CSC Notes

SECTION I The Canadian Investment Marketplace

Chapter 1 The Capital Market

• Investment Capital

• Investment capital is available and investable wealth (e.g., real estate, stocks, bonds and money) that is used to enhance the economic growth prospects of an economy.

• In direct investment, an individual or company invests directly in an item (e.g., house, new plant or new road); indirect investment occurs when an individual buys a security and the issuer invests the proceeds.

• Characteristics of Capital: mobile, sensitive to its environment and scarce. The decision as where capital will flow is guided by country risk evaluation, which analyzes such things as: the political environment, economic trends, fiscal policy, monetary policy, investment opportunities, and labour force.

• Sources and Users of Capital

• The only sources of capital is savings. • Sources of Capital:

• Retail investors: individual investors who buy and sell securities for their own personal accounts, and not for another company or organization.

• Institutional investors: organizations that trade large volumes of securities and typically have a steady flow of money to invest.

• Foreign investors • Users of Capital:

• Individuals: individuals use capital to finance major purchases or for consumption. • Business: business use capital to finance day-to-day operations, to renew and

maintain plant and equipment, and to expand and diversify activities.

• Governments: government use capital when expenditures exceed revenue and to finance large projects.

• The Financial Instruments • Financial Instruments

• Debt Instruments (bonds, debentures, mortgages): the issuer promises to repay a loan at maturity and in the interim makes payments of interest or interest and principle at predetermined times. the term to maturity of a debt instrument can be either short (less than five years) or long (more than ten years).

• Equity Instruments (stocks): the investors buys a share that represents a stake in the company. Preferred share & common share.

• Investment funds (mutual funds, segregated funds): a company or trust that manages investments for its clients.

• Derivatives (options, futures, rights): products derived from an underlying instrument such as stock, financial instrument, commodity or index.

• Other investment products (linked notes, exchange-traded funds): investments that are relatively new and do not fit into any of the standard categories.

• Private Equity

• Private equity is the financing of firms unwilling or unable to find capital using public means — for example, via stock or bond markets. It complements publicly

traded equity by allowing businesses to obtain financing when issuing equity in the public markets may prove difficult or impossible.

• Long term returns on private equity typically exceed most other asset class, while it also exposes investors to far higher risks.

• Public and private pension plans, endowments, foundations, and wealthy individuals are the main investors in the private equity market.

• The Financial Markets

• The financial markets facilitate the transfer of capital between investors and users through the exchange of securities.

• The exchange do not deal in physical movement of securities; they are simply the venue for agreeing to transfer ownership.

• In the primary market new securities are sold by companies and governments to investors for the first time. When a company issues stocks for the very first time in the primary market, the sale is known as an initial public offering (IPO).

• In the secondary market investors trade securities that have already been issued by companies and governments.

• In an auction markets, buyers enter bids and sellers enter offers for a stock.

• the bid is the highest price a buyer is willing to pay for the security being quoted. • the ask (offer) is the lowest price a seller will accept.

• the spread is the difference between the bid and ask prices.

• the last price is the price at which the last trade on the stock took place.

• Dealer markets are network of dealers that trade with each other directly on a negotiated market with market makers. Most bonds and debentures trade on these markets.

Chapter 2 The Canadian Securities Industry

• Canadian capital markets are among the most sophisticated and efficient in the world. These qualities are measured in terms of the variety and size of new issues brought to the markets and the depth and liquidity of secondary market trading.

• Financial Intermediaries

• Types of Firms in the Canadian Securities Industry

• Integrated firms offer products and services that cover all aspects of the industry. • Institutional firms primarily handle the trading activity of large clients such as pension

funds and mutual funds.

• Retail firms include full-service firms and discount brokers. Full-services retail firms offer a wide variety of products and services for the retail investors. Discount brokers execute trade for the clients at reduced rates but do not provide advice.

• Main Functions of Investment Dealers

• Main role of an investment dealer is to bring new issues of securities to the primary markets and facilitate trading in the secondary markets.

• When acting as a principal, the dealer owns securities as part of its inventory when conducting transactions with clients and inventors. Profit is made on the spread between the original cost of the securities and what they eventually sell for.

• When acting as an agent, the dealer acts on behalf of a buyer or seller but does not itself own title to the securities at any time during the transaction. Profit is earned on the commission charged for each transaction.

• Chartered Banks in the capital markets

• The Canadian chartered banks are the largest financial intermediaries in the country.

• Most Canadian-owned banks are designated as Schedule I banks. They are the dominant competitors in the industry both in term s of the wide-ranging services offered and their overall asset base.

• Schedule II banks are incorporated and operate in Canada as federally regulated foreign bank subsidiaries. These banks can engage in all the types of business that are permitted to schedule I.

• Schedule III banks are federally regulated foreign bank branches of foreign institutions. Most operate as full-service branches able to accept deposits, though some are merely leading branches.

• Trust Companies, Credit Unions and Insurance Companies in the Capital Markets

• These financial intermediaries offer a broad range of financial services that in many cases overlap with the services provided by chartered banks, including deposit-taking and lending, debit and credit cards, mortgage and mutual funds.

• The insurance company has two main business: life insurance and property and casualty insurance.

• Investment Funds, Saving Banks, Loan Companies and Pension Plans in the Capital Markets • Investment funds sell their shares to the public, most often in the form of closed or

opened funds, and invest the proceeds in a diverse portfolio of securities.

• Loan companies make direct cash loans to consumers who typically use them to repay principal and interest on instalment loans. These intermediaries also purchase instalment sales contracts from retailers on such items as new automobiles, appliances, or home improvements that are purchased on instalment.

• Pension plans represents a type of institutionalized savings. These plans are offered to the employees of many companies, institutions and other organizations.

Chapter 3 The Canadian Regulatory Environment

• Federal Regulators

• The Office of the the Superintendent of Financial Institutions (OSFI) provides regulatory oversight for all federally regulated financial institutions, including banks and insurance, trust, loan and investment companies licensed or regulated by the federal government. OSFI does not regulate the Canadian securities industry.

• The Canadian Deposit Insurance Corporation (CDIC) is a federal Crown Corporation that provides deposit insurance and contributes to the stability of Canada’s financial system. CDIC insures eligible deposits up to $100,000 per depositor in each member institution.

• The Provincial Regulators

• Each province is responsible for creating the legislation and regulation under which the securities industry must operate. This regulatory authority is usually delegated by the province to its own provincial securities commission or administrator.

• The 13 securities regulators of Canada’s provinces and territories joined together to form the Canada Securities Administrators (CSA), a forum to co-ordinate and harmonize regulation of the Canadian capital markets.

• The Self-Regulatory Organizations

• SROs are responsible for enforcing member conformity with securities legislation and they have the power to prescribe their own rules of conduct and financial requirements for their members.

• Canadian SROs include the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association (MFDA). SRO regulation is divided between securities markets and mutual funds distribution side.

• IIROC deals with all investment dealers and trading activity regulation on debt and equity marketplace in Canada.

• MFDA deals with the distribution side of the mutual fund industry. • Investor Protection Funds

• CIPF protects clients of IIROC dealer members against losses caused by the insolvency of an IIROC dealer member. CIPF also oversees the self-regulatory system.

• MFDA IPC protects clients of MFDA member firms against losses caused by the insolvency of an MFDA member firm.

• The Principles of Securities Legislation

• Provincial securities acts are designed to regulate the underwriting, distribution and sale of securities, and to protect buyers and sellers of securities. Generally, the acts use three basic methods to protect investors:

• Registration of securities dealers and advisors: The National Registration Database (NRD).

• Disclosure of facts necessary to make reasoned investment decisions: full, true and plain disclosure.

• Enforcement of the laws and policies.

• The industry also relies on the SROs for their members’ compliance to legislation. • The Ethics of Trading

• Ethical trading is of paramount importance to both the investing public and the users of the capital markets, the listing corporations.

• Unethical conduct may be defined as any omission, conduct, manner of doing business or negotiation, which in the opinion of the disciplinary body is not in the public interest nor in the interest of the exchange.

• Public Company Disclosures & Investors Rights • Public Company Disclosures:

• Once distributing securities, the issuer must comply with the timely and continuous public disclosure requirements of the acts.

• The primary disclosure requirements include issuing a press release and filing a material change report with the administrators if a material change occurs.

• Issuers also must file with the administrators annual and interim financial statements meeting prescribed standards of disclosure.

• Statutory Rights for Investors

• The right of withdrawal: the purchasers have the right to withdraw from an agreement to purchase securities within two business days after the deemed receipt of the company’s prospectus.

• The right of rescission: the purchasers have the right to cancel the purchase of securities if the prospectus contains a misrepresentation. The purchasers have 180 days after the purchase to take advantage of this right.

• The right of action damages: if it is deemed that a prospectus contains a misrepresentation, the issuer, the directors of the issuer, the seller of the security, the underwriter, and any other person who signs off on the prospectus may be liable for the damage.

• Takeover Bids & Insider Trading

• A takeover bid is an offer to the shareholders of a company to purchase the shares of the company that, with the offeror’s already owned securities, will in total exceed 20% of the outstanding voting securities of the company.

• The reporting of trading activity by insiders of a reporting issuer is based on the principle that shareholders and other interested persons should be regularly informed of the market activity of insiders

SECTION II The Economy

Chapter 4 Economic Principles

• Economics is fundamentally about understanding the choices individuals make and how the sum of those choices determines what happens in our market economy.

• Microeconomics analyzes the market behaviour of individual consumers and firms.

• Macroeconomics focuses on the performance of the economy as a whole. • The decision makers

• Consumers set out to maximize their satisfaction or well-being. • Firms set out to maximize profits.

• Governments set out to maximize the public good. • Demand & Supply

• The interaction that takes place between buyers and sellers in the market ultimately determines an equilibrium price for that product.

• Gross Domestic Product (GDP)

• GDP is the market value of all finished goods and services produced within a country in a given time period, usually a year or a quarter.

• Mesure GDP

• Expenditure approach: measuring GDP as the sum of personal consumption, investment, government spending, and net exports of goods and services.

• Income approach: measuring GDP as the total income earned producing those goods and services.

• c.f. real GDP & nominal GDP • Growth in GDP

• increase in population over time • increase in the capital stock • improvements in technology • Business Cycle

• Phases of Business Cycle

• Expansion: real GDP is rising during an expansion. • Peak: the top of the cycle.

• Contraction: when an economy passes its peak, it enters a contraction. If the downturn lasts longer than two consecutive quarters, then the economy has typically entered a recession.

• Trough: the growth cycle reaches its lowest point. • Recovery: GDP returns to its previous peak. • Economic Indicators

• Leading indicators tend to peak and trough before the overall economy. e.g., housing starts, manufacturers’ new orders, commodity prices, average hours worked per week, stock prices, the money supply.

• Coincident indicators are those which change at approximately the same time and in the same direction as the whole economy. e.g., personal income, GDP, industrial production, retail sales.

• Lagging indicators are those which change after the economy as whole changes. e.g., unemployment, private sector plant and equipment spending, business loans and interest on such borrowing, labour costs, the inflation rate.

• Improvement in long-term economic growth are attributed to improvements in productivity. Productivity growth has major implications for the overall wealth of an economy.

• Labour Market

• The Key Labour Market Indicators

• The participation rate represents the share of the share of the working-age population that is in the labour force.

• The unemployment rate represents the share of the labour force that is unemployed and actively looking for work.

• Main Types of Unemployment

• Cyclical unemployment is the result of fluctuations in the business cycle. • Frictional unemployment is the result of normal labour turnover.

• Structural unemployment occurs when working workers are unable to find work or fill available jobs because they lack the necessary skills, do not live where jobs are available, or decide not to work at the wage rate offered by the market. • Interest Rate

• factors Influencing Interest Rates • demand for and supply of capital • default risk

• central bank credibility

• foreign interest rates and the exchange rate • inflation

• Interest Rates Affecting the Economy

• Higher interest rate raises the cost of capital for consumers and business. This discourage consumers from spending and borrowing money to purchase. Thus higher rates lead to slower economic growth.

• Lower interest rate has an expansionary effect on the economy. • Inflation

• Inflation is a generalized, sustained trend of rising prices measured on an economy-wide basis.

• current CPI - previous CPI previous CPI

• Inflation erodes the standard of living for those on a fixed income, it reduces the real value of investments because the loans are paid back in dollars that buy less, and it distorts the signal that prices send to participants in the market. Rising inflation rates typically brings about rising interest rates and slower economic growth.

• Disinflation is a decline in the rate at which prices rise, meaning a decrease in the rate of inflation.

• Deflation is a sustained fall in prices where the annual change in the CPI is negative year after year. A sustained fall in prices can have negative implications for corporate profits and the economy.

• International Economics Impacting the Economy

• The Balance of Payments: a detailed statement of a country’s economic transactions with the rest of world for a given period — typically over a quarter or a year.

• The current account records the exchanges of goods and services between Canadians and foreigners, the earnings from investment income, and net transfers. • The capital and financial account records financial flows between Canadians and

foreigners related to investments by foreigners in Canada and investments by Canadians abroad.

• The Exchange Rate: the price of one currency in another.

• The key determinants of the exchange rate include commodity prices, inflation differentials, interest rate differentials, current account, economic performance, public debts and deficits, political stability.

Chapter 5 Economic Policy

• The rational expectations theory suggests that firms and workers are rational thinkers and can evaluate all the consequences of a government policy decision, thereby neutralizing its intended impact.

• Keynesian economics advocates the use of direct government intervention to achieve economic growth and stability. Keynesians believe the use of active fiscal policy, using government spending and taxation, is necessary to stabilize the business cycle.

• Monetarist theory suggests that the economy is inherently stable, with its own self-adjusting mechanism that automatically moves the economy to a stable path of growth. Monetarists believe the central bank should simply expand the money supply at a rate equal to the economy’s long-term growth rate.

• Supply-side economics suggests that to foster an environment of prosperity, the market should be left alone and government intervention should be minimal, only occurring through changes in tax rates.

• Fiscal Policy

• Fiscal policy is the use of the government’s spending and taxation powers to pursue such economic goals as full employment and sustained long-term growth. They do this by spending more and taxing less when the economy is weak, and by spending less and taxing more when the economy is strong.

• The federal budget: budget surplus, budget deficit, balanced budget. • Monetary Policy

• The goal of monetary policy is to improve the performance of the economy by regulating growth in the money supply and credit.

• The Bank of Canada

• The role of the Bank of Canada is to monitor, regulate and control short-term interest rates and the external value of the Canadian dollars.

• The major functions of the Bank of Canada include: • The issue and removal of bank notes.

• Acting as fiscal agent and financial advisor for the Federal Government. • The implementation of monetary policy.

• Inflation Control

• In Canada, monetary policy involves following specific inflation-control targets that establish a range within which to contain annual inflation. Currently, the target range is 1％ to 3%.

• The Bank of Canada achieve this through its influence over short-term interest rates. id inflation approaches the top of the target range, this needs to be controlled through an increase in short-term interest rates; while when inflation fall towards the bottom, the Bank decreases interest rates.

• Implementing Monetary Policy

• The overnight rate is the interest rate set in the overnight market. The Bank uses the target for the overnight rate to implement changes in the direction of monetary policy.

• The bank rate is the minimum rate at which the Bank of Canada will lend money on a short-term basis to the chartered banks and other members of CPA. • Open Market Operations

• Special Purchase and Resale Agreements (SPRAs) are used to relieve undesired upward pressure on the overnight rate. If overnight money trade above the target of the operating band, the Bank intervenes and offers to lend at the upper limit of the band. This action effectively reinforces the upper limit of the overnight target. • Sale and Repurchase Agreements (SRAs) are used to offset undesired downward

pressure on the overnight rate. If overnight money is trading below the target of the operating band, the Bank intervenes and offers to borrow at the lower limit of the band. This action effectively reinforces the lower limit of the overnight target. • Cash Management Operations

• The Bank established the Large Value Transfer System (LVTS) to facilitate its cash management operations. This system allows participating financial institutions to conduct large transactions with each other through an electronic wire system. • A drawdown is the transfer of deposits to the Bank from the chartered banks,

effectively draining the supply of available cash balances from the banking system. This cause a contraction in the availability of loans to consumers and business, which places upward pressure on interest rates.

• A deposit is the transfer of funds from the Bank to the chartered banks, effectively increasing deposits and reserves and the availability of funds in the banking system, which places downward pressure on interest rates.

• The Challenges of Government Policy

• The economy may be slow to react to policy changes.

• The economy makes its way quickly to its natural equilibrium, and that no need for policy other than to constrain policy.

• Fiscal and monetary policies are often unsynchronized, increasing the cost to the economy.

SECTION III Investment Products

Chapter 6 Fixed-Income Securities: Features & Types

• Fixed-income securities represent debt of the issuing entity. • The Rationale for Issuing Fixed-Income Securities:

• To finance operations or growth.

• To take advantage of operating leverage. • The Basic Terminology

• A bond is a long-term, fixed-obligation debt security that is secured by physical assets. The details of a bond issue are outlined in a trust deed and written into a bond contract.

• A debenture is secured by something other than a physical asset. The asset secured may be a general claim on residual assets or the issuer’s credit rating.

• Face or par value is the amount the bond issuer contracts to pay at maturity. • The coupon is the regular interest income that the bond pays.

• Bonds that trade in the secondary market have a price and a quoted yield. • The remaining life of a bond is called its terms to maturity.

• The maturity date is the date at which the bond matures and the principal is repaid. • Describing Bond Features.

• Interest on Bonds: while most bonds pay a fixed coupon rate, bonds with variable coupon rates are typically referred to as floating-rate securities.

• Denomination: the most commonly used denomination are $1,000 or $10,000. • Bond Pricing

• A bond trading at a quoted price of 100 is said to be trading at face value, or par. • A bond trading below par is said to be trading at a discount.

• A bond trading above par is said to be trading at a premium. • Categorizing bonds (based on term to maturity)

• Money market: up to one year term or less.

• Short-term bonds: from one year to 5 years remaining to maturity. • Medium-term bonds: from 5 years to 10 years remaining to maturity. • Long-term bonds: greater than 10 years remaining to maturity. • Liquid bonds, negotiable bonds & marketable bonds

• Liquid bonds are bonds that trade in significant volumes and for which it is possible to make medium and large trade quickly without making a significant sacrifice on the price.

• Negotiable bonds are bonds that can be transferred because they are in deliverable form.

• Marketable bonds are bonds for which there is a ready market.

• A strip bond is created when a dealer acquires a block of high-quality bonds and separates the individual future-dated interest coupons from the rest of the bond. The bonds are then sold at significant discounts to their face value. Holders of strip bonds receive no interest payments; instead, the income earned is considered interest rather than a capital gain.

• A callable bond gives the issuer the right, but nor the obligation, to pay off the bond before maturity, either to take advantage of lower interest rates or to reduce debt when excess cash is available.

• For callable bonds, the period before the first possible call date is known as the call protection period.

• Most corporate bonds are issued with a Canada yield call that requires the issuer to call the bond at a price based on the greater of par or the price based on the yield pf an equivalent term Government of Canada bond plus a yield spread.

• Extendible & Retractable Bonds

• Extendible bonds and debentures are usually issued with a short maturity term, but with an option for the investor to exchange the debt for an identical amount of long-term debt at the same or slightly higher rate of interest by the extension date.

• Retractable bonds are issued with a long maturity term, but give investors the right to turn in the bond for redemption at par several years sooner by the retraction date. • With both extendible and retractable bonds, the decision to exercise the maturity

option must be made during a time period called election period.

• Convertible bonds and debentures combine certain advantage of a bond with the option of exchanging the bond for common shares of the issuing company. A convertible bond allows an investors to lock in a specific price (the conversion price) for the common shares.

• Sinking Funds & Purchase Fund

• Sinking funds are sums of money taken out of earnings each year to provide for the repayment of all or part of debt issue by maturity. Sinking fund provisions are as binding on the issuer as any mortgage provision.

• A purchase fund arrangement establishes a fund to retire a specified amount of the outstanding bonds or debentures through purchases in the market if these purchases can be made at or below a stipulated.

• Protective Provisions fo Corporate Bonds

• Corporate bonds typically include protective covenants that secure the bond and make it more likely that investors receive their principal at maturity. These protective provision are essentially safeguards in the bond contract to guard against any weakening in the security holder’s position.

• Government of Canada Securities

• Marketable bonds have a specific maturity date and a specified interest rate, and are transferable, which means they can be traded in the market. The Government of Canada issues marketable bonds in its own name.

• Treasury bills are short-term government obligations with original terms to maturity of three months, six months and one year. They are offered in denominations from $1,000 up to $1 million.

• Canada Savings Bonds (CSBs) can be purchased only through the Payroll Savings Program from early October to November 1st of each year but are cashable at any time at their full par value plus any accrued interest earned for each full month elapsed since the issue date. • Canada Premium Bonds (CPBs) are very similar to CSBs but offer a higher interest rate

when they are issued. Investors can purchase CPBs through most financial institutions from early October to December 1st and are cashable at any time at their full par value plus any accrued interest paid up to the last anniversary date of the issue.

• Real return bonds (RRB) resemble a conventional bond because it pays interest throughout the life of the bond and repays the original principal amount on maturity. However, unlike conventional bonds, the coupon payments and principal repayment are adjusted for inflation. • Provincial government and Municipal Debentures

• Provincial bonds are actually debentures because they are promises to pay and no provincial assets are pledged as security. The value of the bonds depends on the province’s ability to pay interest and repay principal. Provincial bonds are second in quality only to Government of Canada bonds.

• Municipalities typically raise capital from market sources through instalment debentures or serial bonds (part of the bond matures in each year during the term of the bond). Part of the bond matures in each year during the term of the bond. Broadly speaking, a municipality;s credit rating depends on its taxation resources. All else being equal, a municipality with many different types of industry is a better investment risk than a municipality built around one major industry.

• Corporate Bonds

• Mortgage bonds are the senior securities of a company because they constitute a first charge on the company’s assets, earnings and undertakings before unsecured current liabilities are paid.

• Collateral trust bonds are secured, not by a pledge of real properties, as in a mortgage bond, but by a pledge of securities or collateral.

• An equipment trust certificate pledge equipment as security instead of real property. These certificates are usually issued in a serial form, with a set amount that matures each year. • Subordinated debentures are junior to other securities issued by the company and other debts

assumed by the company.

• Floating-rate bonds automatically adjust to changing interest rates. They can be issued with longer terms than more conventional issues.

• A corporate note is an unsecured promise made by a borrower to pay interest and repay the funds borrowed at a specific date or dates. Corporate notes rank behind all other fixed securities of the borrower.

• Foreign bonds are issued outside of the issuer’s country and denominated in the currency of the foreign country where issued, allowing the issuer access to sources of capital in many other countries.

• Eurobonds are issued in a foreign market and are denominated in a currency other than that of the market in which the bonds are issued.

• Other Fixed-Income Securities

• A bankers’ acceptance is a short term debt guaranteed by the borrower’s bank that is sold at a discount and matures at face value.

• Commercial paper is a one-year or less unsecured promissory note issued by a corporation and backed by financial assets, sold at a discount and matures at face value.

• Term deposits offer a guaranteed rate for a short-term deposit (usually up to one year). There are generally penalties for withdrawing funds before a certain period.

• Guaranteed investment certificate (GIC) offer fixed rates of interest for a specific term (longer than with a term deposit). Both principal and interest payments are guaranteed, and they can be redeemable or non-redeemable. Non-redeemable GICs cannot be cashed before maturity except in the event of the depositor’s death or extreme financial hardship.

Chapter 7 Fixed-Income Securities: Pricing & Trading

• Present value is the value today of an amount of money to be received in the future and is the most accurate method of determining appropriate price for a bond.

• The discount rate is the interest rate used to calculate present value. In general it represents the minimum interest rate an investment should provide after factoring in risk.

• The fair price for a bond is the sum of the present value of its coupons and the present value of its principal.

•

• Treasury bills are very short-term securities that trade at a discount and mature at par. The difference between the purchase value and the maturity value represents the return on the security. The yield on a treasury bill is calculated as

• The current yield of any investment, whether it is a bond or stock, is the income yield on that security relative to its current market price. The current yield is calculated as:

• A bond’s yield to maturity incorporates both interest income and any capital gain or loss resulting from holding the bond to maturity. YTM is calculated based on the assumption that all interest received from coupon bonds is reinvested (or compounded) at the YTM prevailing at the time the bond was purchased. The risk that the coupons cannot be reinvested at that rate is called reinvested risk. A financial calculator simplifies the YTM calculation. The approximate YTM on a bond is calculated as:

• The Term Structure of Interest Rates

• The Real Rate of Return: nominal rate = real rate +inflation rate.

• The yield curve is a graphical depiction of interest rates by term to maturity and shows how interest rates on debt securities differ depending on the term to maturity. • The expectations theory states that the shape of the yield curve is a reflection of

market consensus expectations for future interest rates. For example, an upward sloping curve reflects the expectation that interest rates will rise in the future.

• According to the liquidity theory, investors must be compensated for assuming the risk of holding longer-term debt securities, and this compensation is in the form of a yield or liquidity premium.

• According to the market segmentation theory, investors concentrate their debt holdings in a particular term to maturity. For example, an institutional investor may focus its

holdings on bonds with terms of two or five years, while another investors may have a preference for long-term bonds.

• The Fundamental Bond Pricing Properties

• The Relationship Between Bond Prices and Interest Rates: the value of a bond changes in the opposite direction to interest rates (or bond yields): as interest rates rise,, bond prices fall, very versa.

• The impact of maturity: for two bonds with the same coupon rate and same yield, the price of the bond with the longer term to maturity is more volatile than the price of the bond with the shorter term to maturity.

• The impact of the coupon: for two bonds with the same term to maturity and the same yield, the price of the bond with the higher coupon rate is less volatile than the price of the bond with the lower coupon rate.

• The impact of yield changes: the relative yield change is more important than the absolute yield change.

• Duration is a measure of the sensitivity of a bond’s price to change in interest rates. It is defined as the approximate percentage change in the price or value of a bond for a 1% change in interest rates. The higher the duration of the bond, the more it will react to change in interest rates.

• The Rules and Regulations of Bond Delivery and Settlement • Fixed-income trading activities

• The sell side of fixed-income trading is the investment dealer side. Sell-side services include everything related to creating, producing, distributing, researching, marketing and trading fixed-income products. (investment banker, trader, sales representative)

• The Buy-side focuses on asset management on behalf of institutional clients. (portfolio manager, trader)

• Buying bonds through an investment dealer

• Trading in forms with a large institutional dealing desk allows for automatic execution in most cases. All non-electronic trades carried out between the investment advisor and the trader are consummated over the phone.

• Trading without a large internal institutional inventory to draw on, the retail trading desk must build its own inventory and source products it does not own from other dealer.

• Inter-dealer brokers are participants in the wholesale bond market (the bond market between the institutional buy side and sell side). They act solely as agents bringing together institutional buyers and sellers in matching traders.

• Mechanics of the trade

• The trade ticket is an electronic confirmation that contains the specifics of the counterparties, identification of the bond, the CUSIP (Committee on Uniform Security Identification Procedure) or other electronic settlement ID number, the nominal, par, or face amount of the transaction, the price and yield, the settlement date, the custodian’s name, and the settlement amount.

• Bond Settlement Periods

• GoC treasury bills settle on the same day as the transaction.

• GoC bonds with a term on maturity of three years or less settle on the second clearing day after the transaction takes place.

• GoC bonds with a term on maturity of more than three years and all other bonds. debentures, or other certificates of indebtedness settle on the third clearing day after the transaction takes place.

• Accrued Interest

• Accrued interest is the amount of interest built up during the previous holding period.

• The client that buys a bond pays the previous holder the purchase price plus the interest that has accrued since the last interest date.

• accrued interest = par amount * coupon rate * time period • Bond Indexes

• An index measures the relative value and performance of a group of securities over time.

• Bond indexes are generally used as a guide to the performance of the overall bond market or a segment of that market, and as a performance measurement tool to access bond portfolio managers. Bond indexes are also used to construct bond index funds.

Chapter 8 Equity Securities: Common & Preferred Shares

• Common Share Ownership

• Common shares are evidence of ownership: shares are most often registered in street certificate form, meaning they are registered in the name of the securities firm rather than the beneficial owner. This increase the negotiability of the shares, making them more readily transferable to a new owner.

• Benefits if common share ownership

• Potential for capital appreciation: common shares may increase in value as retained earnings increase the size of shareholder’s equity, making the stock more attractive to investors. Increasing profits and increasing dividend payments can also lead to the stock’s capital appreciation.

• The right to receive any common share dividends paid by the company • Voting privileges, including the right to elect directors, to approve financial

statements and auditor’s report, and vote on other important issues. • Favourable tac treatment in Canada of dividend income and capital gains. • Marketability - shareholdings can easily be increased, decreased or sold, for

most public companies.

• The right to receive copies of the annual and quarterly reports, and other mandatory information pertaining to the company’s affairs.

• The right to examine certain company documents such as the by-laws and register of shareholders at a specified times.

• The right to question management at shareholders’ meetings. • Limited liability.

• Dividends

• some companies paying common share dividends designate a specified amount that will be paid each year as a regular dividend.

• some companies may also pay an extra dividend on the common shares, usually at the end of the company’s fiscal year.

• Declaring & claiming dividends: the Board of Directors decides whether to pay a dividend, the amount and the payment date. An announcement is made in advance of the payment date.

• Ex-dividend & Cum dividend

• individuals that have legal ownership of the shares before the ex-dividend date will receive the dividend; these individuals are the shareholders of record.

• The last day of a stock trades cum dividend (meaning with dividend) is the third day before the dividend record date (the first ex-dividend date).

• Dividend reinvestment plans: the company diverts the shareholders to the purchase of additional shares of the company.

• Stock dividends

• the dividend in form of additional stock rather than cash.

• the advantage to the company is that the cash is conserved for expansion purposes while shareholders receive additional shares, which can be sold if they require the cash.

• Voting privileges

• through the right to vote at the annual meeting and at special or general meetings, shareholders exercise their rights as owners to control the destiny of the corporation.

• Restricted shares

• Non-voting: shares which have no right to vote, except perhaps in certain limited circumstances;

• Subordinate voting: shares which carry a right to vote, where there is another class of shares outstanding that carry a greater voting right on a per share basis;

• Restricted voting: share which carry a right to vote, subject to a limit or restriction on the number or percentage of shares that may be voted by a person, company or group.

• Tax Treatment

• A dividend tax credit is available that makes the purchase of dividend-paying shares of taxable Canadian companies relatively attractive compared to interest paying securities.

• The current exemption from tax of 50% of capital gains provides investors with a tax inducement to buy shares.

• Stock savings plans entitle residents of some provinces to deduct up to specified annual amounts from (or obtain a tax credit for) the cost of certain stocks purchased in their respective provinces during the year.

• Dividends paid on foreign equities are also subject to taxation but receive no favourable tax treatment.

• Stock Splits & Stock Consolidations

• A stock split increase the number of shares outstanding, while a consolidation reduces the number of shares outstanding.

• The market price of the underlying stock is adjusted to reflect the split or consolidation on the day it occurs.

• Preferred Shares

• The Preferred’s Position

• Preferred shareholders are usually entitled to a fixed dividend payment subject to the discretion of the Board of Directors. They occupy a position between the company’s creditors (including bondholders) and the company’s common shareholders, if any.

• Preference as to assets: preferred shares are usually given a prior claim to assets ahead of the common shares in the event of bankruptcy or dissolution of a company.

• Preference as to dividends: preferred shares are usually entitled to a fixed dividend expressed either as a percentage of the par or stated value, or as a stated amount of dollars and cents.

• Since most preferred shares can be considered fixed-income securities, they do not offer, from an investment standpoint, the sam e potential for capital appreciation that common shares provide.

• Preferred Issue

• Preferred shares are usually more expensive for a company than issuing debt because dividends paid are not a tax-deductible expense.

• Preferred shares are typically issued instead of debt securities when it is not practical or feasible to issue new debt, market conditions are temporarily unreceptive to new debt issues, the company’s current debt-to-equity ratio is high, the company does not want to assume legal obligations related to debt, or low apparent tax rate makes it cost effective to pay dividends from after-tax profits. • Preferred Share Feature

• Holders of cumulative preferred shares have the right to accumulate unpaid dividends in arrears and to have all accumulated dividends paid before dividends are paid on common shares or before the preferred shares or redeemed.

• Holders of non-cumulative preferred shares are entitled to payment of a specified dividends in any year but only when declared.

• Issuers of callable preferred shares have the right to call or redeem preferred issues at a stated time and at a stated price.

• Non-callable preferred shares cannot be called or redeemed as long as the issuing company is in existence.

• Preferred shares are usually non-voting as long as preferred dividends are paid on schedule; however, once a stated number of preferred dividends have been omitted, it is common practice to assign voting privileges to the preferred shareholders.

• A purchase or sinking fund will attempt to buy preferred shares in the market if the price of the shares declines to or below a stipulated price.

• Straight preferred shares have normal preferences as to asset an dividend entitlement, pay a fixed dividend rate, and trade in the market on a yield basis. • Convertible preferred shares enable the holder to convert the preferred shares

into some other class of shares (usually common) at a predetermined price and for a stated period of time.

• A retracted preferred shareholders can force the company to buy back the retractable preferred shares on specific date(s) and at a specified price(s).

• Floating- or variable- rate preferred shares pay dividends in amounts that fluctuate to reflect changes in interest rates.

• Foreign-pay preferred shares pay dividends in a foreign currency or in relation to a foreign currency.

• Participating preferred shares have certain rights to a portion of company earnings over and above their specified dividend rate.

• Deferred preferred shares do not pay out regular dividend. Shares mature at a preset future date with the return based on the difference between the purchase price and the redemption value paid out at maturity.

• Stock Indexes & Averages

• A stock index is a time series of numbers used to calculate a percentage change in the series over any period of time. Most stock indexes are value-weighted and are derived by using the market capitalization of all stocks used in the index relative to a base period.

• A stock average is the arithmetic average of the current prices of a group of stocks designed to represent the overall market or some part of it.

• Canadian Market Indexes: the S&P/TSX Composite Index, the S&P/TSX 60 Index, the S&P/TSX Venture Composite Index.

• U.S. Market Indexes: Dow Jones Industrial Average, the S&P 500, the New York Stock Exchange Indexes, the Amex Market Value Index, the NASDAQ Composite, the Value Line Composite.

• International Market IndexesL Nikkei Stock Average (225) Price Index, United Kingdom FTSE 100 Index, German DAX, France CAC 40 Share Price Index, the Swiss Market Index.

Chapter 9 Equity Securities: Equity Transactions

• Cash Accounts: clients with regular cash accounts are expected to make full payment for purchase of full delivery for sales on or before the settlement date, which is prescribed by industry rules and specified in the contract.

• Margin Accounts: for clients who wish to buy and/or sell securities on credit and initially pay only part of the full price of the transaction. In such cases, the dealer member lends the remainder of the transaction price to the client, charging interest on the loan.

• Free credit balances are uninvested funds held in client accounts that the dealer member may use as a financing source for its business.

• Long Position & Short Position

• A long position represents actual ownership in a securities.

• A short position is created when an investor sells a security that he or she does not own. To close the short position, the investor would buy back the stock from the market, and return the stock to the broker.

• A long margin position allows the investors to partially finance the purchase of securities by borrowing money from the dealer. An investor enters a long position with the expectation that the underlying stock price will rise.

• A short margin position allows the investors to sell securities short by arranging for the dealer to borrow securities to cover the short position.

• When a long position is established on margin, sufficient funds (or securities with excess loan value) must be in the account to cover the purchase.

• Margin is the amount put up by the client (not the amount borrowed or loaned), and the minimum margin required equals the initial cost of the transaction minus loan. • The loan value of securities in an account is strictly regulated an depends on the loan

value status of the individual securities.

• No loan is made to the client in a short sale. The client must maintain a margin amount that is more than the value of the short sale, although the proceeds of the short sale can be used as part of the margin amount if not withdrawn from the account.

• Short Selling

• Short selling is defined as the sale of securities that the seller does not own. Profits are made whenever the initial sale price exceeds the subsequent purchase cost.

• Steps of Short Selling

• You call broker and instruct him to sell ABC short.

• Your broker lends you the ABC shares and you immediately sell ABC into the market.

• The proceeds from the short sale are deposited in your account. • The required margin is then deposited into your account.

• The share price of ABC falls and you want to close your position. You buy ABC back at the lower price and return the stock to your broker.

• There is no limit on how long a short sale position can be maintained, provided the stock does not become de-listed or worthless.

• The risks associated with short-selling

• Difficulties in borrowing or continuing to borrow the securities sold short. • Maintaining adequate margin if the price of the shorted security fluctuates. • Liability for dividends or other benefits paid while the security is sold short. • Potential volatility in the price if a large number of short sellers cover their

position.

• The potential for unlimited loss if the price of the security rises rather than falls. • The Trading & Settlement Procedures for Equity Transactions

• Once a buy order and sell order are matched and trade is completed on an exchange, the exchanges’s data transmission system reports the trade over the ticker and provides the buying firm with trade details.

• A confirmation with details about the settlement (i.e. date, amount, location) is sent to the buyer and seller once the transaction has occurred.

• Cross trades occur when a dealer matches buy and sell orders internally instead of on an exchange.

• Principal transaction (i.e. new issuer or orders filled out of a dealer’s inventory) are done outside of an exchange.

• In all cases, the buyer provides payment and the seller delivers the security by the settlement date. The mechanism and time frame for settlement depend on the type of securities traded.

• Buy & Sell Orders

• A market order is an order to buy or sell a specified number of securities at the prevailing market price.

• A limit order is an order to buy or sell securities at a specified price or better.

• A day order is an order to buy or sell that expires if it is not exceed on the day it entered.

• A good till cancelled (GTC) order is an order to buy or sell that remains in effect until it is either executed or cancelled.

• An all or non (AON) order must be filled for the entire number of shares specified. No smaller amount will be accepted, nor will a succession of trades adding to the total amount specified.

• An any part order can be filled by any combination of odd lot or standard trading units up to the full amount of the order (opposite of AON order).

• A good through order is an order to buy or sell that is good for a specified number of days and then automatically cancelled if it has not been filled by the end of the trading session on the date specified.

• A stop loss order is an order to buy or sell a security when the price of one standard trading unit of the security declines to or falls below a certain price (the stop price), and it becomes a market order when the stop price is reached.

• A stop buy order is an order to buy a security only after it has reached a certain price (the stop price), and it becomes a market order when the stop price is reached. • Professional (pro) orders are orders for the accounts of partners, directors, officers,

shareholders, investment advisors and, in some cases, specified employees.

Chapter 10 Derivatives

• A derivative is a financial contract between two parties whose value is derived from, or dependent upon the value of some other asset. The other asset, known as the derivative’s underlying asset or underlying interest or security, can be a financial asset, and also can be a real asset or commodity.

• Options: the buyer of option has the right, but not the obligation, to buy or sell a specified quantity of the underlying asset in the future at a price agreed upon today.

• Forwards: both buyer and seller obligate themselves to trade the underlying asset in the future at a price agreed upon today.

• Features Common to All Derivatives

• All derivatives are contractual agreements between two parties, know as counterparties.

• All derivatives have an expiration date. Both parties must fulfill their obligation or exercise their rights under the contract on or before the expiration date.

• When a derivative contract is drawn up, it includes a price or formula for determining the price of an asset to be bought and sold on or before the expiration date.

• With options, the buyer makes a payment to the seller when the contract is drawn up, known as a premium.

• With forward, no up-front payment is required. Sometimes one or both parties make a performance bond or good-faith deposit.

• Derivative Market

• Over-The-Counter (OTC) Derivatives market is an active and vibrant market that consists of a loosely connected and lightly regulated network of brokers and dealers who negotiate transactions directly with one another primarily over the telephone and/or computer terminals.

• Exchange-Traded Derivatives: a derivative exchange is a legal corporate entity organized for the trading of derivate contracts. The exchange provides the facilities for trading, either a trading floor or an electronic trading system or both.

• the Montreal Exchange • ICE Futures Canada

• OTC Derivatives vs. Exchange-Traded

• Standardization & Flexibility: in the OTC market, the terms and conditions of a contract can be tailored to the specific needs of their users. For exchange-traded derivatives, each contract has standardized terms and other specifications.

• Privacy: in an OTC derivative transaction, neither the general public nor others (competitors) know about the transaction. On exchange, all transactions are recorded and known to the general public.

• Liquidity & Offsetting: because they are private and custom designed, OTC derivatives cannot be easily terminated or transferred to other parties in a secondary market. By contract, the standardized and public nature of exchange-traded derivatives means that they can be terminated easily by taking an offsetting position in the contract.

• Default Risk: the risk that one of the parties to a derivative contract cannot meet its obligations to the other party. OTC derivatives have greater default or credit risk.

• Regulation: OTC contracts are private and exchange-traded contracts are public.

• Underlying Assets

• Commodities that underlie derivative contracts include grains and oilseeds; livestock and meat; forest, fibre, and food; precious and industrial metals; and energy products.

• Financials that underlie derivative contracts include equities and equity indexes, interest rates and interest-rate sensitive securities, and currencies.

• Users of Derivative Trading

• Individual Investors: for most part, individual investors are able to trade exchange-traded derivatives only.

• Institutional Investors (mutual fund managers, hedge fund manager, pension fund managers, insurance companies, etc) use derivatives for both speculation (speculators) and risk management (hedgers).

• Corporation & Business use derivatives primarily for hedging purpose. These users tend to focus on derivatives that help them hedge interest rate, currency and commodity price risk.

• Derivative Dealers are the intermediaries in the market, buying and selling to meet the demands of the end users.

• Options

• Basic Option Positions

• Buyer long position & call option: PAYS premium to the writer; has the RIGHT to BUY the underlying asset at the predetermined price, expects the price of the underlying asset to RISE.

• Buyer long position & put option: PAYS premium to the writer, has the RIGHT to SELL the underlying asset at the predetermined price, expects the price of the underlying asset to FALL.

• Writer short position & call option: RECEIVES premium from the buyer, has the OBLIGATION to SELL the underlying asset at the predetermined price, if called upon to do so, expects the price of the underlying asset to REMAIN THE SAME or FALL.

• Covered call writing: writers own the underlying stock, and will use this position to meet their obligations if they are assigned.

• Naked call writing: writers do not own the underlying stock. If a naked call writer is assigned, the underlying stock must be purchased in the market before it can be sold to the call option buyer.

• Writer short position & put option: RECEIVE premium from the buyer, has the OBLIGATION to BUY the underlying asset at the predetermined price, if called upon to do so, expects the price of the underlying asset to REMAIN THE SAME or RISE.

• Cash-secured put writing: writing a put and setting aside an amount of cash equal to the strike price.

• Naked put writing: writers have no position in the stock and have not specifically earmarked an amount of cash to buy the stock.

• Basic Terminology

• Strike price (exercise price): the price at which the underlying asset can be purchased or sold in the future.

• American-Style & European-Style: options that can be exercised at any time up to and including the expiration date are referred to as American-style options. If the option can be exercised only on the expiration date, it is referred to as a European-style option.

• Owners of options will exercise when an option is In-the-money: a call option is in-the-money when the price of the underlying asset is higher than the strike price; a put option is in-the-money when the price of the underlying asset is lower than the strike price.

• Owners of options will NOT exercise when an option is Out-of-the-money & at-the-money: a call option is out-of-the-money when the price of the underlying asset is lower than the strike price; a put option is out-of-the-money when the price of the underlying asset is higher than the strike price. Call and put options are at-the-money when price of the underlying asset equals the strike price.

• Intrinsic value: the value of certainty; the in-the-money portion of a call or put option.

• Time value: the value of uncertainty; option price = intrinsic value + time value. • Forwards & Futures

• Future contract: forward is traded on an exchange. Futures contracts can be offset through the exchange prior to the expiration. Daily gains and losses on futures are marked-to-market (calculated and settled) daily.

• Financial futures: contracts that have a financial asset as the underlying asset. • Commodity future: contracts that have a commodity asset as the underlying asset. • Forward agreement: forward is traded on OTC.

• Investors buy futures wither to profit from an expected increase in the price of the underlying asset or to lock in a purchase price for the asset on some future date. Investors sell futures either to profit from an expected decline in the price of the underlying asset or to lock in a sale price for the asset on some future date.

• Rights & Warrants

• Rights and warrants are securities that give their owner the right, but not the obligation, to buy a specific amount of stock at a specified price on or before the expiration date. they are usually issued by a company as a method of raising capital. Rights are usually very short term, with an expiration date often as little as four to six weeks after they are issued, while warrants tend to be issued with three to five years to expiration.

• A right is a privilege granted to an existing shareholder to acquire additional shares directly from the issuing company.

• Theres is no cost for shareholders to acquire these rights. The exercise price of a right, known as the subscription or offering price, is usually lower than the market price of the shares at the time of the right issue.

• Corporations issue rights when market conditions are not conductive to an ordinary common share issue, a company wants to give existing shareholders the opportunity to acquire additional shares before anyone else, or a company wants to allow existing shareholders to maintain their proportionate interest in the company.

• When a company decides to do a rights offering, they announce a record date to determine the list of shareholders who will receive the rights. For the two business day before the record date, the shares trade ex rights (anyone buying shares on or after the ex rights date is not entitled to receive the rights from the company). Between the announcement and ex rights date, the stock is said to be trading cum rights (anyone who buys the stock is entitled to receive the rights if they hold the stock until at least the record date).

• The intrinsic value of a right during the ex-rights period is calculated as:

• A warrant is a security, often issued as part of a package that also contains a new debt or preferred share issue, that gives its holder the right to buy shares in a company from the issuer at a set price until expiration.

SECTION IV The Corporation

Chapter 11 Financing and Listing Securities

• Sole proprietorship involves one person running his or her own business, and the individual is taxed on earning at their personal income tax rate. He or she is also personally liable for all debts, losses and obligations arising from the business activity beyond the assets held in the business.

• Partnership involves two or more persons contributing to the business, whether it be capital or expertise required to run the business.

• General Partnership involves in the day-to-day operations and are personally liable for all debts and obligations incurred in the course of business.

• Limited Partnership: a limited partner cannot participate in the daily business activity and liability is limited to the partner’s investment.

• A corporation is an incorporated business that is a distinct legal entity separate from the people who own its shares. Property acquired by the corporation does not belong to the shareholders of the corporation, but the corporation itself. The shareholders have no liability for debts of the corporation and there can be no additional levy on shareholders if the debts of a bankrupt corporation exceed the value of its realizable assets. The corporation can raise funds by issuing debt or equity.

• Private corporation, which have in their charters a restriction on the right of shareholders to transfer shares, a limitation on the number of shareholders to not more than 50, and a prohibition on inviting members of the public to subscribe for their securities.

• Public corporation, which are companies whose shares are listed on a stock exchange or traded over the counter.

• Corporation are created through incorporation, which requires filing of jurisdiction dependent documents with the relevant provincial or federal authorities.

• Advantage of incorporation: limited liability of shareholders, continuity of interest, ability to transfer ownership of shares, certain tax benefits, feasibility of capital growth, status as a separate legal entity and professional management.

• Disadvantage of incorporation: loss of flexibility, double taxation, additional expenses, and restrictions on withdrawal of capital.

• Government Finance

• For government, this financing is often accomplished through an auction process and occasionally through a fiscal agency.

• Auction bids can be submitted on a competitive or non competitive tender (the bid is accepted in full and bonds are awarded at the auction average). Competitive bids are filled from highest price to lowest price, until all bonds not allocated to the amount of the non-competitive tender are distributed.

• New issues of provincial direct and guaranteed bonds offered in Canada are usually sold at a negotiable price through a fiscal agent.