FOCUS POINTS Flashcards
are derivative securities that may be linked to a variety of underlying (reference) assets including a stock index, foreign currency, commodity, basket of securities, change in spread between asset classes, single security, or an interest-rate and inflation-linked product.
- typically built around a fixed-income instrument (a note) and a derivative product.
- the note pays a specified rate of interest to the investor at defined intervals
- the derivative component establishes the amount of payment at maturity
- created by major financial services institutions
- registered as securities with the SEC
- clients must receive disclosure that these products are NOT bank deposits and are NOT insured by the
Federal Deposit Insurance Corporation (FDIC).
Structured products
Bonds initially issued by municipalities and later traded among investors in the secondary market.
- Amortizable Bond Premium: The excess of the amount you paid for the bond over the bond’s face value can be amortized and it reduces the amount of interest includable in your income.
- Sale Before Maturity: If you sell the bond before maturity, you may recognize a taxable gain or loss.
Secondary Market Municipal Bonds traded at a Premium
- If you bought the bond at a market discount, you might have to include the discount in your income as interest over the term of the bond.
- If you sell the bond before maturity, you may recognize a taxable gain or loss.
Secondary Market Municipal Bonds traded at a Discount
an options strategy involving the purchase or sale of both a call and put option with the same strike price and expiration date.
Goal: To profit from a big movement in the underlying asset, regardless of the direction.
Pros: Potential for unlimited profits; protects against a significant move in either direction.
Cons: High cost; the underlying asset must move significantly to become profitable.
Max Gain (MG): Unlimited for long _ ; premium received for short _ .
Max Loss (ML): Limited to the premium paid for long _ ; unlimited for short _ .
Break-Even (BE): Strike price +/- total premium for long _ ; same as MG for short _.
Goal: To profit from a big movement in the underlying asset, regardless of the direction.
Pros: Potential for unlimited profits; protects against a significant move in either direction
Cons: High cost; the underlying asset must move significantly to become profitable.
Max Gain (MG): Unlimited for long straddle; premium received for short straddle.
Max Loss (ML): Limited to the premium paid for long straddle; unlimited for short straddle.
Break-Even (BE): Strike price +/- total premium for long straddle; same as MG for short straddle.
Answer: Straddles
Bonds that have their principal and interest ensured by an escrow account with Treasury securities.
- often created when the issuer wishes to refinance at a lower rate but the original bond has a non-call feature until a future date.
- common terminology: Escrow secured, defeasance, advance refunding
- Refinancing strategy for issuers.
- Lower yield due to high security.
Pre-Refunded Bonds
A type of Private Activity Bond issued to finance commercial enterprises.
- Proceeds often loaned to a private entity for a qualified purpose.
- Can provide tax-exempt financing for commercial developments.
- Higher risk than public-purpose bonds.
- Who invests?: Investors seeking higher yield and willing to take on risk.
Industrial Development Bonds (IDBs)
Bonds secured by a lien on the property that benefits from the improvements financed with the bond proceeds.
- Common terminology: Special assessment, benefit assessment
- Tied to specific property or improvement
- Risk if improvement doesn’t add expected value.
- Who invests?: Income-focused investors with appetite for some risk.
Assessment Bonds
A type of revenue bond that carries a moral, but not legal, commitment to avoid default
- Non-binding commitment by state or local government to support.
- Higher yield.
- Higher risk due to non-binding nature of support.
- Who invests?: Risk-tolerant investors seeking higher yield.
Moral Obligation Bonds
Short-term notes issued in anticipation of future revenues, such as taxes, revenues, or bond issuances.
- Short-term, bridge financing, interim financing
- Often used to manage cash flow timing issues.
- Short-term, lower risk.
- Lower yield.
- Investors seeking short-term, lower-risk options.
Anticipation Notes (TANs, RANs, BANs, etc.)
Bonds that are paid off from the revenues generated by the specific project that the bonds are issued to fund.
- Project-based, self-liquidating, revenue-backed
- Tied to specific projects (e.g., toll road, stadium).
- Income can be more predictable if revenue source is reliable.
- Risk of project failure.
- Who Investd?: Income-focused investors with appetite for some risk.
Revenue Bonds
a type of municipal bond
bonds issued at a price lower than their face (or par) value.
- The discount on these bonds is considered to be a form of interest
- The IRS requires that the implied annual interest (the discount) be reported as income each year, even though the bondholder does not receive any cash interest payments. This process is known as accretion.
- ## The constant yield method (also called the constant interest method) is used to calculate this annual income.
original issue discount (OID)
These are long-term bonds with an interest rate that is reset periodically through a Dutch auction process.
- ## Liquidity risk, as the auction process can fail if there are more sellers than buyers.
Auction Rate Bonds
These are long-term floating-rate tax-exempt bonds. The interest rate is reset periodically, and investors have the option to tender their bonds back to a financial intermediary.
- Interest is usually tax-exempt at the federal level, and possibly at the state and local level depending on residency. (Municipal)
Variable Rate Demand Obligation Bonds (VRDO)
These are short-term debt instruments that consist of a high-yield, short-term note of the issuer, and an embedded short put option on a separate security
- The issuer repays the principal unless the value of the underlying security falls below a predetermined level.
- Interest income is taxed as ordinary income.
- Any capital gain or loss at maturity or sale is treated as a short-term capital gain or loss.
- coupon rates are typically higher than conventional bonds due to the embedded put option.
Reverse Convertible Securities
In many IPOs, insiders are subject to _ agreements that prevent them from selling their shares for a certain period after the IPO (Typically 6-months)
Lock-Up Agreements
- short-term notes that are issued by banks and broker-dealers.
- usually pay a coupon rate that’s set above prevailing market rates; however, in return, the buyer may be required to take
possession of the shares of an underlying asset. - the principal is typically intended to be paid back in full when the security matures unless the price of the underlying asset drops below a certain level. (knock-in level)
- If the underlying asset’s price stays above a predetermined level (the barrier), the investor receives their principal back and the high-interest payments.
reverse convertible securities (RCS)
How will a new municipal issue allocate its bonds?
When allocating bonds in a new municipal issue, presale orders normally have first priority. This is followed by group net, designated, and then member orders.
All of the following statements are TRUE concerning both auction rate securities (ARSs) and variable-rate demand obligations (VRDOs), EXCEPT:
A.They are long-term securities with short-term trading features
B. Interest rates are set at specified intervals
C. They are often issued by municipalities
D. They have a put feature allowing the holder to redeem the security at par
Answer: D
Although they are both long-term securities with short-term trading features, only VRDOs have a put feature that permits the holder to sell the securities back to the issuer or third party. Auction rate securities (ARSs) do not have this feature and, if the auction fails, the investor may not have immediate access to her funds. In addition, ARSs use an auction process to reset the interest rate on the securities, whereas the interest rate on a VRDO is reset by the dealer at a rate that allows the securities to be sold at par value.
- always stands ready to buy or sell a specific stock
- assumes risk by taking the other side of the trade
- provides a two-sided quote. The bid being the price it’s willing to buy the stock, the ask being the price it’s willing to sell the stock (to other dealers)
Market Maker
Often executed between the bid and offer with both customers paying the firm a commission.
Agency cross
True or False. If a dealer is acting as a Riskless Principal on a customer trade it must disclose its profit (markup, markdown).
True
In a ______ trade, rather than charging a markup, the dealer profits by charging a different price for the securities.
Net-basis trade
True or False. In a net-basis trade, a firms profit is not disclosed on the customers confirmation; however, in a riskless principal trade, the markup must be disclosed.
True
- corporate bonds
- municipal securities
- U.S. government and government agency securities
Often trade in the ________ settings
Dealer-to-dealer settings
Aka over-the-counter (OTC) markets.
Within each broker-dealer, a ________ is responsible for maintaining the broker-dealer’s inventory as well as trading the firm’s proprietary account.
Position trader
An inquiry regarding the availability of a block of stock.
Workout quote
Indicates a quote is subject to confirmation and is therefore not firm.
Subject quote
True or False. Unless a specific qualification is given, all quotes are considered firm.
True
The state price at which market makers are willing to buy or sell securities
Firm quote
What are aftermarket trading session hours?
4:00 PM to 8:00 PM.
Those market makers that participate must keep their quotes open until at least 6:30 PM
What are premarket trading hours?
4:00 AM - 9:30 AM
Any Equity that’s not listed or traded on a national securities exchange is considered
An OTC equity security
- domestic and foreign equity issues
- warrants
- units
- ADRs
- DPPs
All are considered ?
OTC equities
Prices of OTC equities may be obtained from the
OTC Markets Group
Lists the name and phone number of the market makers for each stock in the non-listed exchange.
The OTC Markets Group
Refers to exchange-listed securities being traded over-the-counter between broker-dealers and large institutional investors.
The third market
Refers to direct insitution-to-institution trading and doesn’t involve the services of a broker-dealer.
The Fourth Market
The electronic service that provides quotations for listed securities that are traded in markets outside of the primary marketplace where the securities are listed.
- does not quote securities listed on the OTC Bulletin Board or the OTC Markets Group.
The Consolidated Quotation System
True or Flase. Directed Orders (those orders where an investor’s specifies the exchange in which they want their trade executed) are exempt from a broker-dealers best execution rule
True.
However, non-direct orders are subject to the best execution rule.
This means the broker-dealer is obligated to execute the trade on the exchange that offers the best deal.
Becomes a market order to buy or sell securities if the orders specified price is reached or passed. (I.e. the order is activated).
Stop (loss) order.
Guarantees execution but not a specific execution price.
Is always placed above the current market price of the security and is used to limit a loss or protect a profit on a short sale.
Buy Stop Order.
generally defined as the insertion of a third party between the customer and the best market.
- specifically prohibited if it’s to the detriment of the customer
However, this is allowed if the member firm can demonstrate that the customer received a better price because of the intervention of a third party.
Interpositioning
Nasdaq Level _ provides subscribers with the highest bid and the lowest offer (i.e., the inside market) for a security that has at least two market makers
- actual market makers are not listed
- does not display the cumulative trading volume or the prices of the transactions as they occur
- typically used by the branch offices of member firms (Although non-members firms can also subscribe)
Nasdaq Level I
True or False.
A broker-dealer must satisfy the locate requirement before allowing a customer to execute a short sale.
True
Regulation SHO requires a broker-dealer to make a notation on every sell order ticket to indicate whether the transaction is a long sale or a short sale. A long sale is when the customer is selling stock that he owns and is not required to borrow the security to make delivery. With a short sale, the broker-dealer (not the customer) must be able to borrow the security to make delivery. There’s no requirement for a broker-dealer to become a market maker in order for its customers to execute short sales. The margin requirement on short sales is 50%.
Allows investors to compare the yields available on T-bills with the yields available on notes, bonds, and other interest-bearing securities
ask yld or bond/coupon equivalent yield
Government securities are quoted in increments of ?
1/32 nds of a point.
Ex: 99.12 = 99 12/32 = 99.375 = $993.75
This may also be quoted as
99-12
- most common security issued by government agencies
- interest in the pool are sold to investors as pass-through certificates
- represents an undivided interest in the pool and owners are entitled to share in the cash flow that’s generated by the pool
- fully negotiable (marketable) securities
- each payment includes a portion of both interest and principal
Pass-through certificates
Raises money to buy insured FHA, VA, and conventional residential mortgages from lenders such as banks and savings and loan associations
- backed by its authority to borrow from the Treasury
FNMA
How do you calculate accrued interest on a dated date basis?
Start counting at: last coupon date
And count up to: but not including, the settlement date.
Corporate, municipal, and U.S. government agency bonds calculate accrued interest on a _____ day basis
30/360 day basis
Treasury bonds and notes calculate accrued interest on a ______ day basis
Actual calendar/365 day basis
Calculate accrued interest
Annual interest X. # of accrued days/ 360 or 365
Most bonds pay interest ?
Semi-annually
Corporate and municipal bonds trade in increments of ?
1/8 of a point or $1.25
Remember a point = $10
1 point = ?
$10
Define level debt service
Serial maturity bonds that are structured so that principal and interest payments represent approximately equal annual payments over the life of the offering
.01 % =
1 basis point
100 basis points =
1.00
Define Defeasance
Elimination of restrictive covenants (such as a limit on how much debt an issuer my raise)
If an amount deposited into an escrow account is enough to pay off the outstanding issue at the call date.
This is considered?
Pre-refunded to call (advanced refunding)
If the amount deposited into an escrow account is sufficient to pay debt service at maturity, this is considered?
Escrowed to maturity
What are the tax implications for corporate bonds?
Interest
- treated as ordinary income; subject to federal, state, and local taxation.
- Accrued interest
- seller reports the amount of Interest received from the buyer and pays taxes on that interest
- buyer reports interest payment received minus the amount paid to seller
Are Zero-Coupon bonds taxed?
Yes, over the life of the bond the cost basis is accreted each year up to par. Each year you pay taxes on the accredited amount
