Understanding Products and Their Risks Flashcards
What are the risks of owning Preferred Stock?
- Purchasing Power risk (with inflation).
- Interest Rate Sensitivity (value of preferred shares decrease when interest rates rise.
- Decreased or no dividend income.
- Low priority at dissolution (paid behind all creditors).
What are some of the benefits of owning common stock?
- Growth (capital gains).
- Income (dividend).
- Limited Liability.
What are the risks of owning common stock?
- Market risk.
- Decreased on or dividend.
- Low priority at dissolution.
Term Bond
Serial Bond
- A term bond is issued so that the entire principal matures all at once.
- A serial bond is issue schedules portions of the principal to mature an intervals until the entire balance has been repaid.
Calculate Net Worth.
Assets - Creditors’ Claims. Resulting net worth belongs to its stockholders.
Define Preferred Stock
Equity security that represents a class of ownership in a corporation. Similar to a debt security, the rate of return is fixed and the annual dividend represents its fixed rate of return making it appealing to income-oriented investors. Normally, a preferred stock is identified by its annual dividend payment stated as a percentage of its par value. Always assume the par value is $100 unless stated differently. Preferred stock has no voting rights.
What are the main types of Preferred Stock?
Straight (non-cumulative): No special features beyond the stated dividend payment. Missed dividends are not paid to the holder.
Cumulative: Accrues payments due its shareholders in the event dividends are reduced or suspended.
Callable preferred. Preferred stock that a corporation can buy back from investors at a stated price after a specified date. The right to call a stock allows a company to replace a relatively high fixed dividend obligation with a lower one when the cost of money has gone down. When a company calls a preferred stock, dividends cease on the call date.
Convertible preferred: A preferred stock where the owner can exchange the shares for a fixed number of shares in common stock. Tracks the price of common stock since two are related in value.
Adjustable-rate preferred: Preferred where divided rate is usually tied to other benchmarks such as T-bill or money market rates.
Participating preferred: Offers owners a share of corporate profits that remain after all dividends and interest due to other securities are paid. Least appropriate for investors seeking income.
Describe SEC Rule 144.
SEC Rule 144 regulates the sale of control and restricted securities, stipulating the holding period, quantity limitations, manner of sale and filing procedures.
Define “control securities”.
Control securities are those owned by directors, officers or persons who own or control 10% or more of the issuer’s voting stock. Extends to sum ownership of family members.
Define “restricted securities”.
Restricted securities are those acquired by some other means other than a registered public offering. Restricted securities may not be sold until they have been held fully paid for 6 months. Once eligible for sale, restricted securities are subject to volume restrictions as follows: In any 90 day period, an investor may sell greater of: -1% of the total outstanding shares of the same class at time of sale or -the average weekly trading volume in the stock over the past 4 weeks on all exchanges or as reported through NASDAQ, Unaffiliated investors may sell the stock completely unrestricted after the 6-month holding period.
Define Rule 144A.
Rule 144A Transactions Under the Act of ‘33 is an exemption that is only available to QIBs where a QIB is permitted to resell the securities with no volume restriction or holding period as long as buyer is also a QIB.
What are ADRs.
American Depository Receipts. Allows for investors to purchase foreign stocks in local currency more easily. An ADR is created when common shares are purchased in the foreign company’s home market. These shares are deposited in a foreign branch of a US bank and a receipt (ADR) is created. ADRs trade on NYSE or NASDAQ and sometimes OTC and settle T+2 - same as traditional US common stock. Dividends paid on ADRs may be subject to foreign tax (through a credit is applied to US tax) and any capital gains tax is only applied to US tax. Currency and political risk are two main risks associated with ADRs - above and beyond market risk.
Define a Debt Security (Bonds)?
Debt capital represents money borrowed by corporations, the federal government or local governments (municipalities) from investors. The bond (certificate of indebtedness) state the borrower’s obligation to pay back a specific amount of money on a specific date and to pay a specific rate of interest for the use of the funds.
What is a bond maturity date.
The date at which the investor receives the loan principal back. Common maturities are in the 5-30 year range but can be shorter or longer.
Define “Term Bond”.
A “term bond” is structured so that the principal of the whole issue matures at once.
Define “Serial Bond”.
A serial bond issue schedules portions of the principal to mature at intervals over a period of years until the entire balance has been paid.
Define “Balloon Bond”.
A bond that uses elements of both a term and serial bond where the issuer pays part of the bond’s principal before the final maturity date but pays off the major portion of the bond at maturity.
Define “coupon rate”.
The interest rate the issuer has agreed to pay the investor. Also referred to as “stated” or “nominal” yield. Calculated from bond’s par value (also known as face value) and is usually $1,000 per bond. Interest is generally paid twice a year.
How is accred interest calculated on a bond.
Buyers must pay sellers accrued interest on bonds so that the new owner gets paid the full coupon rate. Corporate a municipal trades use a 30-day month / 360 day year while Treasury bonds and notes employ the actual number of days.
How is bond pricing measured.
Bonds pricing is measured on points with each point representing 1% of face value. For example, a bond trading at 90 is worth $900 (on a $1,000 bond) or a discount while a bond trading at 103 is worth $1,030 (or a premium.
Define “nominal yield” for a bond.
The coupon rate of the bond (or stated yield) that is set at the time of issue. Fixed as a percentage of bond’s par value.
Define “current yield” for a bond.
Current yield measures a bond’s annual coupon payment (interest) relative to its market price. Annual coupon payment divided by market price = current yield.
Define a bond’s Yield to maturity.
A bond’s YTM reflects the annualized return of the bond if held to maturity.
What is the difference between “points” and “basis points”?
A basis point is a measurement of yield equal to 1/100 of 1%. A full percentage point equals 100 basis points. A “point” is a measurement of the change in a bond’s price which equals 1% of face value or $10 per bond. Sometimes YTM is referred to as a bond’s basis. For example, a bond trading a 5.83 basis means the bond has a YTM of 5.83%.
Define Yield to Call
YTC. Some bonds are issued with what is known as a call feature. A bond with a call feature may be redeemed before the maturity at the issuer’s option.
What is a “call feature” in context of a bond?
Allows the issuer to call in a bond before the maturity date.
What is a “put feature” in context of a bond?
A put feature is the opposite of a call feature. An issuer can “call in” the bond before the maturity date.
What is a convertible feature in context of a bond?
Allows the issuer to convert the bond into shares of common stock.
