic value of the following put option: exercise price = $25 market price = $28
zero
what is the intrinsic value of the following call option: exercise price = $72 market price = $78
$6
what is the intrinsic value of the following put option: exercise price = $30 market price = $29
$1
what is the intrinsic value of the following call option: exercise price = $50 market price = $45
$0
the greater an option’s time to expiration the ____ it’s time value
greater
the greater an option’s volatility the ___ it’s time value
greater
what is the time value of the following put: put option selling for $5 exercise price is $60 current price is $67
$5 (premium - intrinsic value)
what is the time value of the following call: call option selling for $7 exercise price is $38 current price is $42
$3 (premium - intrinsic value)
how do you calculate an option’s time value?
premium - intrinsic value
For example, if Alphabet Inc. (GOOG) stock is priced at $1,044 per share and the Alphabet Inc. $950 call option is trading at $97, then the option has an intrinsic value of $94 ($1,044 - $950) and a time value of $3 ($97 - $94).
if you are buying a call option you are expecting the price of the stock to ___
rise
if you are buying a put option you are expecting the price of the stock to ___
drop
if you are selling a call option you are hoping the price of the stock will ___
drop
if you are selling a put option you are hoping the price of the stock will ___
rise
clears option transactions and acts a guarantor for option contracts
Options Clearing Corporation
number of outstanding option contracts in the market
open interest
options that are exercisable at anytime during the contract period
american options
An American option is a version of an options contract that allows holders to exercise the option rights at any time before and including the day of expiration. Another version or style of option execution is the European option that allows execution only on the day of expiration.
options that are exercisable only on the expiration date
european options
when are you “in the money” for a call option?
when the exercise price is less than the market price
when are you “in the money” for a put option?
when the exercise price is greater than the market price
term used to describe when the exercise price equals the market price
at the money
when are you “out of the money” for a call option?
when the exercise price is greater than the market price
when are “out of the money” for a put option?
when the exercise price is less than the market price
what is the maximum gain when you buy a call option?
unlimited
what is the maximum gain when you buy a put option?
exercise price minus the premium paid
what is the maximum gain when you sell a call option?
the premium received
what is the maximum gain when you sell a put option?
the premium received
what is the maximum loss when you buy a call option?
the premium paid
what is the maximum loss when you buy a put option?
the premium paid
what is the maximum loss when you sell a call option?
unlimited (naked)
what is the maximum loss when you sell a put option?
exercise price minus the premium received
used to estimate the price of a call option
binomial option pricing
assumes the price of the option will change in discrete increments on the basis of movements in the price of the underlying stock
binomial option pricing
estimates the price of a european call option
black-scholes option valuation method
states that the underlying security price movement is assumed to follow a geometric pattern
black-scholes option valuation method
We’ll discuss the limitations of the Black-Scholes model, which is one of the most popular models for options pricing. Some of the standard limitations of the Black-Scholes model are:
- Assumes constant values for risk-free rate of return and volatility over the option duration—none of those may remain constant in the real world
- Assumes continuous and costless trading—ignoring liquidity risk and brokerage charges
- Assumes stock prices to follow lognormal pattern, i.e., a random walk (or geometric Brownian motion pattern)—ignoring large price swings that are observed more frequently in the real world
- Assumes no dividend payout—ignoring its impact on the change in valuations
- Assumes no early exercise (i.e., fits only European options)—the model is unsuitable for American options
- Other assumptions, which are operational issues, include assuming no penalty or margin requirements for short sales, no arbitrage opportunities and no taxes—in reality, all these do not hold true; either additional capital is needed or realistic profit potential is decreased
a call option price will increase if the current market price ___
increases
a call option price will increase if the exercise price ___
decreases
a call option price will increase if the time to expiration ___
increases
a call option price will increase if the volatility of returns ___
increases
a call option will increase if the risk free rate ___
increases
used to protect a gain in a long position with no cash outlay
zero cost collar
involves an investor giving up stock price appreciation above the exercise price of the call option
zero cost collar
A zero cost collar is a form of options collar strategy to protect a trader’s losses by purchasing call and put options that cancel each other out. The downside of this strategy is that profits are capped, if the underlying asset’s price increases. A zero cost collar strategy involves the outlay of money on one half of the strategy offsetting the cost incurred by the other half. It is a protective options strategy that is implemented after a long position in a stock that has experienced substantial gains. The investor buys a protective put and sells a covered call. Other names for this strategy include zero cost options, equity risk reversals, and hedge wrappers.
what three aspects does a zero cost collar include?
a long stock position a long put position a short call option
To better understand all of this information, let’s look at an example of a zero cost collar.
- Assume an investor owns 100 shares of stock XYZ that he bought at a price of $90. Currently, the stock is trading at $85. To protect against further downside risk, the investor sets up a zero cost collar by purchasing a put option with a strike price of $83 and selling a call option with a strike price of $92.
- Assume the call options were sold at a premium price of $2 per share. Assume the put options were bought at a premium price of $2 per share. Therefore, the investor enters the trade with zero costs.
- If the stock expires at $92 or above, then the investor will achieve the maximum profit of $200, or 100 shares x (92 – 90).
- If the stock expires at $83 or below, then the investor will experience his maximum loss of $700, 100 shares per contract x (90 – 83).
- From this example, an investor can see how a protective position can be established at zero cost. This is an effective strategy to use when an investor wants to protect his stock position from further downside risk.
what is the maximum profit, maximum loss and breakeven price given the following info: an investor purchases a stock for $29 and a put on the same stock for $0.20 with an exercise price of $27.50. The investor also sells a call on this stock for $0.20 with an exercise price of $30
max profit = $30 - $29 max loss = $29 - $27.50 +0 = $1.50 breakeven = $29 + $0 = $29
term used to describe outs and call with lengthy expirations
LEAPS long term equity anticipation securities
Premiums are a nonrefundable cost to trade in the options market. The premiums for LEAPS are higher than those for standard options in the same stock. The further out expiration date gives the underlying asset more time to make a substantial move and for the investor to make a healthy profit. Known as the time value option marketplaces use this lengthy timeframe and the intrinsic value of the contract to determine the value of the option.
As mentioned earlier, the option contract has a basis of 100 shares of the asset. So, if the premium for Facebook (FB) is $6.25 the option buyer will pay $625 total premium ($6.25 x 100 = $625).
right to purchase a specified number of common shares for a specified price within a specified period
warrants
A major difference between stock warrants and stock options is how they originate. Stock options are listed on exchanges, whereas stock warrants are issued by the company itself.
When a stock warrant is exercised, the shares of the stock are received not from another investor, but from the company itself.
Stock warrants exist for long terms that can last up to 15 years. Stock options usually exist for a month, with some lasting at most two to three years.
what is the profit on the following transaction: Stewart purchases a warrant for $1 per share that gives him the right to buy 50 shares of KRF stock at $10 per share for a period of 5 years from date of purchase. Assume that KRF stock goes up to $14 per share after 3 years and Stewart exercises the warrant.
profit = (gain on stock - cost of warrant) x # of shares profit= ($4 - $1) x 50 =$150
attached to a bond or preferred stock issue and is offered as an inducement to make securites more attractive
warrant
true or false? A warrant will reduce the interest rate or dividend required by an investor
true
Warrants are frequently attached to bonds or preferred stock as a sweetener, allowing the issuer to pay lower interest rates or dividends.
true or false? investors buy warrants when they are bearish on a stock
false
partner who controls business activities
general partner
person who determines when distributions are made to limited partners
general partner
true or false? general partners have unlimited liability
true
partners who do no participate in management
limited partner
limited partners have ___ liability
limited
are private limited partnerships registered with the SEC?
no
true or false? limited partnerships are usually riskier investments than bonds or exchange traded funds
true
true or false? limited partnerships may offer periodic income payments to investors
true
true or false? warrants have long expiration dates, typically up to 5 years
true
a warrants exercise price is set ____ the current market price
above (Well above)
Warrants are a derivative that give the right, but not the obligation, to buy or sell a security—most commonly an equity—at a certain price before expiration. The price at which the underlying security can be bought or sold is referred to as the exercise price or strike price. An American warrant can be exercised at any time on or before the expiration date, while European warrants can only be exercised on the expiration date. Warrants that give the right to buy a security are known as call warrants; those that give the right to sell a security are known as put warrants.
a managed, diversified portfolio of real estate or real estate mortgages and construction loans
Real Estate Investment Trust (REIT)
invest in income producing properties
equity trusts
make loans to develop property and/or finance construction
mortgage trusts
manage real estate and transact mortgages
hybrid trusts
true or false? real estate capital gain distributions are treated as long term capital gain regardless of holding period
true
a self liquidating, flow through entity that invests exclusively in real estate mortgages or mortgage backed securities
real estate mortgage investment conduits (REMICs)
- A real estate mortgage investment conduit (REMIC) is a special purpose vehicle that is used to pool mortgage loans and issue mortgage-backed securities (MBS). Real estate mortgage investment conduits hold commercial and residential mortgages in trust and issue interests in these mortgages to investors.
- Fannie Mae and Freddie Mac are some of the more prominent issuers of REMICS
do holders of REMICs have to report taxable income received from the underlying mortgages?
yes
are willing to take significant risks and lose their entire investment in several ventures, in hopes of cashing in on a few highly profitable ventures
venture capitalists
true or false? venture capitalists have a high correlation with equities
false
funding for the purpose of research and development of an idea
seed financing
funding for product development and marketing
start-up financing
funding for initial manufacturing and sales
first-stage financing
funding for expansion of an existing company
second-stage financing
funding for major expansion
third-stage financing
funding for companies that expect to go public within the year
mezzanine or bridge financing
individual investment accounts offered by financial consultants who provide advisory services and are managed by independent money managers using an asset based fee structure
separately managed accounts
what is the key difference between a mutual fund and a separately managed account?
with a separately managed account the money manager is purchasing securities for the investor not the fund
true or false? in a separately managed account, the investor directly owns the underlying security
true
true or false? in a mutual fund, the investor directly owns the underlying secuirty
false
