Unit 2 Flashcards
Understanding Products and Their Risk
Equities
By Purchasing shares of a capital can participate in company’s prosperity
Capital Appreciation - Increase Stock Price
Distributed Profits - Dividends
Common Stock
Company issues stock to raise capital
investors buy stock also buy a share of ownership in the company’s net worth
each share of stock entitles its owner to a portion of the companies earnings and dividends and proportionate vote in major management decisions.
by electing board - stockholders have a say in company’s management
Benefits of Owning Common Stock
Common shareholders benefits including voting rights, opportunity for capital appreciation, and current income as well as limited liability
C/S Benefits - Rights of Common Stockholders
Have right to vote for corporate directors
C/S Benefits - Proxy
absentee ballot want vote but can’t attend
C/S Benefits - Growth (Capital Gains)
Increase in market price of securities is capital appreciation
hedge against inflation
C/S Benefits - Income
Many Pay dividends
dividends declared by BOD may increase overtime as profits increase
issuers may also pay stock dividends or property dividends
C/S Risk - Market Risk
chance that stock will decline in price is one risk of owning common stock
investors have no assurance able to recoup
C/S Risk - Decreased or No Dividend Income
a rise of stock ownership is the possibility of dividend income decreasing or ceasing entirely if company loses money.
decision to pay dividend rest with BOD
C/S Risk - Low Priority at dissolution
owners of bonds and preferred stock have priority over common stockholders.
debt and preferred shares are considered senior securities
C/S have residual rights to corporate assets upon dissolution
C/S - Owning Common Equity
in owning common equity, investor stands to lose current income through dividend reduction or suspension, as well as capital loss, should the market price decline.
in return shareholder has limited liability, liability is limited to the amount invested.
C/S - Bankruptcy
Reorganization - entity will likely be able to retain property and continue doing business.
Liquidation - keeping property or continuing business will not occur
C/S - Liquidation
Priority Claims on Assets Sold
- IRS taxes and employees (unpaid wages)
- Secured Debt (Bond and Mortgages)
- Unsecured Liability and general creditors (suppliers and utilities)
- subordinated debt (debt holders who agreed to be paid last)
- Common Stockholders
- Common Stockholders
Corporate Liquidation Priority - Common Shareholders
Common Shareholders are paid last of all bond and stockholders. Consider that only in cases where there are funds remaining after all other parties are paid do common stockholders receive anything
Preferred Stock
is an equity security because it represents class of ownership in corporation.
characteristic debt security
- rate of return is fixed, C/S is variable
- annual dividend represents fixed rate of return
No Voting Rights
No preemptive Rights
Common Vs. Preferred Stock
all corporations issue C/S, but not all incorporations issue P/S
Benefits of Owning Preferred Stock
- Dividend Preference - paid prior to common stock
2. Priority at Dissolution over Common Stock
Risk of Owning Preferred Stock
- Purchasing Powering Risk
potential because inflation fixed income produced not purchase much in future - Interest Rate Sensitivity
Interest Rate Rise, Value of P/S Decline
Interest Rate Decrease, Value Increase - Decreased or no Dividend
Dividend decreasing or Ceasing - Priority at Dissolution
Paid Before Common, behind creditors
Why Include P/S
- Fixed Income Dividends
- Prior Claim ahead of Common Stock
- Convertible preferred sacrifices income in exchange for potential appreciation
Preferred Stock - Straight (NonCumulative)
no special features beyond stated dividend payment
missed dividends are not paid
Preferred Stock - Cumulative
accrues payments due to shareholders in event dividends are reduced or suspended
receive current plus total accumulated
Preferred Stock - Callable Preferred
Company can buy back from investors at a stated price after specified date
allow replace high fixed dividend obligation with lower one when cost of money has gone down
dividend payment cease when called
Preferred Stock - Convertible Preferred
owner can exchange shares for fixed number of shares of common stock
issued with lower state dividend rate that nonconvertible given opportunity enjoy capital gain
because value of convertible preferred stock is linked to value of common stock, convertible preferred share price tends to fluctuate in line with common
Preferred Stock - Adjustable Rate Preferred
Adjustable dividend rates
dividends tied to rates of other interest rate benchmarks such as treasury bills and money markets rate
can adjust as often as quarterly
price of stock remains relatively stable
for investors looking for income through P/S this is least appropriate choice
Preferred Stock - Participating Preferred
Offers owner a share of corporate profits that remain after all dividends and interest due to other securities are paid.
6% preferred participating to 9%, company pays it holders up to 3% in additional dividends in profitable years
SEC Rule 144
regulates sales of control and restricted securities, stipulating period, quantity limitations, manner of sales, filing procedure
SEC Rule 144 - Control Securities
directors, officers, persons own 10% or more of issuers voting stock
SEC Rule 144 - Restricted Securities
acquired through means other than registered public offering.
may not be sold until held fully paid 6 months
after holding 6 months, may begin selling - volume restrictions
buyers of stock being sold subject to rule 144 are not subject to any restrictions if they choose to resell
Penny Stocks
is an unlisted security trading at less than $5 per share
highly speculative
risk disclosure document
monthly account statement
Penny Stock - Cold Calling Rules
Must disclose
- name of penny stock
- number shares to be purchased
- current quotation
- amount commission that firm and representative received.
Penny Stock - Provisions
provision of penny stock rules apply only to solicited transactions like those that might occur during cold call. unsolicited transactions are exempt
Penny Stock - Established Customer Exemption
established customer are exempt
- has held account with broker dealer for at least one year
- has made at least three penny stock purchases on different days
Bonds
money borrowed by corporations, federal government or local governments (municipalities) from investors.
load is evidenced by bond which is certificate representing the borrowers indebtedness to investor
when investor buys a bond investor is lending the borrowing entity money for a set period of time at fixed annual interest rate
acquires no ownership in entity unlike purchasing stock
investor becomes creditor
Bond Characteristics - Maturities
Term Bond - principal and whole issue mature at once
Serial Bond - portion of principal at intervals until entire balance is repaid
Ballon - elements of both serial and term. repay part before maturity, and major portion at maturity
Bond Characteristics - Coupons
represent interest rate issuer agreed to pay investor
interest rate bond pays is called coupon rate
interest is generally paid on semiannual basis -
bond with 6% coupon is paying $60 .
Bond Characteristics - Pricing
once trading in second market they can trade at a price of par, premium, or discount to par
Bond Characteristics - Market Forces
sensitivity to market interest rates
bond prices have inverse relationship to interest rates
Interest rates increase, bond price decrease
interest rates decrease, bond price increase
though price of bond will react to market forces and supply / demand, coupon is always the same.
Bond Characteristics - Yields
Bonds Yield expresses cash interest payments in relation to bonds value.
Yield is determined by issuers credit, prevailing interest rates, time to maturity, and bond features.
Bond Characteristics - Yield - Nominal Yield
coupon, nominal, or stated yield
set at time of issue
Bond Characteristics - Yield - Current Yield
measures bonds annual coupon payment
annual coupon payment / market price = current yield
Bond Characteristics - Yield - Yield to Maturity
reflects annualized return of bond if held to maturity
Discount - investor makes money, discount amount increases the turn
Premium - Investor loses money at maturity, the premium amount decreases the return
Bond Characteristics - Yield - Yield to Call
redeemed before maturity at issuers option.
investor received principal back sooner than anticipated.
YTC reflect acceleration of discount gain if bond at discount and accelerated premium loss if purchased at premium
Bond Features - Call Features
a call feature allows an issuer to call bond before maturity.
issuers generally do this when interest rates are falling
benefits issuer
Bond Features - Put Feature
opposite of call feature
investor can put the bond back to the issuer before matures
investors will do this when interest rates are rising
benefits bondholder
Bond Features - Convertible
allow investor to convert bond into shares of common stock
opportunity to exchange debt instrument for one that gives investor ownership right
benefit investor
Bond Features
when bonds are issued with features that benefit issue - call feature, issuer generally will need to pay slightly higher coupon rate of interest to make bond attractive to new investors
when bonds are issued with features that benefit the bondholder, put or conversion features, the issuer can usually pay slightly lower coupon rate of interest as the feature will compensate for lower return
Treasury Securities
US Treasury department - determines type of government securities it must issue to meet federal budget needs.
Marketplace - determines interest rates securities will pay
are backed by full faith and credit, based on power to tax
all are issued in book form
Treasury Securities - Treasury Bills
T-Bills
direct short term debt obligations of US Government
Maturity: 4,13,26,52 weeks
Pay no interest,
Issued at discount
- Treasury bills are only issued at discount
- treasury bills are only issued without stated interest rate
- treasury bills are highly liquid
- 13 week are used in market as risk free investment
Treasury Securities - Treasury Notes
T-Notes:
pay semi annual interest as percentage of stated par value and mature at par value
2-10 years
Treasury Securities - T Bonds
Pay semiannual interest as % of states par value and mature at par value
10 years to 30 years
Treasury Securities - Treasury Receipts
brokerage firms create
broker dealers buy treasury securities, place them in trust at bank sell separate receipts against the principal and coupon payments.
not backed by full faith and credit of US government
Treasury Securities - Treasury STRIPS
treasury department own version of receipts.
certain issues are suitable for stripping into interest and principal components
banks and broker dealers perform actual separation of interest
backed by US Government
Treasury Securities - Alert
treasury STRIPs are backed by full faith of US government.
Treasury Receipts are not
US Government Agency Issues
the settlement of agency issues securities occurs regular way -
T+2
known as asset backed or mortgage backed securities
Farm Credit System (FCS)
national network of lending institutions that provide agricultural financing and credit
privately owned, government sponsored
Government National Mortgage Association (GNMA)
is government owned corporation that supports department housing.
Ginnie Mae are only agency securities backed by full faith and credit of federal government
Freddie Mac
public corporation
promote development of nationwide secondary market in mortgages by buying residential mortgages from financing institutions and packaging them into mortgage backed securities for sale to investors
Fannie Mae
Publicly Held Corporation
provides mortgage capital
FNMA purchases conventional and insured mortgages from FHA and VA
securities created are backed by FNMA general credit
Corporate Bonds
Secured - backed by various assets
Unsecured - backed by reputation, credit record, financial stability. backed by corporations full faith and credit
Corporate Bonds - Mortgage Bonds
corporation borrow money backed by real estate and physical assets of corporation.
real estate assets pledged as collateral - sold
purchaser of montage bond in position safety
secured loan
Corporate Bonds - Equipment Trust Certificates
finance acquisition of capital equipment used in course of their business.
equipment held in trust, usually by bank acting as trustee, until certificates paid in full.
not paid - repossessed as collateral
secured loan
obligation to pay investor is secured by the equipment
Corporate Bonds - Collateral Trust Bonds
Deposits debt securities it owns into a trust to serve as collateral for lender
can be securities in other corporations or those partially or fully owned as long as securities are marketable - liquidated
secured by securities deposited, better quality securities, better quality of certificate
Corporate Bonds - Debentures
debt obligation of corporate backed only by its word and creditworthiness
written promise,
are not secured by any pledge of property
sold on general good faith and credit of company
unsecured
although debentures are unsecured - issuers whose credit standing is so good that debentures might be considered safer than unsecured bonds of less creditworthy companies
Corporate Bonds - Guaranteed Bonds
backed by company other than issuing company such as parent company
value of guarantee is only as good as faith of company making guarantee
unsecured - never be fooled by guarantee as it relates to guaranteed bonds
Corporate Bonds - Income Bonds
adjustment bonds
pay interest only if have enough income to meet interest
unsecured
income bonds are true oxymoron, if investor is seeking income, an income bond is likely not a suitable recommendation
Senior of Subordinated Debt
- Secured Creditors Debt Instruments
(Mortgage Bonds, Equipment Trust Certificates, Collateral Trust Bonds, Mortgages) - Unsecured Creditors Debt Instruments
(General Creditors, debenture holders, guaranteed bonds, income bonds) - Subordinated debt
(debt holders agreed to be paid back last) - Preferred Stock
- Common Stockholders
Municipal Securities
considered second in safety of principal only to US government and US government agencies
Municipal Bonds - issued either by state or local government
Municipal Securities - General Obligations Bonds
Municipal Bonds issued for capital improvements
interest must be paid by taxes collected from municipal issuer
known as good faith and credit issues - backed by municipality’s taxing power
back by income taxes, license fees, sales tax
ad valorem
can be limited to protect from excessive taxing
Municipal Securities - Revenue Bonds
used to finance any municipality that generates sufficient income.
principal and interest are made from revenues generated
utilities - housing - transportation - education - health - industrial - sport
not supporting by issuers authority to tax
Municipal Securities - Anticipation Notes
ST securities generate funds, less than 12 month maturity but can range from 3mo - 3yr
repaid when municipality receives funds
TAN - finance current operations in anticipation taxes
RAN - finance current from future revenues
TRANS - combination of above
BANs- interim financing be converted to long term through sale of bonds
Tax Exempt Commercial paper 270 days
CLN - construction
variable rate notes - fluctuating interest, put option
GANS - expectation receiving grant
Municipal Securities - Taxable Municipals
Build America Bonds
Bondholder pay tax on interest received
Tax Credit BABS - federal income tax credit equal to 35% of interest paid on each bond each year. excess credit carried forward
Direct Payment BABs: no credit to bondholder, provide municipal issuer with payments from UST equal to 35% of interest paid to issuer
Municipal Securities - Section 529 Plans
- Overall contributions levels can vary
- assets remain in donors control until student becomes legal age
- no income limitation
- monthly payments if desired
- unused may be transferred
- rollover are permitted
up to 10,000 per year
official statement or offering circular
Municipal Securities - LGIP
provide other government entities cities, counties, school,
short term investment vehicle to invest funds.
generally formed as a trust which municipalities can purchase shares or units in LGIP investment portfolio.
Not Money market Fund
Not required to register with SEC or subject o regulations
No prospectus
do have disclosure documents
Municipal Securities - ABLE
tax advantage savings accounts for individuals with disabilities and their families
must have before 26
only one able account per customer
Money Market Instruments
Capital and Money Market
Money Market Instruments - Capital Markets
source of intermediate term and long term financing
equity or debt securities with maturities of more than one year
Money Market Instruments - Money Market
provides short term funds to corporations, banks, broker dealers, government municipalities, and US Federal Government.
Fixed Income (debt) securities with short term maturities, less than year
Consider to be highly liquid, little time to default.
high degree safety
investors purchase generally do not receive interest but issued at discount or par and mature at face value.
return = difference between purchase price and face value
Why Include:
- highly liquid
- very safe
- good place investment money needed short term
Risk:
- rate of return low
- due to ST, principal potentially reinvested at different rate each time, fluctuate each new instrument purchased
Money Market Instruments - Certificate of Deposits
banks issue and guarantee
fixed interest rates and minimum face value of 100k
jumbo - face value of 1m or more and most common
most mature in less than one year
some can be traded in secondary market = negotiable CD - these are consider money market
negotiable CD - banks version of unsecured promissory note, backed only by good faith and credit
Money Market Instruments - Bankers Acceptance
short term time draft with specified payment date.
BA is postdate check
payment date 1 to 270 days
corporation use extensively to finance international trade
typically pays for goods and services in foreign country
Money Market Instruments - Commercial paper
corporations issue short term, unsecured paper known as promissory notes.
raise cash to finance accounts receivable and inventory
maturity - 1 to 270 days, most mature 90 days
excellent credit
Money Market Instruments - US Treasury Bills
Direct short term debt obligations of US government
issued with maturities
4,13,26,52
thought T Notes and T Bonds are issued with longer maturities than T Bills, once notes and bonds have only a year left to maturity they are considered to be money market instruments
Money Market Instruments - Repurchase Agreement
financial institution, bank or broker dealer raise cash by temporarily selling securities hold with agreement to buy back securities at later date at higher price.
agreement to conduct transaction, reverse transaction in future.
contract - repurchase price, and maturity date
Reverse Repo
dealer agrees to sell securities to lender and buy back at higher price,
reverse dealer agrees to buy securities form investor and sell back at higher price
Federal Funds
FRB mandates money supply
excess deposits of required amount know as federal funds
can be loaded to member bank to meet reserve requirement
loans are short term, occur overnight
Options
derivative securities -
derive value from that of an underlying instrument such
- stock
- stock index
- interest rate
- foreign currency
offer investor to hedge, or protect investment value or speculate price movement of
- individual securities
- foreign currencies
- other instruments
two parties involved in contract - right to exercise, other obligated to fulfill
Contract Premium
amount paid for contract when purchased, or received for contract when it is sold
Options - The Buyer
Pays premium for contract
referred to as owner, holder, or party
long the contract
right to exercise contract
- purchaser
- long
- pays premium
- owns right
- in control
Options - The Seller
receives premium
writer, party
short the contract
obligated to perform if buyer chooses to exercise contract
Options - Transaction Types
Buy Calls
Sell Calls
Buy Puts
Sell Puts
Options - Calls - Long Call(Purchase)
- Call buyer
- Owns Rights to buy at specified stock at expiration
- exercise before expiration
- bullish investor
- anticipates price of underlying security will rise
Long 1 XYZ Jan 60 Call at 3
- Buyers of Calls want the underlying stock to rise in value.
- hopes market price above 60
- pays $300 premium
Options - Calls - Short Call (Sales)
- Call Writer (Seller)
- obligation to sell specified stock at specified price if buyer exercises contract
- bearish investor
- anticipates price of underlying security will fall
Short 1 XYZ Jan 60 Call at 3
- want price to stay at or below 60
- if unexercised receives $300 premium
Options - Puts - Long Put (Purchase)
- Put Buyer
- Owns rights to sell specified stock at specified price
- bearish investor
- wants price to fall
Long XYZ Jan 60 Put at 3
- market price to fall to 40, sell at 60
- investor pays $300 premium to buy put
Options - Puts - Short Put (Sale)
- Put writer (seller)
- obligation to buy at specified price
- bullish investor
- price to rise or remain unchanged
- received premium
Short 1 XYZ Jan 60 Put at 3
Options - Calls - Call Buyer
- Bullish Investor
- Wants market to rise
- call is exercised only if market price rises
Options - Calls - Call Writer
- Bearish Investor
- want market fall or remain unchanged
- contract not exercise if market price is below strike price
Options - Puts - Put Buyer
- bearish investor
- wants market to fall
- exercise only if market price falls below strike price
Options - Puts - Put Writer
- bullish investor
- market rise or remain unchanged
- contract not exercised if market price above strike price
Options - Calls - In the Money
Price of Stock EXCEEDS strike price of call
- buyer will exercise calls that are in the money
- buyer wants options to be in the money
- seller NOT wants in the money
Options - Calls - At the Money
Price of Stock EQUALS strike price of call
- buyer will not exercise
- seller want at the money
- buyers do not
- seller keeps premium without obligation
Options - Calls - Out of the Money
Price of Stock Lower than Strike Price of Call
- buyer will not exercise
- sellers want
- seller keeps premium
Options - Calls - Intrinsic Value
amount a contract is in the money
Has Intrinsic value - price of stock above strike price
options
- never negative
- always positive
- At the Money or In the money have IV
- Buyer like to have intrinsic value
- sellers do not
call that has intrinsic value will be exercised by buyer
call no intrinsic value will not be exercised
during lifetime
buyer - contract to move in the money
sellers - contract to move out of the money
Options - Calls - Parity
premium equals intrinsic value
Example
ABC Stock is at 62
ABC June 60 Call trading at 2
Trading @ 62
intrinsic value = 62-60 = 2
premium = 2
given contract is trading at premium of 2, it is known to be trading at parity
Options - Puts - in the money
Price of stock LOWER than strike price of put
- buyer exercise put in the money
- buyer want in the money
- sellers do not
Options - Puts - at the money
price of stock EQUALS strike price of put
- buyer will not exercise
- seller want
- buyer do not
Options - Puts - out of the money
price of stock HIGHER than strike price of put
- buyer will not exercise
- sellers want
- buyers do not
Options - Puts - intrinsic value
same as in the money
put has intrinsic value
- stock price below strike price of put
- buyers like options with IV
- put with IV will be exercised
Options - Puts - Parity
premium equals intrinsic value
ABC stock is at 58
ABC June 60 Put trading at 2
Strike price - stock price = 2
trading at premium of 2 trading at parity
Long Call - BE, MG, ML
Call Buyers are bullish, profit from increase stocks price
For Calls
BE = Strike Price + Premium, Profit above BE
MG = Unlimited
ML = premium paid
Long 1 July 40 Call at 3 BE = 40+3 MG = Unlimited ML = 300 above 43 call buyer is profitable
Short Call - BE, MG, ML
call writers are bearish, investor profit from stock price fall
For Short call
BE = Strike Price + Premium, Profit below BE
MG = Premium Received
ML = Unlimited
Short 1 July 40 Call at 3 BE = 40+3 = 43 MG = 300 ML = unlimited at or below 43 call writer is profitable
Long Put - BG, MG, ML
Put Buyers are Bearish, investor profit from decrease in price
BE = Strike Price - Premium, profitable below BE
MG = Strike Price - Premium, no lower than 0
ML = Premium Paid
Long 1 July 40 Put at 3 BE = 40-3 = 37 MG = from BE to zero, same as BE = 3,700 ML = 300 below 37 put buyer is profitable
Short Put - BE, MG, ML
Put sellers are bullish, profit if stock price rises
BE = Strike Price - Premium, profitable above BE
MG = Premium Paid
ML = same as BE
Short 1 July 40 Put at 3 BE = 40-3 = 37 MG = 300 ML = 37 at or above 37, put writer is profitable
Options Clearing Corporations
OCC is clearing agent for listed options,
standardize, guarantee, issue
determines when new should be offered
designates strike price and expiration for new
Trading Times - 930am - 4pm et
Settlement - T+1
Expiration - third Friday of expiration month
Exercise - by owner until expire. BD notifies OCC
Automatic Exercise - In the money .01 exercised
Assignment - short broker dealer, OCC assigns on random, FIFO
options contracts are traded without certificate. an investors proof of ownership is the trade confirmation
OCC - Contract Specifications
only owners of option contracts, those who are long the contracts, have the right to exercise them.
writers of contracts, those who are short contracts, will be assigned to fulfill their obligation to perform, either sell, if short call, buy if short put
Exercise and Assignment - Owner of Call
party long contract
right to buy stock at strike price
must exercise call
Exercise and Assignment - Writer of Call
assigned
obligation to sell stock at strike price
Exercise and Assignment - Owner of Put
Party Long the contract
right to sell stock at strike price
exercise put
Exercise and Assignment - Writer of Put
assigned
obligation to buy stock at strike price
Exercise and Assignment - American Style
call or put buyers can exercise contract any time before expiration
Exercise and Assignment - European Style
call or put buyers can only exercise contract on expiration date only
Exercise and Assignment - Foreign Currency
may be either American or European style
Underlying Security and Cash Settlement
Settled - equity option is exercised shares of stock must be delivered
Cash Settle - index and foreign currency options are cash settled. cash must be delivered by party (short the contract)
settling in cash (US dollars) facilities exercise and assignment process
Options Account Diagram
Customer open option account
- provided ODD
- approved by BOM before trading
- Options agreement - 15 days
note chronological conundrum
- options must be approved before trading
- account approve - trades occurred
- having 15 days after approval, has not returned signed options agreement
- customer wishes trade options
- RR determines suitability
- OCC disclosure document provided before account approval
- Options account approved by ROP
- first trade may take place immediately following approval
- options contact bought and sold (T+1) premiums paid
- signed option agreement returned within 15 days
- closing transaction only if option agreement not returned or late
Options - Covered
if contract is covered, writer already owns underlying security.
ensures writers ability to perform (deliver) should the owner exercised the contact
have security - or cash to settle
Long 100 shares xyz at 40
short 1 xyz july 45 call
if owner exercise call, writer will need to deliver stock at strike price 45.
already owning stock at 40, no risk
Options - Uncovered (Naked)
if contract is uncovered, writer does not own underlying security
contract exercised by owner, writer will need to purchase underlying security at current market price in order to deliver it
uncovered (naked) contracts entail much more risk due to the uncertainty in price regarding purchase of security in the current marketplace if the contact is exercised.
writers of naked calls are willing to accept risk in return for the premium when selling short (writing) the call.
Long 100 shares xyz at 40
short 1 xyz july 45
if owner exercises call, writer need to deliver stock at strike price of 45.
not owning- need to purchase in open market in order to deliver it.
Investment Companies
is a corporation or trust that pools investors money and then invest money in securities on their behalf.
investors able to pool and have investment company invest based on clearly defined objective such as growth or income
investing single large account, jointly owned by ever investor, able to invest in many different securities reducing overall risk
investment companies raise capital by selling shares to public
same registration and prospectus required imposed by securities act of 1933
subject to regulations shares sold
regulated by investment company act of 1940
Types of Investment Companies
investment company act o 1940
classified into three broad categories
- Face Amount Certificate Companies (FACS)
- Unit Investment Trust (UITs)
- Management Investment Companies
variable annuities have subaccounts that are defined as either UITs or open end management investment companies
FAC and UITs are not managed, once portfolios are composed they do not change
FAC and UIT do not trade in secondary market, they are redeemable only through the issuer
Investment Companies - Face Amount Certificates (FAC)
contract between investor and issuer
issuer guarantees payment of stated (face amount) sum to investors at some set date
investor agrees to pay issuer set amount money, lump sum or periodic installment
lump sum - fully paid face amount certificate
issues of these investment group face amount certificate companies
few exist today
Investment Companies - unit Investment Trust (UITs)
organized under trust indenture
do not have board of directors
have trustees
portfolio and debt or equity securities designed to meet company objective
sell redeemable interest = units = shares of beneficial interest
each share undivided interest to entire underlying portfolio
Fixed UIT
purchases a portfolio of bonds and terminates when bonds in portfolio mature
equity fixed UIT purchases portfolio of stock an terminates at a pre-determined date
non fixed UIT
Purchases shares of underlying mutual fund
Managed Investment Companies
actively manages a securities portfolio to achieved a stated investment objective
is either closed end or open end.
both sell shares in IPO
Closed End - initial shares limited
Open End - perpetually offering new shares to public
Closed End Investment companies
Initial Shares Limited
raise capital for its portfolio by conducing common stock offering.
Initial Offering, registers fixed number of shares with SEC
offers to public with prospectus for limited time through underwriters.
once all shares sold, fund closed
elects closed end because of sector
may also issue bonds and preferred stock
often called publicly traded -
anyone an by OTC in secondary market
supply and demand determine bid price and ask price
trade at premium to NAV
NAV per share is funds NAV divided by number of outstanding shares
- closed end investment companies are the only investment company security that trades in secondary market
- closed end companies may issue common stock, preferred stock and debt securities
Open End Investment Companies (Mutual Funds)
only issues one class of security
only issue common stock
does not issue preferred shares or bonds.
when registers and has open offering does not disclose exact number of shares
mutual funds conduct continuous primary offering of common stock
can raise unlimited amount of investment capital by continuously issue new shares
investors wanting to sell their holding, fund itself redeems shares.
mutual funds are like FAC and UIT do not trade in secondary market
investor sell shares back to fund, fund sends investor money for proportionate share
mutual fund capital shrinks when investors redeem shares, do does outstanding share,
value of each share does not fall as result of redemption
** while mutual funds only issue common shares to shareholders, funds themselves can purchase common stock, preferred stock, and bonds for investment portfolio.
** each fund has stated investment objective, types of securities purchases has largely to do with fulfilling their objective
Variable contracts / Annuities
insurance contract designed to provide retirement income.
stream of payments guaranteed for period of time
actual amount paid may not be guaranteed but stream payment itself is
can provide rest of life - mortality guarantee
insurance companies introduced as way to keep pace with inflation
investors assumes investment risk
considered security
Separate Account - premium payments - various subaccounts
returns of account not guaranteed
Directly Managed
- Investment Act 1940
- Open end Management Investment Company
Indirectly Managed
- passes responsibility
- UIT
- a fixed annuity differs from variable annuity. though both are insurance company products and guarantee stream of income, fixed annuity promises a state rate of return, insurance company is at risk
- fixed are not considered security
Mutual Fund (Open End) Characteristics
MF is pool of investors money invested various securities.
offer guaranteed marketability - mutual fund ready to buy back
redeemable security - do not trade in secondary market
all investors are mutual participants
- professional investment adviser manages portfolio
- diversification
- allow minimum investment 500
- may all investments at reduces sales charge based on amount of investment
- investors retain voting rights,
- must offer reinvestment of dividends and capital gains at NAV
- liquidate without disturbing
- provided 1099
- reinstatement provision, reinvest within 30 days with no new sales charge, in prospectus, available one time
Mutual Fund - Share Class
Investors can purchase the same underlying mutual fund shares in several way.
sales charges in way the distribution services fund underwriters provides.
Class A (Front End Load) Shares
Front end Sales charge (loads)
sales charge are paid at time investor buys shares and sales charge is taken from total amount invested
Most common
10,000 @ 2%
purchase with 9,800
Class B (Back End Load) Shares
back end sales charge
contingent deferred charge (CDSC)
paid at time investor sell shares.
declining percentage reduced annually
structured, drops to zero and converted to A shares and no sales charge applied.
with class b - full investment amount is available to purchase shares no sales charge is applied at purchase but instead deferred to time of redemption
shares grow in value - sales charge can be greater than amount initially invested if not held long enough
Class C( Level Load) Shares
typically one year
1% CDSC
.75% 12b-1
.25% shareholder fee
fees never go away, considered to have level load,
good for investors with short time horizon
bad or investors long time
No load Shares
market directly to public eliminating need for underwriters and thus sales charges used to compensate them.
fund does not charge any type of sales charge
can charge fees - purchase, account, exchange, redemption
redemption fee deducted like deferred sales load, often fixed amount vs. percentage of redemption
Mutual Fund - Market Timing
Short term buying and selling of mutual fund shares to take advantage of inefficiencies in mutual fund pricing.
Can harm long term shares, dilute value
prohibited by vast majority of mutual funds
not intended for day trading
Mutual Fund - NAV
trade in secondary market
Total Assets - Total Liability = TNAV
net Asset value of fund / shares outstanding = nav per share
purchase price = POP
Front End = NAv + SC = POP
NAV changes daily because market
See page 88
Mutual Fund Prospectus
Full and fair disclosure fund objective sales charge management expense service charge five and 10 year performance or performance over life
if fund has been in existence for 8 years, show performance for five and 8
if existence for 4, show one and 4
delivery type of any sales literature is considered solicitation and must be accompanied by delivery of prospectus
Purpose: sale document
Contains: full and fair disclosure
Presented: prior to or with solicitation, if summary used no later than confirmation of sale
Mutual Fund - Summary Prospectus
Standardized summary of key information
investor purchases using summary must have access to full no later than confirmation date
- fund name and class of shares
- fund ticker or ETF
- legend -summary of nature, full stat. prospectus, investment strategy, risk, holding, shareholder information
Purpose: rule 498, short form
Contains: summary of key information in prospectus
Presented: prior to or with solicitation
Mutual Fund - SAI
both open and closed required to have
funds history and policies
must contain consolidated financial information balance sheet statement of operations income statement portfolio list
Purpose: more data for investor
Contains: additional details not found in prospectus
Presented: 3 days of customer request
Mutual Fund - Disclosure
SEC requires
- discussion of factors
- graph performance to market index
- names, title, responsible day to day management
Mutual Fund - Financial Reports
investment company act 1940 requires investors received financial reports at least semiannual. Must be audited
- investment company balance sheet
- valuation of securities (portfolio list)
- income statement
- complete statement compensation to board and advisory
- total dollar amount securities purchased and sold
** an investment company must send copy of balance sheet to any shareholders who request one in writing between semiannual reports
Mutual fund - Fund Cost and Fees
services may include retirement, custodianship, investment plans, check writing privileges, transfer by phone, withdrawal plans,
investor should always weigh the cost of services provided
sales load, management fees, operating expense reduce returns because they are reduced from money available for the funds to invest
Mutual Fund - Sales Load
fund can charge front end, back end, level load
permitted to charge up to 8.5% for money invested in a shares.
percentage sale charge compensate sale force, broker dealers, underwriters, market and sell shares to public.
Mutual Fund - Expenses
incur operating and management fee
Mutual Fund - Operating Expenses
salary and administrative fees
Mutual Fund - Fund Portfolio Management Fee
paid to those hired to manage investments in fund portfolio calculated as % of assets under management
** the management fee is every funds greatest expense. charged annually this fee is a percentage of total assets under management
Mutual Fund - 12b-1
investment company act 1940 permits mutual fund to collect fee for promoting, selling, undertaking activity in connection with distribution sales.
determined annually by flat dollar amount or as % of NAV charged quarterly.
associated with no load fund,
if fee is greater than .25%, front may not use no load term
expense ratio compares management fees and operating expense against net assets
expenses / assets
an expense ratio of 1..72% means that the fund charges $1.72 per year for every 100 invested
Stock Equity expense ratio 1 and 1.5%
bond debt funds between .5 and 1%
Non US Market Securities
most are structured for long term.
investors need to be sensitive to different risk political, currency, and liquidity
Direct Participation Programs (DPPS)
unique forms of business that raise money to invest in real estate, oil and gas, equipment leasing, and other similar business ventures.
Not taxed directly - income or losses are passed directly to owners of partnership/ investors.
investors are individually responsible for satisfying tax consequences.
considered high illiquid
Real Estate Programs
Invest in raw land, new construction, existing property
- Capital Growth Potential - appreciation of property
- Cash flow - collected rom rents
- tax deductions - mortgage interest expense, depreciation allowances for wear, capital improvements
- tax credits - government assisted housing, historical rehabilitation, reduce tax liability
Oil and Gas Programs
speculative or exploratory
riskiest development
producing wells - least risky
Intangible Drilling cost
cost associated with drilling, wages, supplies, fuel, insurance, no salvage value when program ends.
Written off in fully amount first year
drilling equipment - deductible over several years as deprecation,
depletion allowance
tax deductions compensate program for decreasing supply of oil or gas
Leasing Programs
created when DPP purchase equipment leased to other businesses.
investor receive income form lease payments and proportional share of write offs from operating expense, interest expense, and depreciation of actual equipment
primary investment objective is tax sheltered income, income being sheltered by write offs.
Limited Partnership
Most common type of DPP
permits economic consequences of business to flow or pass through to investors.
business not tax paying
investors (partners) have responsibility to report individually to IRS
greatest disadvantage is lack of liquidity
secondary market is extremely limited
Investors in Limited Partnership
involves GP and LP
property held in TIC provides limited liability and no management responsibility to LP
General Partners
Unlimited liability - personally liable for business losses and debts
manage all aspects and have fiduciary responsibility.
may not compete personally with business, borrow money from, or commingle with own personal assets
LP
limited liability can’t lose more than they invest
no business management responsibility
rights to vote, receive distributions, inspect all books, right to sue GP
- investment managed by others (GP
- limited liability
- flow through of income and certain expenses
may be sold private or public placement
private - small groups of limited partners each contributing large sums of money - accredited investor
sold by prospectus for disclosure in public offering
LP are liquidated on predetermine date specified in partnership agreement
dissolution - GP settle accounts
- secured lenders
- other creditors
- limited partners for claims profit / contribute capital
- GP
Real Estate Investment Trust
company that manages portfolio of real estate, mortgages, or both to earn profits.
pools capital similar to investment company but are NOT investment companies, open or closed
shareholders receive dividends from investment income or capital distributions
- own commercial property (equity REIT)
- mortgage and commercial (Mortgage REIT)
- do both ( hybrid)
organized as trust - buy shares or certificates of interest on stock exchange or OTC
Subchapter M - avoid being taxed - 75% of income from real estate, distribute 90% or more to shareholders
- owners of REIT hold undivided interest in a pool of real estate investments
- REIT may or may not be registered with SEC
- REITS may or may not be listed on exchanges
- REITS are not investment companies (open or closed)
- REITS offer dividends and gains to investors but do not pass through losses like partnership, NOT considered DPP
Registered REIT
Registered with SEC
Subject to all disclosure requirements
Nonregistered REIT
Not Registered
not subject to same disclosure requirements as public and subject to greater risk
Listed REIT
Traded on Stock Exchange,
non listed REIT
not listed on exchange and trade OTC market
unique risk exist
not be exchange trade difficult to price and possibly illiquid
Hedge Funds
Private Investment Companies
Not classified
hedge funds are considered unregulated as they currently do not have to be registered with SEC
Hedge Fund Structure and Characteristics
Similar to mutual funds
investments are pooled, fund has more flexibility in investment strategies
limit risk, higher returns, shoulder substantial risk
suitable sophisticated investors
while hedge funds are unregulated, US laws required that investors meet sophisticated investor. Considered accredited, minimum annual income.
- highly leverage portfolios (borrowing to purchase)
- use of short positions (selling does not own)
- utilization of derivatives such as options and futures
- currency speculation
- commodity speculation
- investment politically unstable
private investment partnership, limit investors, minimum length
Lock Up Provisions
not unusual for hedge fund organizers to be investors themselves
Exchange Traded Products
Securities that trade intra day on national securities exchange
priced so value of product derived from other investment instruments
commodity, currency, share price, interest rate
benchmarked to stocks, commodities, indices,
can be actively or passively managed
ETPS - ETF
Equity security, invest in specific group of stocks and mimic particular index.
similar to mutual fund that track index
trades like stock on floor of an exchange
registered as open end or UIT
investors can take advantage of intraday price change due to normal market forces.
can be purchased on margin or sold short
expenses lower than mutual funds, management fee is low as well.
securities unlikely to change
greater tax efficiency for investor
every time purchase or sell, commission, can add up
registered as open end funds,
ETN
senior, unsecured debt securities issued by bank or financial institutions.
backed only by good faith and credit of issuer
note track performance of particular market index
do not represent ownership in a pool of securities the way ownership of fund does
ETNs are bond like instruments
- stated maturity date
- do not pay interest
- do not offer principal protection
ETN investors
receive cash payment linked to performance of underlying index minus management fees when note matures
ETN risk
if credit of underwriter falter, note might lose value like senior debt of issuer would,
ETN Trade
might trade at premium could be subject to loss later depending on value
Investment Risk
greater risk , greater reward
Systematic Risk
risk that changes in overall economy will have adverse effect on individual securities regardless of company circumstance
War, global security threats, inflation
cannot diversify
** no matter how diversified a portfolio of investment is, it will be subject to systematic risk
Systematic Risk - Market Risk
risk that overall market declines, so too will any portfolio of securities is comprised of.
DJIA plummet, so too would portfolio of common stock. could not escape large fall in market without being affected
Systematic Risk - Interest Rate Risk
if FRB push interest rates up, market price of bonds affected
interest rates rise, market price of bonds fall
market risk for bonds
Systematic Risk - Reinvestment Risk
variation of interest rate risk
interest rates decline, difficult to reinvest proceeds from redemption
securities with call risk, reinvestment distributions and maintain same level of income without increasing credit or market risk
Systematic Risk - Inflation Risk
Purchasing Power Risk
effect of continually rising prices on investment returns
investment yield lower than inflation, purchasing power diminish over time
investor purchased 30 year bond, 5% inflation above 5% , interest payment no longer sufficient to purchase good and services initially had
Nonsystematic Risk
risk can be reduced through diversification
unique, specific to industry, business, investment type e
Nonsystematic Risk - Capital Risk
potential for investor to lose some or all of his money, under circumstances non- related to issuers financial strength.
capital risk is minimal to none when investing in securities backed by federal government such as T bills but could be far greater when investing in derivative products such as options or DPP
Nonsystematic Risk - Business Risk
operating risk caused by poor management decisions
at best - earning lower
worst - companies go out of business and lose investment
introducing new product turns out to have narrow market, and poor business decisions
Nonsystematic Risk - Financial Risk
companies that use debt financing (leverage)
inability to meet interest and principal payment on those debt obligations lead to bankruptcy
sometimes called credit risk or default risk
Nonsystematic Risk - Call Risk
bond might be called before maturity and investor unable to reinvest principal at a comparable rate of return.
can lead to reinvestment risk.
interest rates falling - bond with higher coupon rates more likely to be called.
concerned about call risk - call protection - period bond cannot be called.
most corporate and municipal securities provide some year of call protection
investor holds callable bond yielding 5%, interest rates fall to 3%, bond call and investor receives principle, now left to reinvest at 3 when at 5
Nonsystematic Risk - Prepayment Risk
risk that a borrower will repay principal on loan or debt instrument (bond) before maturity
deprive lender of future interest payments
associated with call risk
Nonsystematic Risk - Currency Risk
possibility of an investment in one currency could decline if value of decline in exchange rate.
important consideration when investing in foreign
Nonsystematic Risk - Liquidity Risk
investor not able to sell investment quickly at fair market value
marketability risk
marketability of RR consistent with client liquidity needs
while common stock and money market instruments are considered fairly liquid for potential buyer and market to sell them is readily available, investments in fixed assets like real estate, fine art, collectibles are not
Nonsystematic Risk - Regulatory Risk
comes from change in regulations
government, state, federal, pass regulations
changes in rules a business must comply with
EPA / FD
upset business model and profitability
pharmaceutical drug companies biggest drug is pulled by FDA - left decision either sell at depressed or hold for correction
Nonsystematic Risk - Legislative Risk
changes in law
most common is tax law
implementation of luxury tax on higher priced items such as automobiles severely impact industries
Nonsystematic Risk - Political Risk
interrelated with legislative risk
potential instability in the political underpinnings of the country
particular true in emerging, can happened in highly developed
Nonsystematic Risk - Sovereign Risk
risk of country defaulting on its commercial debt obligations.
when country is at risk, impact is felt worldwide
Open Vs. Closed Comparison
Capitalization
Open - unlimited, continuous offering
Closed - fixed, single offering
Issues
Open - Common stock only, no debt, can borrow
Closed - common, preferred, debt securities
Shares
Open- full or fractional
Closed - Full Only
Offerings and Trade
Open - sold and redeemed by fund only, continuous primary offering, must redeem shares
Closed - IPO, secondary trading, OTC, does not redeem shares
Pricing
Open - NAV + sales charge, selling price by formula in prospectus
Closed - CMV + commission, price determined by supply and demand
Shareholders Rights
Open - dividends when declared, voting
Closed - dividends, voting, preemptive
Ex Date
Open - Set by BOD
Closed - Set by exchange or FINRA
Advantages of ETF
- pricing and ease of trading - traded on exchange can be bought and sold anytime at price currently trade
- margin - ETF can be bought and sold short on margin like other exchange products. MF cannot
- Operating Cost - lower than mutual funds
- Capital Gains - sometime distribute gain, rare, none until sell, greatest advantage associated
Disadvantages of ETF
- commission - commissions paid can erode the low expense advantage, greatest impact while trading small sums of money
- overtrading - ability to trade, excessive trading can eliminate advantage of diversified portfolio + commission eroding expense and operating cost advantages
- market influence on price - trade on exchange, share prices an be influenced by market forces like supply and demand. investors might receive less than book value per share when selling corporate share of stock, investor might receive less than NAV when selling ETF
