SF CH 2

Question 1

What is indirect investing?

Answer 1

The buying and selling of the shares of investment companies that hold portfolios of securities. Example: buying shares from a mutual fund.

Question 2

What are the three categories of marketable securities?

Answer 2

1. The money market.
2. Capital Market.
3. Derivatives Market.

Question 3

What are non-marketable financial asset? What are their characteristics?

Answer 3

These are securities that are not traded in the market.

1. Typically a direct exchange of claims between an issuer and investor: this means that as the owner of a savings account, you must open the account personally and deal with the bank.
2. Highly liquid.

Question 4

What are examples of non-marketable financial assets?

Answer 4

1. Savings accounts with financial institutions.
2. GICs Guaranteed Investment Certificates. non-transferable time deposits that offer investors higher returns than those available on savings accounts.

Question 5

What are money market securities?

Answer 5

These are securities that are short-term (matures in one year or less), highly liquid, low risk debt instruments sold by governments, corporations with temporary excess funds to invest.

Question 6

How do intermediary money market make profit?

Answer 6

They buy large blocks of these instruments at a certain rate. Then they sell smaller denominations of that block to customers but for a lower interest.

Question 7

What are some examples of money market securities?

Answer 7

1. Treasury bills: short-term notes sold a discount and redeemed at face value.
2. Commercial paper: short-term unsecured notes issued by large well-known corporations.
3. Eurodollars:
4. Repurchase agreement: agreements between a borrower and lender to sell and repurchase money market securities.
5. Banker’s acceptance

Question 8

What are Capital market securities and are the two sub-categories under it?

Answer 8

Capital Market securities have maturities greater than one year and the risk is much higher than in the money market.

1. Fixed income securities
2. Equity securities.

Question 9

What are Fixed Income Securities?

Answer 9

These are securities with specified payment dates and amounts and must mature at some future date.

Question 10

What are bonds and why is considered a fixed income security?

Answer 10

Bonds are long-term debt instruments representing the issuer’s contractual obligation.

They are considered as fixed-income securities because the interest payments and the principal repayment are specified at the time the bond is issued and is fixed for life.

Question 11

What are treasury bonds?

Answer 11

Long-term bonds sold by the US government.

Question 12

What is a call provision and what is its benefit to the issuer?

Answer 12

An element of a bond that gives the issuer the right to “call in” bonds, thereby depriving investors of that bond.

A call provision benefits issuer because they save money if the market rate is below the coupon rate.

Question 13

What is a sinking fund provision?

Answer 13

A provision in some bonds that requires the issuers to put money aside to be able to repay bondholders at maturity

Question 14

What are callable bonds, retractable bonds, extendible bonds, convertible bonds and floating rate bonds?

Answer 14

1. Callable bonds: gives the issuer the option to call or repurchase outstanding bonds at predetermined “call prices”.
2. Retractable bonds: allows the bondholder to sell the bonds back to the issuer at predetermined prices at specified times.
3. Extendible bonds: allows the bondholder to extend the maturity date of the bond.
4. Convertible Bonds: these bonds can be converted into common shares at predetermined conversion prices.
5. Floating rate bonds: bonds that have adjustable coupons tied to T-bill rates. They are attractive for the times of volatile interest rates.

Question 15

What are the two types of bonds?

Answer 15

Government bonds and corporate bonds

Question 16

What are mortgage bonds and debentures?

Answer 16

1. Mortgage bonds: These are bonds secured by real assets. Which means that the holders have legal claim to specific assets of the issuer.
2. Debentures: unsecured and are backed only by the general financial worthiness of the firm.

Question 17

What are negative and positive covenants?

Answer 17

1. Negative covenants: these are protective measures written in bond indentures (contracts) that prohibit certain actions by the issuer to ensure that the bonds are able to be repaid.
2. Positive covenants specify actions that the firm agrees to undertake.

Question 18

What is securitization?

Answer 18

Refers to the transformation of illiquid, risky individual loans into more liquid, less risky securities referred to as asset-backed securities.

Question 19

What are asset-backed securities?

Answer 19

Securities issued against some type of asset-linked debts bundle together, such as credit card receivable or mortgages.

Question 20

What are mortgage backed securities?

Answer 20

Created when a financial institution purchases a number of mortgage loans that are then repackaged and sold to investors as mortgage pools. The investors assume little default risk because most mortgages are guaranteed by a federal government agency.

Question 21

What is the difference between fixed-income securities and equity securities?

Answer 21

Equity securities represent an ownership interest in a corporation.

Question 22

What are the three forms of equity securities?

Answer 22

1. Preferred stock
2. Income trusts
3. Common stock

Question 23

What are preferred stocks, and why is it considered a hybrid security?

Answer 23

Preferred stocks have elements of a equity security and a fixed income security.

Preferred stocks are securities that increases in value but also pays a fixed dividend amount with the payments known in advance.

Question 24

Common Characteristics of Preferred stocks include

Answer 24

1. Non-voting rights.
2. Payment to preferred shareholders are prioritized compared to common shareholders.
3. Cumulative feature which requires the company to pay all preferred dividends both current and arrears before paying any dividends to common shareholders.

Question 25

What are derivative securities?

Answer 25

Securities that derive their value by having a claim on some underlying security.

Question 26

What are options and puts and calls?

Answer 26

Are the rights to buy or sell a stated number of shares of stock within a specified period at a specified price.

1. Puts: Options to sell a specified number of shares at a stated price within a specified period.
2. Calls: Options to buy a specified number of shares of stock at a stated price within a specified period.

Question 27

21. What are forward and future contracts?

Answer 27

1. Forward contracts are commitments today to transact in the future.
2. Futures contracts: agreements for the future exchange of a particular asset between a buyer and seller at a specified date.

Question 28

What is the difference between a savings deposit and a GIC?

Answer 28

1. Savings deposit: a nonmarketable account and the investor’s funds are available on demand, with no specific maturity date.
2. GICs: offered by banks as well but are non-transferable time deposits available for various maturity dates.

Question 29

Distinguish between a serial bond and a term bond.

Answer 29

1. Serial bond is bond that has a certain percentage of the issue maturing each year.
2. Term bond has a specified maturity date in the future for the entire issue.

Question 30

What is the similarity and difference between a warrant and a call option?

Answer 30

Both of them give the investor the right to purchase a specific number of shares of the underlying stock at a specific price within a specified time period.

Difference: the time of issuance, a warrant usually has a much longer time until expiration and has a lowed exercise price.

Question 31

What are the advantages and disadvantages of investing Government of Canada bonds versus corporate bonds?

Answer 31

Advantages of Government bonds:

• lower risk
• better liquidity.

Disadvantages:

• Lower yields
• no convertibility features.

Question 32

Why are convertible and retractable figures generally advantageous for bondholders? How do they pay for these privileges?

Answer 32

The convertible feature gives the bondholder an option to convert bond into shares at a predetermined price.

The retractable feature allows the bondholder to sell the bond back to the issuing company at predetermined prices at specific times.

Bondholders pay for these privileges by paying more for the bonds.

Question 33

List three types of derivative securities and explain the difference in each one.

Answer 33

1. Warrants: corporate created, long term options to purchase a stated number of shares at a specified price.
2. Options: give investors the right to buy or sell a stated number of shares within a specified period.
3. Futures contracts: an agreement for a future exchange of a particular asset at a specified date for a specified amount.

Question 34

Under what conditions might a bondholder utilize the convertible feature of a bond?

Answer 34

can be utilized if the price of the underlying stock rises above a certain point.

Question 35

Under what conditions might a bondholder utilize the retractable feature of a bond?

Answer 35

Can be utilized if interest rates rise substantially above the coupon rate of the bond.

Question 36

What kind of investment would be attractive to an individual who is in a high tax bracket?

Answer 36

An individual would rather invest in stocks than bonds, or zero-coupon bonds (strip bonds) because interest income for bonds is taxed at a higher rate than capital gains or dividend income.