Ch. 7 Debt Securities Flashcards

Corporate and US Govt Loans

1
Q

Most ______ are safer than stocks

A

Bonds

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2
Q

What are Bondholders considered?

A

Bondholders are considered creditors. They lend $$$ to an institution for a fixed period of time and receive interest for doing so.

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3
Q

Why are bonds attractive to issuers?

A

Allows the issuer to borrow $$$ on its terms (w/ its chosen maturity date, scheduled interest payments, interest rate, etc.)

The issuer cannot set it’s own terms by borrowing from a lending institution.

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4
Q

What is a Bond Maturity Date?

A

The date issuers pay bondholder back for the loan they .

Par Value

Stated at issuance

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5
Q

What is Par Value (Bonds)

A

The face value or principal of the bond

The Par Value for corporate bonds is $1,000 unless otherwise stated

Regardless of what the investor paid at purchase, they will receive the par value plus any interest due at the maturity date

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6
Q

How are Bond Prices Quoted?

A

Bond prices are quoted as a percentage of par value, often w/o the % sign.

A bond trading at 100 is trading at 100% of par or $1,000.

A bond trading a 86 is trading at 86% of par or $860

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7
Q

How are Corporate Bonds typically quoted?

A

Corporate bonds are typically quoted in increments of 1/8%

So, a corporate bond quoted at 99 3/8 would be trading at $993.75

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8
Q

How are Government Bonds typically quoted?

A

Government Bonds are typically quoted in increments of 1/32%

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9
Q

What is the Coupon Rate

A

Coupon Rates is the interest an investor would receive for providing loans to the issuer

Tells the investor how much annual interest they will receive

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10
Q

Bonds w/ a set coupon rate are considered what kind of security?

A

Fixed Income Security

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11
Q

How is the coupon rate expressed?

A

As a percentage of Par Value

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12
Q

How often to Bonds pay interest?

A

Semi-Annually

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13
Q

What is a Bond Indenture
Deed of trust
Resolution

A

The legal agreement between the issuer and its bondholders

Contains
1. Maturity Date
2. Par Value
3. Coupon Rate (Nominal Yield) and interest payment dates
4. Any collateral securing the bond
5. Any call or conversion features
6. Includes a Trustee

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14
Q

What is a Trustee (re: a bond indenture)

A

Charged w/ making sure the issuer does the right thing for the bondholders.

An organization that administers a bond issue for an institution

Ensures that the bond issuer meets all the terms and conditions associated w/ the borrowing

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15
Q

What is Collateral?

A

assets that the issuer owns

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16
Q

What are secured Bonds?

A

Bonds backed by collateral adn involve a pledge from the issuer that a specific asset will be sold to pay off the outstanding debt in the event of default

Lower yield than unsecured bonds due to lower risk

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17
Q

Four types of secured bonds

A
  1. Mortgage Bonds
  2. Equipment Trusts
  3. Collateral Trusts
  4. Guaranteed Bonds
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18
Q

What are mortgage bonds?

A

Secured Bond backed by property that the issuer owns

May be OPEN END or CLOSE END

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19
Q

What is an open end mortgage Bond?

A

a secured bond backed by property that the issuer owns where the issuer MAY BORROW MORE MONEY using the same property as collateral

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20
Q

What is a CLOSED END MORTGAGE BOND?

A

A secured bond backed by property that the issuer owns where the issuer MAY NOT BORROW MORE MONEY using the same property as collateral.

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21
Q

What is an Equipment Trust?

A

Secured bond mainly issued by transportation companies. Backed by equipment owned

Trustee holds the title

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22
Q

What is a Collateral Trust?

A

Secured Debt.

A collateral trust is a bond backed by financial assets of other issuers that the issuer owns.

Trustee holds the assets and sells them to pay off the bonds in the event of default.

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23
Q

What is a Guaranteed Bond?

A

Secured debt. Backed by a firm other than the original issuer (parent company). If the issuer defaults, the parent company pays of the interest and / or principal

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24
Q

What is an Unsecured Bond?

A

Bonds not backed by assets, but only backed by the god faith and credit of the issuer

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25
What is a Debenture?
Unsecured Debt Bonds backed only by the issuer's good word and written agreement stating that the issuer will pay the investor interest when due and par value at maturity
26
What is an Income Adjusted Bond?
Unsecured Debt Super risky Isssuer promises to pay par value back at maturity and will make interest payments ONLY IF earnings are high enough Companies reorganizing issue these at deep discounts
27
Zero Coupon Bond
Can be secured or unsecured Issued at a deep discount and mature at par value Require a low investment b/c issued at a discount, the bonds must be accreted Good for planning for future events such as college B/c of deep discount, current prices of discount bonds fluctuate quite a bit when interest rates change
28
What is a EuroDollar Bond?
Debt securities isued by foreign companies and government OR US companies with foreign locations Issued outside of the US but may trade in the US AFTER 40 DAYS of issuance. Interest and principal are in US dollars (dollar-denominated) Do NOT have to register w/ SEC Subject to currency risk May be ideal for customers looking to protect themselves from a decline in the value of the US dollar
29
What is a Sovereign Bond?
Debt security issued by Foreign National Governments Interest and principal payments are in the foreign currency Subject to Currency Risk May be ideal for customers looking to protect themselves from a decline in the value of the US dollar
30
What are some things bond prices are affected by?
supply & demand corporate rating change interest rate changes purchased at discount or premium
31
If interest rates increase, outstanding bond prices...
Decrease
32
If interest rates decrease, outstanding bond prices...
Increase
33
If you have a 4% coupon bond and interest rates decrease, you would be able to sell your bond at a...
Premium When interest rates fall, bond prices go up. your 4% bond is more attractive to investors who can get the same bond for 2% or 3%. They will pay more than par value, so you can sell your bond at a premium
34
What is the nominal yield?
The nominal yield is the coupon rate.
35
How do you calculate the coupon rate on a bond?
Coupon X par value So, on a 7% bond... 7% X $1,000 = $70 / year
36
What is the Current Yield (CY) on a bond?
The annual rate of return on a security CY changes when the market price changes
37
How do you calculate Current Yield of a bond?
Current Yield annual interest CY = ------------------------ market price
38
What is Yield to Maturity (YTM) of a bond?
The yield an investor can expect if holding the bond until maturity. Takes into account... 1. market price 2. par value 3. coupon rate 4. amount of time until maturity
39
What is Yield to Call (YTC) of a bond?
The amount an investor receives if the bond is called prior to maturity
40
What is Yield to Worst (YTW) of a bond?
The worst number of the YTM and YTC for all call dates
41
What is Discount Yield?
The yield on securities that are issued at a discount and don't make interest payments. These include - T- Bills - T- Strips - Zero-Coupon Bonds
42
What three debt securities don't make interest payments?
T-bills T-STRIPS Zero-Coupon Bonds
43
What government debt security is issued on a discount yield basis?
T-Bills
44
What is Accrued Interest?
Due when bonds are purchased between coupon dates and is the portion of the interest still due to the seller. (Bonds pay interest semiannually)
45
Accrued interest on corporate and Municipal bonds is calculated based on...?
30 day month and 360 day year
46
Accrued interest on US Govt bonds is calculated based on...?
Actual days per month and Actual days per year
47
Accrued interest is calculated from...to, but...
the previous coupon date up to but not including the settlement date
48
To calculate Accrued Interest for corporate and municipal debt securities...
1. ID the Settlement date (T+1) mm/yy 2. ID the Previous Coupon Date mm/yy 3. Subtract the mm/yy s 4. Multiply the number of months by 30 5. Add the result to the number of days of interest accrued
49
What is the Dated Date of a bond
The first date the bonds start acruing interest
50
What does it mean if a bond has a Long Coupon?
It means that the dated date of the bonds does not line up exactly six months from the first coupon date. It is a Long coupon if the first coupon date is MORE than six months from the dated date.
51
What does it mean if a bond has a Short Coupon?
It means that the dated date of the bonds does not line up exactly six months from the first coupon date. It is a Long Coupon if the first coupon date is LESS than six months from the dated date.
52
For newly issued bonds which haven't made an interest payment yet, accrued interest is calculated from the...
Dated Date (NOT the previous coupon date because there isn't one.)
53
The institutions that rate bonds are most interested in what?
likelihood of default
54
The higher the credit rating, the ____ the bond and the ____ the yield.
The higher the credit rating, the SAFER the bond and the LOWER the yield.
55
The lower the credit rating, the ____ the bond and the ____ the yield.
The lower the credit rating, the RISKIER the bond and the HIGHER the credit yield.
56
What are the two companies who rate bonds?
Standard & Poor's and Moody's
57
What is the first rating considered "junk" bonds for S&Ps and Moody's?
S&P = BB and lower Moody's = Ba and lower
58
What are S&P's Investment Grade Bond Ratings?
Highest:------------------------ AAA High:----------------------------- AA Upper Medium:---------------- A Low Medium:---------------- BBB
59
What are Moody's Investment Grade Bond Ratings?
Highest:-------------------------Aaa High:-------------------------------Aa Upper Medium:----------------- A Lower Medium:-------------- Baa
60
What are S&P Junk / Speculative Grade Bond Ratings?
Speculative -------------------------------BB Speculative missed pymnts-----------B Speculative no interest paid----------C In default-------------------------------------D
61
What are Moody's Junk / Speculative Grade Bond Ratings?
Speculative --------------------------------Ba Speculative missed pymnts-----------B Speculative no interest paid---------Caa In default-------------------------------------D
62
On an S&P rating, what does the + / - represent?
+ is the high end of the category - is the low end of the category No mark is in the middle of the category
63
On a Moody's rating, what does the numbers 1, 2, or 3 represent?
1 = highest ranking w/in the category 2 = middle of the category 3 = lowest ranking w/ in the category
64
Bonds can be issued in ____ and ____ forms
Callable and put forms
65
What is a Callable Bond?
A bond that the issuer has the right to buy back from investors at the price stated on the indenture (deed of trust)
66
How are callable bonds priced compared to noncallable bonds?
Callable bonds are riskier for the investor To compensate for the risk, callable bonds are issued w/ a higher coupon rate.
67
Most callable bonds are issued with ______ and are sometimes issued with _____.
Call protection And sometimes a Call Premium
68
What is Call Protection?
The amount of time (usually several years) that an issuer has to wait before being able to call its bonds
69
What is a Call Premium?
The amount over par the issuer has to pay if they call the bond
70
What is a Make Whole Call Provision?
Issuer may call the bond, BUT they will also make a lump sum payment that includes payment for the bond AND the present value of any future interest payments missed due to the call.
71
What is a Step Coupon Bond?
Start at a low coupon rate which increases at predetermined intervals. Issuer typically has the right to call the bond at Par Value at the time the coupon rate is due to increase
72
What is a Put Bond?
Allow the investor to redeem the bonds at any time at the price stated on the indenture Better for investors Rarely issued lower coupon rate
73
When do issuers tend to call bonds?
When rates decrease The issuer could call existing bonds and reissue the same bonds at a lower interest rate when interest rates decrease
74
When to investors tend to put (redeem) bonds?
When rates increase So the investor could take the money tied up in the bond and invest it at a higher interest rate.
75
If interest rates increase, what happens to bond yields?
Bond yields increase
76
What is a Convertible Bond?
It is a bond that the investor can convert into shares of common stock. Investors convert when
77
What is Parity re: convertible bonds?
When a convertible bond and its underlying stock are trading equally ie,. When a bond trading for $1,100 is convertible into $1,100 worth of stock
78
What is the Conversion Ration re: Convertible Bonds?
The number of shares that the bond is convertible into You always need to calculate the conversion ration to answer conversion questions
79
What is the Conversion Ratio Equation? re: Convertible Bonds
Conversion Ration (CR) Par Value Conv Ratio = -------------------------- shares Conversion Price Then use this to calculate the parity price
80
What is the Parity Price Equation re: Convertible Bonds?
Parity Price of the Bond (PP) PP = MP of Stock X Conversion Ratio
81
If the stock is trading above parity to the bond, the investor should...
Convert (For test purposes)
82
What is Arbitrage (re: Convertible bonds?)
Taking an advantage of a disparty in prices Investors will convert their bonds when the value of the convertible bond is trading at a price that is lower than the value of the stock it's convertible into
83
US Govt Bonds are considered....
...the safest of all securities
84
What risks are US government securities subject to?
Interest Risk Reinvestment Risk Inflation / Purchasing Power Risk
85
How can US Govt Securities be purchased?
1. Directly (Treasury Direct Website) 2. Broker Dealers 3. Commercial Banks
86
What are the maturities on T-Bills?
4, 8, 13, 17, 26, and 52 weeks
87
What are the maturities on FRNs? (Floating Rate Notes)
2 years
88
What are the maturities on T-Notes?
2, 3, 5, 7 and 10 years
89
What are the maturities on T-Bonds?
20 or 30 years
90
What are the maturities on T-STRIPS? (Separate Trading of Registered Interest and Principal of Securities)
6 months to 30 years
91
What are the maturity on TIPS (Treasury Inflation Protected Securities)
5, 10, and 30 years
92
What are the Characteristics of a T-Bill
Short Term - 1 year MAX Issued at discount, mature at par The difference b/n the purchase price and par is considered interest even though no interest payments are made. Sold in $100 increments
93
What are the Characteristics of a FRN (Floating Rate Note)
Mid Term - 2 years Pay an adjustable rate of interest quarterly Tied to the rate of the most recent discount rate of the 13 week T-Bill Sold in $100 increments
94
What are the Characteristics of a T-Note?
Mid Term - 2 - 10 years Pay a fixed rate of interest every 6 months Sold in increments of $100
95
What are the Characteristics of a T-STRIPS (Separate Trading of Registered Interest and Principal of Securities)
Across Terms - 6 mos - 30 years Issued at a discount and mature at par Minimum investment = $100 Sold by financial instituitions and BDs Investors do not receive interest payments. The principal and all remaining interest payments are stripped and sold as separate securities Purchase prices vary
96
What are the Characteristics of TIPS (Treasury Inflation Protected Securities)
5, 10, and 30 year terms Pays a fixed rate of interest every 6 months tied to the adjusted principal amount and based on a percentage of par (which moves) Tied to the Consumer Price Index (CPI) - If inflation is high, the TIPS par value increases - If deflation occurs, the TIPS par value decreases The Par Value and Interest payments adjust according to inflation or deflation. Sold in investment increments of $100
97
On what basis are T-Bills sold?
T-Bills are sold on a discount-yield basis where the BID is HIGHER than the ASK. If you see a BID that is higher than the ASK, it is likely a T-Bill quote.
98
The interest received from US Govt securities is exempt from ???
State and local taxes
99
When you see a question on the Series 7 exam about the best investment when planning for a specific future event (ie. college) The right answer will most likely be...
Zero Coupon Bonds or T-Strips
100
Which government agency's bonds are DIRECTLY backed by the full faith and credit of the US Government?
GNMA Government National Mortgage Association
101
Which government agency's bonds have implied backing of the US Government but are not guaranteed by the Govt?
FNMA (Federal National Mortgage ASsociation or Fannie Mae) FHLMC (Federal Home Loan Mortgage Corporation or Freddie Mac) FFCS (Federal Farm Credit System SLMA (Student Loan Marketing Association)
102
GNMAs support what?
The Department of Housing and Urban Development (HUD)
103
Characteristics of a GNMA Debt Security
Taxed on ALL levels (Fed, State, & Local) Often called Pass Through certificates - Investors receive MONTHLY PAYMENTS of interest and principal as people pay their mortgages Issued w/ a face value of $25,000 but can be purchased in denominations as low as $1,000 Subject to prepayment and extension risk
104
What are the Characteristics of FNMA?
Publicly held and privately owned but still Government Sponsored Entity (GSE) Responsible for providing capital for certain mortgages. Purchases conventional mortgages, VA mortgages, FHA mortgages, etc.
105
What are the Characteristics of FNMA Debt Securities?
Debentures 3 - 25 year Maturities $10,000 minimum denominations Longer term bonds are Pass Through Certificates (Principal & Interest are paid MONTHLY) Also issues Discount Notes & Benchmark Bills (Shorter term debt securities issued at a discount and mature at PAR) Taxed on all levels (Fed, State & Local) Do NOT have the direct backing of the US Govt so risk of default is higher and investors receive a higher return.
106
What are the Characteristics of FHLMC? (Federal Home Loan Mortgage Corporation or Freddie Mac)
Publicly held Designed to create a secondary market for mortgages
107
What are the Characteristics of FHLMC Debt Securities?
Creates Mortgage Backed Securities (MBS) (purchases residential mortgages from FIs and packages them into MBSs) Also issues Pass Through Certificates and the interest is subject to Fed, State & Local taxes. Do NOT have the direct backing of the US Govt so risk of default is higher and investors receive a higher return.
108
What are the characteristics of the FFCS? (Federal Farm Credit System)
Government Sponsored Entity but privately owned. Consists of lending institutions which provide financing and credit to farmers Overseen by the FCA (Farm Credit Admin)
109
What are the characteristics of FFCS debt securities?
Sells securities through member banks to investors and in turn loans the funds raised to farmers Issues DISCOUNT NOTES & BONDS Maturities from 1 DAY to 30 YEARS Interest received is EXEMPT from State and Local Taxes Must pay Fed Taxes on interest received
110
What are the Characteristics of SLMA (Student Loan Marketing Association or Sallie Mae)?
Provides a secondary market for student loans No longer a GSE! (Government Sponsored Entity) Private Company and issues stock
111
What are the Characteristics of SLMA debt securities?
Purchases student loans and repackages them as short- and medium- term debt securities. Interest earned is subject to Federal Tax. Interest earned MAY BE exempt from state and local taxes, depending on the state.
112
Certain mortgage backed securities have an AVERAGE LIFE, which is...
Shorter than the initial loan term due to investors selling or refinancing. Subject to prepayment risk, reinvestment risk, and extension risk
113
What are Collateralized Mortgage Obligations (CMOs)
Debt securities backed by pools of mortgages Do NOT have a set maturity date
114
Prepayment risk associated w/ CMOs
The risk that a tranche (slice/portion) of the loan will be called sooner than expected due to decreasing interest rates; more people refinance when interest rates are low
115
Average life associated w/ CMOs
The average amount of time until a mortgage is refinanced or paid off; for example, a 30-year mortgage may have an average life of 17 years
116
Extension Risk associated w/ CMOs
The risk that a tranche will be called later than expected due to a less-than-normal amount of refinancing; extension occurs when interest rates are high
117
Plain Vanilla Offering Tranche (re: CMO)
Tranches paid in a specific sequence. All tranches receive interest payments Only the tranche w/ the shortest maturity receives principal payments until it is retired. After the shortest is paid off, the next shortest tranche receive principal payments until it is retired. and so on
118
Planned Ammortizaton Class (PAC) Tranches (CMO related)
Most common b/c most certain prepayment date Low yield b/c safe can mitigate the prepayment and & extension risk it does have with a companion tranche
119
Targeted Amortization Class (TAC) Tranches (CMO related)
Second Safest CMO Somewhat less-certain principal payments More subject to prepayment & extension risk Low yields but higher than PAC tranches
120
Companion Tranches (Support Bonds) (CMO related)
Included in every CMO that has PAC or TAC tranches Absorb prepayment risk associated w/ CMOs Average life varies greatly depending on interest rate flux More risky, so higher yields
121
Z Tranches (Accrual Bonds) (CMO related)
Last tranche in a series of PAC or Companion tranches due to longest maturity Do NOT receive interest or principal until all of the other tranches in the series have been retired Wide fluctuations in market value Similar to zero-coupon bonds
122
Principal Only (PO) Tranches (CMO Related)
Purchased at a deeply discounted price Investors receive face value through regularly schduled mortgage payments and prepayments Market Value increases IF - Interest Rates DROP AND - Prepayments INCREASE
123
Interest Only (IO) Tranches (CMO related)
All CMOs w/ principal-only tranches also have interest-only tranches. IOs are sold at a deep discount below their expected value based on the principal amount used to calculate the amount of interest due The market value of an IO increases IF - Interest Rates INCREASE AND - Prepayments DECREASE
124
Floating Rate Tranches (CMO related)
Appear when interestrates are tied to an interest rate index (ie. LIBOR) Investors can use Floating Rate tranches to HEDGE interest rate risk on other investments
125
What are the four basic points of CMO Tranches?
The Plain Vanilla Offering is the most basic PAC tranches are the safest TAC tranches are the second safest Companion tranches support PAC and TAC tranches Z-tranches have the longest maturity
126
Retail communications re: CMOs MUST include...
1. Must include the words "Collateralized Mortgage Obligation 2 .Must NOT compare CMOs to other investment vehicles 3. Must disclose that the GSE backing the CMO are only responsible for face value and not any premium paid 4. Must disclose that the CMO YIELD & AVERAGE LIFE WILL FLUX based on interest rates and repayment and refinance rates.
127
Before selling a CMO to any investor (except institutional investors), members MUST...
1. Offer the investor educational materials about CMOs which includes... -Characteristics and risks of investing in CMOs -Structure of the CMO -Different tranches & their risks -The relationship b/n Mortgage securities & Mortgage loans -Questions an investor should ask before investing in CMOs -A Glossary of Terms
128
What are the characteristics and risks of investing in CMOs?
Credit quality Prepayment rates Average lives How interest rates affect prepayment rates Tax considerations Liquidity Minimum investments Transaction costs
129
Any retail communications mailed out re: CMOs (and other securities) must include
Firm's name Memberships Address Phone Reps Name
130
If promoting a specific CMO, any communications must include the following:
Coupon rate specific tranche (# & class) Anticipated yield Anticipated average life Final maturity date Underlying collateral disclosure "The yield and average life shown above consider prepayment assumptions that may or may not be met. Changes..."
131
Radio and TV ads for CMOs must include the following statements:
The following is an ad for CMOs. Contact your representative for information on CMOs and how they react to different market conditions The yield and average life reflect prepayment assumptions that may or may not be met. Changes in payments may significantly affect yield and average life.
132
What is a Collateralized Debt Obligation (CDO)?
Backed by a pol of bonds, loans or other debt instruments, broken down into tranches representing differing amounts of risk and/or maturities. In the event of a shortfall of cash, holders of Senior CDOs are paid first. Interest received is taxable at Fed, State & Local levels For sophisticated investors
133
What are Money Market instruments?
aka Cash Equivalents Relatively safe short term loans (mature in 1 year or less) can be issued by corporations, banks the US Govt and municipalities Issued at a discount and mature at Par.
134
What are Federal Funds?
Money Market instrument for banks usually overnight Loans between banks to help meet reserve requirements
135
What are Reserve Requirements?
Percentage of deposits that member banks must hold each night Banks unable to meet these may borrow from other banks at the Fed Funds Rate
136
What is Corporate Commercial Paper?
A Money Market Instrument Unsecured corporate debt issued at a discount, matures at par issued w/ an initial maturity of 270 days or less Exempt from SSEC registration
137
What are Brokered (Negotiable) Certificates of Deposit (CDs)?
A Money Market Instrument AKA Jumbo CDs Low risk investments originate from a bank and outsourced to BDs to sell to investors Negotiable (can be traded in the market) Min investment of $100,000
138
What is a Banker's Acceptance?
A Money Market Instrument Time Draft (short term credit investment) Created by a company whose payment is guaranteed by a bank Used for importing and exporting goods.
139
What is a T-Bill? (re: Money Market)
A money market instrument US Govt Issued Issued at a discount and matures at PAR Maturities of 4, 8, 13, 17, 26 or 52 weeks Sold and quoted on a Discount-yield basis (YTM) Safest security of all securities
140
What are a list of Money Market Instruments?
Fed Funds Corporate Commercial Paper Brokered (Negotiable Certificates of Deposit) Banker's Acceptances T-Bills
141
What are Structured Products?
Packaged products based on derivatives require a minimum investment Fixed term Combine a note (short term debt security) and a derivative product Investors receive interest payments and, at maturity, receive face value of the note plus a premium if the derivative portion performs well Considered complex products and require investors to tie $$ up for a number of years. Not suitable for most investors. ETNs Equity Linked Notes
142
What are Exchange Traded Notes?
Unsecured debt securities issued by a bank of FI that trade on an exchange Returns are linked to a market index or commodities or currency Don't receive dividends or coupon payments Do receive income at a specified maturity date May be purchased on Margin or sold short At maturity, investor receives a principal amount less any fees based on the performance of the index the note is tracking ETNs value may drop due to a drop in the credit rating of the ETN issuer even if the index has not decreased. DO NOT represent a pool of ownership. They simply track the performance of a specified market index.
143
What is an Equity Linked Note?
Bonds where the interest payments are variable depending on the return of the underlying equity securities. NOT traded on an exchange