Unit 2 - Understanding Products and Their Risks

Question 1

Why are STOCKS referred to as Equities?

Answer 1

Called Equities because people who own stock have equity (ownership) in the company.

Question 2

Common Stock - what is the investment objective of…

[5 choices]

Answer 2

Objective:
1- bought for growth/capital appreciation.
2- bought for Income.
3- The #1 security bought as a hedge against inflation.
4- Purchased in the hope the price will go up.
5- Hope that the return (income) is greater than inflation.

Question 3

Risks associated with Common Stock [6]

Answer 3

RISKS - 1 - Price could go down.
2- How much money can you lose? All of your investment.
3- Loss is limited to the amount invested.
4 - DIVIDENDS may be paid or may not be paid. COMMON DIVIDENDS paid after PREFERRED DIVIDENDS.
5- In LIQUIDATION Common Stock is last to be paid.
6- Would have RESIDUAL CLAIM to assets if company went bankrupt.

Question 4

Residual claim

Answer 4

Definition: According to the residual claimant theory, after all factors of production/service have received their remuneration, the person/agent supposed to receive the left/residual amount is known as the residual claimant. Description: The residual claimant receives the remainder of the sum after all costs have been accounted for.

Question 5

Common Stock risks [4]

Answer 5

a) Lose (all) your money.
b) You may not receive income.
c) Dividend is subordinate to Preferred (Stock) dividend.
d) Liquidation order is last in line.

Question 6

Common Stock LIQUIDATION ORDER

[5]

Answer 6

1) First to be paid, those with Secured Bonds
2) Next paid Debenture Bonds
3) Subordinated Debentures,
4) Preferred Stock
5) Last paid is Common Stock.

Question 7

Subordinated debentures definition?

Answer 7

Subordinated debentures definition
Subordinated Debenture Bond. A class of unsecured bond that, in the event of liquidation, is prioritized lower than other classes of debt. In essence, a subordinated debenture bond is an unsecured loan, which has no collateral. Should the issuer be liquidated, all other bonds and debts must be repaid before the subordinated debenture bond is repaid.

Question 8

Liquidation Order of Common Stock

Answer 8

First to be paid:
#1) First paid: Secured Bond owners. Secured by an asset of the company.
2) Second: Debenture Bond owners. Unsecured bonds no asset backing the bonds. Backed by promise (to pay).
3) Third: Subordinate Debenture: also unsecured but/and subordinate to a Debenture Bond.
4) Preferred Stock
5) Last is Common Stock.

Question 9

PREFERRED STOCK Objective? (Equities - Stock)

Answer 9

Only one objective: Purchased for Income.

Question 10

Preferred Stock RISKS associated with

[4]

Answer 10

1) Pays a Fixed Dividend (fixed but not guaranteed) dividend payment could be missed (not paid).
2) Dividend paid may not keep pace with inflation (it’s fixed, and doesn’t adjust for inflation. A declared rate of interest.
3) Could go up in value or go down in value.
4) In Liquidation, bond holders paid before preferred stockholders, i.e. Secured Bond holders, Unsecured debentures, and Unsecured Debentures all paid before Preferred Stockholders. Being paid in this order is considered a RISK.

Question 11

Preferred Stock BENEFITS

Answer 11

1) Dividends are fixed (declared).
2) Preferred dividends paid before Common dividends. 3) In Liquidation, Preferred stockholders paid before Common stockholders. Ex: If company made enough money this year to pay a dividend to stockholders, but not both Common and Preferred, the Preferred would get paid and perhaps not the Common.

Question 12

What types of Preferred Stock are there? [6]

Answer 12

Straight 
Cumulative 
Callable 
Convertible
Participating
Adjustable-Rate

Question 13

What are the characteristics of Straight Preferred stock?

Answer 13

No special features beyond fixed dividend.

Question 14

What are the characteristics of Cumulative Preferred stock?

Answer 14

Pays Fixed Dividend.
Pays Dividend(s) in arrears. Paid missed Dividends.

Question 15

What are the characteristics of Callable Preferred stock?

Answer 15

Stock can be retired by issuing company.
Benefits the Issuer (not the investor). If interest rates decline, the issuer can call in the preferred stock at a lower dividend rate, reducing their dividend payments.
Investor needs some incentive to buy Callable - Preferred - to attract investors.
Issuer offers investor a Call Protection Period. Ex: No change in interest rates for say 5 yrs (even if int. rates drop in reality).
Callable Preferred pays a higher dividend rate then any other Preferred stock!!! Suitable for a client that seeks to maximize their income by buying Preferred stock.

Question 16

What are the characteristics of Convertible Preferred stock?

Answer 16

Preferred stock that can be converted into Common stock at the Option of the investor.

The convertible feature has a value therefore, the issuer would pay a LOWER DIVIDEND RATE than ANY OTHER Preferred stock.

Suitable when a client is looking to invest in income and have the opportunity for growth.

Ex: Buy the Convertible Pref for the income. If stock rises in value, convert to Common stock and sell it for profit.

https://www.investopedia.com/terms/c/convertiblepreferredstock.asp

Question 17

Which stock cannot be converted into Common Stock”

[3]

Answer 17

Straight preferred, Cumulative preferrred and Callable cannot be converted into Common stock.

Question 18

When would Convertible Stock be least suitable for an investor?

Answer 18

When they’re trying to maximize their income. Because the issuer pays a lower Dividend rate on Convertible Preferred than any other Preferred stock.
Callable Preferred would be recommended.

Question 19

What are the characteristics of Participating Preferred?

Answer 19

Investors can be paid a Fixed Dividend and an additional dividend above the Fixed dividend.

Participating preferred stock is a type of preferred stock that gives the holder the right to receive dividends equal to the customarily specified rate that preferred dividends are paid to preferred shareholders, as well as an additional dividend based on some predetermined condition. Participating preferred stock can also have liquidation preferences upon a liquidation event.

KEY TAKEAWAYS
Participating preferred stock are preferred shares that pay both preferred dividends plus an additional dividend to their shareholders.
The additional dividend ensures that these shareholders receive an equivalent dividend as common shareholders.
Participating preferred stock is not common, but can be issued in response to a hostile takeover bid as part of a poison pill.

https://www.investopedia.com/terms/p/participatingpreferredstock.asp

Question 20

What are the characteristics of Adjustible Preferred stock?

Answer 20

Pays a dividend that adjusts to an Index, say 90 Day T-bill.
It is the ONLY STOCK BOUGHT as a HEDGE AGAINST INFLATION. Dividend rate could keep pace with inflation depending on the Index.