Series 65
study guide

Common stock

• Equity security
• Represents ownership in a company

Issuers

• Persons that raise capital by offering securities to investors

Equity

• Represents ownership
• Examples of equity securities
  • Common stock
  • Preferred stock

Securities

• Formal name for an investment
• Common types:
  • Stocks
  • Bonds

Capital appreciation

• Also known as growth or capital gains
• Occurs when stock prices rise
• Stock prices are driven by supply and demand

Retained earnings

• Profits retained by the company

Stockholder rights

• Right to pro-rate share of dividends
• Right to vote for Board of Directors
• Right to inspect books and records
• Right to maintain proportionate ownership
• Right to assets upon dissolution
• Right to transfer ownership

Dilutive actions

• Reduce proportionate ownership
• May be required to be approved by stockholders
• Rights offerings avoid dilution

Corporate liquidation priority

1. Unpaid wages
2. Unpaid taxes
3. Secured creditors
4. Unsecured creditors
5. Junior unsecured creditors
6. Preferred stockholders
7. Common stockholders

Bondholders in liquidation

• Mortgage bondholders are secured creditors
• Debenture holders are unsecured creditors
• Subordinated debenture holders are junior unsecured creditors

Negotiable securities

• Trade in the secondary market between investors
• Common stock is negotiable
• Most securities are negotiable

Redeemable securities

• May only be bought and sold with the issuer

Primary market

• Where issuers offer securities to investors
• IPOs are a type of primary market transaction

Secondary market

• Where investors trade securities with other investors

Issuer transaction

• Sale of securities where the issuer keeps proceeds
• Takes place in the primary market
• Common example: IPOs

Non-issuer transaction

• Sale of securities where a party other than the issuer keeps proceeds
• Takes place in the secondary market
• Where securities trade after their initial sale

Forward stock splits result in:

• More shares outstanding
• Lower price per share
• Same overall value

Reverse stock splits result in:

• Fewer shares outstanding
• Higher price per share
• Same overall value

Stock dividend consequences

• More shares outstanding
• Lower price per share
• Same overall value

Stockholder approval (voting)

• Stock splits require approval
• Stock dividends do not require approval

Ex-dividend date (ex-date)

• Buyer before ex-date receives dividend
• Buyer on/after ex-date does NOT receive dividend (seller does)
• Stock price typically drops by dividend amount
• Buy limit orders and sell stop orders are reduced by dividend amount

American depositary receipts (ADRs)

• US-registered receipts for foreign investments
• Created by domestic financial firms with foreign branches
• Trade in US dollars in US markets
• Subject to currency exchange risk
• No voting or pre-emptive rights
• Foreign government tax withholding creates a US tax credit

Foreign investing

• Adds diversification to portfolios
• Subject to currency exchange risk

Currency exchange risk

• Currency conversion negatively affects investment

Weak domestic currency

• Unfavorable converting into foreign currency
• Favorable converting out of foreign currency

Strong domestic currency

• Favorable converting into foreign currency
• Unfavorable converting out of foreign currency

Emerging markets

• Traditionally smaller economies
• Increasing economic growth
• High risk & return potential

Preferred stock characteristics

• Form of ownership (equity)
• Market prices are influenced by interest rates
• Considered a fixed income security

Preferred stock settlement

• Regular way: T+1
• Cash: same day if prior to 2:30pm ET

Preferred stock dividends

• Must be approved by the BOD
• Typically paid on a quarterly basis

Preferred stock par value

• Also known as face value
• Typically $100 for preferred stock
  • Could also be $25 or $50
• Never fluctuates
• Dividend rate based on par

Yield

• Represents overall rate of return
• Based on market price and dividend rate
• Continually fluctuates
• Yield and market price are inverses
  • Low market price = high yield
  • High market price = low yield

Current yield formula

• $\text{CY} = \frac{\text{annual income}}{\text{market price}}$

Fixed income market prices

• Discount = trading below par
• Premium = trading above par

Rising interest rates

• Fixed income market prices decline

Falling interest rates

• Fixed income market prices increase

Cumulative preferred stock

• Issuer must eventually pay skipped dividends
• Beneficial feature for investors
• Lower rates of return (vs. straight)

Straight (non-cumulative) preferred stock

• Issuer does not pay skipped payments
• Beneficial feature for the issuer
• Higher rates of return (vs. cumulative)

Participating preferred stock

• Eligible to receive more than the stated dividend rate
• Issuers pay more in profitable years
• Beneficial feature for the investor
• Lower dividend rates (vs. non-participating shares)
• Trades at higher prices and lower yields

Call features

• Allows issuer to end an investment by paying back its par value
• Calls typically occur when interest rates fall
• Beneficial for the issuer
• Sold with higher dividend rates (vs. non-callable)
  • Lower prices & higher yields
• Used by issuers to refinance

Call protection

• Number of years before security can be called

Call premium

• Amount above par required to call shares

Convertible preferred stock

• Convertible into common stock of the same issuer
• Beneficial feature for investors
• Sold with lower dividend rates (vs. non-convertible)
  • Higher prices & lower yields

Conversion ratio

• $\text{CR} = \frac{\text{Par}}{\text{conversion price}}$

Conversion price

• $\text{CP} = \frac{\text{Par}}{\text{conversion ratio}}$

Common stock parity price

• Price paid per common share based on convertible security market price
• $\text{PPoCS} = \frac{\text{Preferred stock market price}}{\text{Conversion ratio}}$

Preferred stock parity price

• Value of preferred stock based only on the conversion feature
• $\text{PPoPS} = \text{common stock market price x conversion ratio}$

Bond parity price

• Value of bond based on its conversion feature
• $\text{BPP} = \text{stock price x conv. ratio}$

Anti-dilution covenant

• Prevents issuer from performing dilution actions without adjusting the conversion feature
• Involved when stock splits occur
• Conversion ratio goes up
• Conversion price goes down

Rule 144

• Rule covering restricted and control stock

Restricted stock

• Stock not registered with the SEC
• Subject to a 6 month holding period (1 year if the issuer isn't an SEC reporting company)

Control stock

• Stock owned by an affiliate (insider)
• Subject to volume limitations

Affiliate

• Officer, director, or 10% shareholder
• Security sales subject to volume limitations

Form 144

• Filed if control or restricted stock intended to be traded in the next 90 days
• Only must be filed if more than
  • 5,000 shares, or
  • $50,000 total value sold

Form 4

• Filed if an affiliate trades control stock
• Must be filed within 2 business days of trade

EDGAR

• Electronic filing system for SEC forms
• Form 144 and Form 4 are filed on this system

QIB (qualified institutional buyer)

• $100 million or more of investable assets

Rule 144A

• QIBs are not subject to rule 144
• QIBs avoid holding periods and volume limitations

Cash dividends

• Taxable income received from common or preferred stock
• Tax rates:
  • Qualified = 15% or 20%
  • Non-qualified = up to 37%
• Reported on tax form 1099-DIV

Progressive tax systems

• Higher taxes if more money involved
• Examples:
  • Income taxes
  • Estate taxes
  • Gift taxes

Regressive tax systems

• Flat tax rates
• Examples:
  • Sales taxes
  • Excise taxes

Corporate dividend exclusion rule

• Corporations avoid paying taxes on dividends
• 50% exemption if owning less than 20% issuer's common stock
• 65% exemption if owning 20% or more of the issuer's common stock

Capital gain

• Securities sold for more than the basis
• Reported on tax form 1099-B

Share selection methods for sales

• FIFO
• LIFO
• Specific share identification
  • Is the best method to reduce taxation

Capital loss

• Securities sold for less than the basis
• Reported on tax form 1099-B

Long-term capital gain

• Gain on security held more than 1 year
• Tax rate: 15% or 20%

Short-term capital gain

• Gain on security held for 1 year or less
• Tax rate: up to 37% (income tax bracket)

Fundamental analysis

• Inspection of a company's finances

Balance sheet

• Compares company assets and liabilities
• Indicates a company's net worth

Net worth

• Determines overall value of company or person
• $\text{NW} = \text{assets - liabilities}$

Income (cash flow) statement

• Displays company income and expenses

Footnotes

• Provides additional context for information in financial statements

10-K annual report

• Audited financial report

10-Q quarterly report

• Unaudited financial report

Current assets

• Assets able to be converted into cash within one year

Current liabilities

• Liabilities owed now or will be within one year

Current ratio

• $\text{CR} = \frac{\text{current assets }}{\text{current liabilities}}$

• Measures ability to pay short term obligations

Net working capital

• $\text{NWC} = \text{current assets - current liabilities}$

• Determines liquid cash and marketable assets on hand

Quick assets

• $\text{QA} = \text{current assets - inventory}$

Quick ratio

• Also known as the acid test ratio

• $\text{QR} = \frac{\text{current assets - inventory}}{\text{current liabilities}}$

• Used to determine a company's liquidity

PE ratio

• $\text{PE} = \frac{\text{market price}}{\text{earnings per share}}$

High PE ratios

• May indicate an overpriced investment
• Typical of growth companies

Low PE ratios

• May indicate an underpriced investment
• Typical of value companies

Technical analysis

• Identifying and predicting market trends
• Technical analysts are known as "chartists"

Saucer bottom formation

• Stock price falls, flattens, reverses upward
• A reverse downward trend
• Bullish indicator

Saucer top formation

• Stock price rises, flattens, reverses downward
• A reverse upward trend
• Bearish indicator

Head & shoulders top formation

• Outline of a person
• A reverse upward trend
• Bearish indicator

Head & shoulders bottom formation

• Outline of an upside-down person
• A reverse downward trend
• Bullish indicator

Fundamental vs technical analysis

• Technical analysis involves looking at trading data.
• Technical analysis is often used for short-term trading strategies
• Fundamental analysis focuses on financial statements, earnings, or company fundamentals
• Fundamental analysis is key for long-term investing.

Market trend

• Identifies general market movement
• Trend lines depict bullish or bearish directions
• Moving averages are a type of trend line

Advance/decline line

• Details the number of stocks up vs. down
• Helps determine overbought or oversold markets

Overbought market

• Rising market, but starting to trend downward
• Bearish indicator

Oversold market

• Falling market, but starting to trend upward
• Bullish indicator

Consolidation

• Market moves within narrow parameters
• Indicates uncertain or neutral market

Market volume

• Measures the number of securities traded

Resistance levels

• The market price where stock avoids going above
• Breakout above is a bullish indicator

Support levels

• The market price where stock avoids going below
• Breakout below is a bearish indicator

Round & odd lots

• A round lot is a standard trading denomination
• Typical round lot (stock) = 100 shares
• Odd lot denomination is less than a round lot

Odd lot theory

• Investors trading in odd lots are wrong
• Do the opposite of odd lot trends to profit

Short interest

• Percentage of shares sold short

Short interest theory

• High short interest = bullish indicator
• Low short interest = bearish indicator

Efficient markets theory

• Market prices instantly reflect new public info

Cash dividends

• Shared corporate earnings with investors
• Paid by larger well-established companies
• Smaller companies usually avoid paying

Dividend discount model

• Determines the value of a stock based on future dividend payments
• Assumes stock value only based on discounted future dividends
• Factors in the time value of money
• Typically utilized for preferred stock
• $\text{Stock value} = \frac{\text{Annual dividend}}{\text{Discount rate}}$

Dividend growth model

• Determines the value of a stock based on the growth of future dividend payments
• Factors in time value of money
• Utilized for common stock; not relevant to preferred stock
• $\text{Stock value} = \frac{\text{Annual dividend}}{\text{Discount rate - dividend growth rate}}$

Benefits of common stock

• Capital appreciation
• Income from cash dividends
• Hedge against inflation

Capital appreciation

• Investment value rises above the cost
• Also known as:
  • Growth
  • Capital gains

Unrealized capital gain

• Current gain on an investment
• Investment has not been sold
• Gains at risk if the market declines

Realized capital gain

• Locked-in gain on an investment
• Investment has been sold
• Gains are not at risk

Growth stock

• Company with expanding business model
• Typical for smaller companies
• High capital appreciation potential
• Little or no dividend potential

Income

• Dividend payments from common stock
• Paid by larger, successful companies

Dividend payout ratio

• $\text{DPR} = \frac{\text{annual dividend per share}}{\text{annual earnings per share}}$

Value stock

• Company with a "bargain" stock price
• Usually well-established businesses
• Commonly pay cash dividends

Diversification

• Investing in multiple assets classes and investments
• Cannot diversify out of systematic risk

Systematic risk

• Occurs when an event or circumstance negatively affects the entire market

Market risk

• An investment is negatively affected by a general downturn in the stock market

Inflation risk

• Also known as purchasing power risk
• General prices rise more than expected
• Common stock tends to outpace inflation over long-term periods

Non-systematic risk

• Affects specific investment or sector
• Can be reduced by diversification

Financial risk

• High debt levels negatively affect company performance

Business risk

• Products or services in low demand due to competition or mismanagement

Regulatory risk

• Potential or current government regulation negatively affects an investment

Liquidity risk

• Also known as marketability risk
• Inability to sell a security without dropping price dramatically

Concentration risk

• Lack of diversification
• Amplifies relevant non-systematic risks

Common stock typical investors

• Younger, risk-tolerant investors
• Long time horizons
• Seeking capital appreciation or income

Benefits of preferred stock

• Fixed dividend rate provides income
• Lower tax rates (15% or 20%)
• Higher income rates than debt securities

Corporate dividend exclusion rule

• Corporations avoid paying taxes on dividends
• 50% exemption if owning less than 20% issuer's common stock
• 65% exemption if owning 20% or more of the issuer's common stock

Participating preferred stock

• Eligible to receive more than the stated dividend rate
• Issuers pay more in profitable years

Convertible preferred stock

• Convertible into common stock of the same issuer
• Has capital appreciation potential

Preferred stock risks

• Dividends are not guaranteed
• No legal recourse for skipped dividends
• Subject to:
  • Interest rate risk
  • Inflation (purchasing power) risk
  • Call risk
  • Reinvestment risk

Preferred stock typical investors

• Must seek income as the primary benefit
• Accepts moderate risk in return for higher income
• Long-term time horizons
• Corporate investors (due to tax benefits

Par value

• Known as a bond's "face value"
• Typically $1,000 for bonds
• Typical sale price for new issue bonds
• Bond interest rates based on par
• Stays fixed for the life of the bond

Interest rate (coupon)

• Represents annual interest paid to bondholders
• Based on the bond's par value
• Largely dependent on market interest rates at the time of issuance

Interest payments

• Legal obligation of the issuer
• Typically made semi-annually

Bearer bonds

• Owned by whoever physically possesses them
• No longer issued in the US

Book-entry bonds

• Ownership tracked electronically by the transfer agent
• All modern securities issued in this format

Zero coupon bonds

• Do not make regular interest payments
• Issued at a discount and mature at par
• Longer maturities = deeper discounts

Bond offerings

• Initially sold in the primary market
• Then trade in the secondary market

Bond market prices

• Influenced primarily by Interest rates
• Interest rates up, market prices down
• Interest rates down, market prices up
• Discount = market prices below par ($1,000)
• Premium = market prices above par ($1,000)

Short-term maturities

• Safer than long-term bonds
• Lower yields

Money markets

• Debt securities with one year or less to maturity

Long-term maturities

• Riskier than short-term bonds
• Higher yields

Secured bonds

• Collateral backs the bond
• Safer investments vs. unsecured bonds

Unsecured bonds

• Also known as full faith and credit bonds
• No collateral backing
• Riskier investments vs. secured bonds

Call feature

• Allows issuers to end a bond before maturity
• Require the payment of accrued interest, par, plus any call premium
• Typically utilized when interest rates fall

Call risk

• Occurs when the bond is called in an unfavorable environment
• Typically results in reinvestments at lower rates
• Type of reinvestment risk

Call premium

• Amount above par ($1,000) issuer must pay to call the bond

Call protection

• Number of years before a bond may be called

Tender offer

• Formal offer to buy a security from current investors

Put feature

• Allows bondholders to end a bond before maturity
• If exercised, the issuer must pay the accrued interest plus par to the bondholder
• Generally utilized when interest rates rise

Price volatility

• Measures how fast bond prices move
• Bonds with the most price volatility:
  • Long maturities
  • Low coupons

Pros & cons of raising capital through debt

• Pros:
  • Don't give up ownership
  • Bondholders do not have voting rights
• Cons:
  • Must pay back borrowed funds plus interest
  • Interest and principal payments can be significant

Pros & cons of raising capital through stock (equity)

• Pros:
  • No need to repay raised capital (money)
  • No interest charged on raised capital
• Cons:
  • Giving up ownership of the company
  • Many corporate decisions require shareholder approval

Liquidation priority

1. Unpaid wages
2. Unpaid taxes
3. Secured creditors
4. Unsecured creditors
5. Junior unsecured creditors
6. Preferred stockholders
7. Common stockholders

Creditors

• Person or organization lending money
• Bondholders are creditors

Corporate bond quotes

• Provided in percentage of par format
• Must be in eighths or reduced from eighth
• M = $1,000 par unit when used in quotes
  • 5M = $5,000 par bond
• s = coupon (interest rate)
  • 10s = 10% coupon
• Zr = zero coupon bond
• M' = references maturity year
  • M'40 = matures in the year 2040

Commercial paper

• Short-term zero coupon corporate debt
• 270-day maximum maturity
• Exempt from SEC registration
• Typically sold in large denominations ($100,000+)
• Sold to raise short-term cash

Debentures

• Long-term unsecured corporate bonds
• Also known as full faith and credit bonds
• Riskier than secured bonds

Funded debt

• General term for long-term corporate debt

Guaranteed bonds

• Backed by a third party's promise to pay interest and/or principal in case of default
• Typical third parties:
  • Parent companies
  • Insurance companies
• Considered unsecured bonds

Income (adjustment) bonds

• Issued after company defaults on debt
• Only pay interest when the issuer meets the earnings test
• High risk securities

Mortgage bonds

• Secured by corporate real estate
• Commonly issued by utility companies

Liquidation priority

• First mortgage bondholders receive liquidation proceeds first
• Second mortgage bondholders receive leftover liquidation proceeds

Equipment trust certificates (ETCs)

• Secured by corporate equipment
• Issued in serial form

Collateral trust certificates (CTCs)

• Bonds secured by marketable corporate assets

Convertible bonds

• Converts to common stock of the same issuer
• Investors eligible to make capital gains on stock
• Sold with lower interest rates (vs. non-convertible)
  • Higher prices & lower yields

Conversion ratio

• Shares received for each bond converted
• $\text{CR} = \frac{\text{Par}}{\text{conversion price}}$

Conversion price

• Price per share at which par is exchanged for stock
• $\text{CP} = \frac{\text{Par}}{\text{conversion ratio}}$

Common stock parity price

• Price paid per common share based on convertible security market price
• $\text{PPoCS} = \frac{\text{Convertible bond market price}}{\text{Conversion ratio}}$

Bond parity price

• Value of bond based only on the conversion feature
• $\text{BPP} = \text{stock price x conv. ratio}$

Anti-dilution covenant

• Prevents issuer from performing dilution actions without adjusting the conversion feature
• Involved when stock splits occur
• Conversion ratio goes up
• Conversion price goes down

US Government

• Largest and most active securities issuer in the world
• Primarily funds activities through deficit spending

US Government debt denominations

• Minimum of $100

Treasury bills

• Short-term zero coupon debt
• Issued at discounts and mature at par
• Available maturities:
  • One month (4 weeks)
  • One and a half months (6 weeks)
  • Two months (8 weeks)
  • Three months (13 weeks)
  • Four months (17 weeks)
  • Six months (26 weeks)
  • One year (52 weeks)

Cash management bills (CMBs)

• Short-term, zero coupon treasury securities
• Issued to close short-term funding gaps
• Maturities as short as one day

Treasury notes

• 2-10 year maturities
• Pay interest semi-annually

Treasury bonds

• Up to 30-year maturities
• Pay interest semi-annually

STRIPS

• Issued by US Government
• Long-term zero coupon bonds

Treasury Receipts

• Issued by financial institutions
• Long-term zero coupon bonds

STRIPS and Treasury Receipts

• Not suitable for investors seeking income
• Subject to phantom taxes
• High price volatility
• Very susceptible to interest rate risk

Treasury Inflation Protected Securities (TIPS)

• Inflation-adjusting debt securities
• Principal (par) value adjusts to CPI
• Coupon stays fixed
• Issued in 5, 10, and 30-year maturities
• Investor receives greater of original par or adjusted par at maturity

Mortgage agencies

• Issue mortgage-backed securities
• Buy mortgages from financial institutions

Mortgage-backed securities

• Make monthly payments of interest and principal
• Subject to prepayment and extension risk

Prepayment risk

• Occurs when interest rates fall
• Homeowners pay off mortgages earlier than expected

Extension risk

• Occurs when interest rates rise
• Homeowners pay off mortgages later than expected

US Government debt market

• Treasury auctions new issues
• Traded in OTC markets after issuance

US Government debt quotes

• Percentage of par quotes (generally)
• Quoted in 32nds using a:
  • Dash
  • Colon
  • Period

Treasury bill quotes

• Discount yield form

Non-self-supporting projects

• Do not make revenue

General obligation bonds

• Fund non-self-supporting projects
• Paid off with property (ad valorem) taxes

Used to analyze G.O. bonds

• Economic diversity
• Population trends
• Municipal obligations
• Tax collection figures

Self-supporting ventures

• Make revenue to pay off borrowed funds

Revenue bonds

• Paid off with revenues from municipal ventures
• Finance self-supporting municipal ventures
• No voter approval is required
• Not subject to debt limits

Feasibility studies

• Forecast profitability of a municipal venture
• Created by independent consultants

Municipal bond risks

• Revenue bonds have a higher risk of default than G.O. bonds
• Liquidity risk
• Low yields (opportunity cost)

Advance refunding

• Refunding bonds refinance outstanding debt before it can be called
• Proceeds are placed in a Treasury-backed escrow account to pay refunded bonds
• Advance refunding = redemption after 90 days
• Current refunding = within 90 days
• Bonds become defeased, often receive higher ratings, and may be called pre-refunded or ETM bonds

Demand deposit

• Funds held in a bank account that can be withdrawn anytime

Certificates of deposit (CDs)

• Pay a fixed amount of interest based on principal
• The "bank version" of a bond

Jumbo CDs

• Large bank deposits made for short periods
• $100k minimum denominations
• $1 million denominations are common
• Trade in the secondary market
• FDIC insurance covers up to $250k

FDIC insurance

• Covers up to $250k of bank deposits
• Coverage provided per customer

Brokered CDs

• CDs purchased through broker-dealers
• Offer FDIC insurance up to $250k per bank
• Suitable for investors seeking a short-term safe cash shelter

Eurodollar deposits

• US Dollars held in foreign banks

Reserve currency

• A currency commonly utilized by the world's central banks and largest financial institutions
• US Dollar is considered the world's reserve currency

Central bank

• An organization operating as a country's centralized financial institution

Eurobond

• Debt security paying interest and principal in a denomination other than the currency of the country it was issued in
• Not subject to SEC jurisdiction or registration

Currency (exchange rate) risk

• Risk of loss due to a currency conversion
• Occurs when:
  • Converting into a strong currency
  • Converting out of a weak currency

Spot rate

• Exchange rate for currency exchanged today

Forward rate

• Exchange rate for currency exchange in the future
• Utilized to hedge against currency risk

Eurodollar bonds

• Debt security issued outside of the US that pays interest and principal in US Dollars
• Issued by:
  • US corporations
  • US municipalities
  • Foreign corporations
  • Foreign governments
• No currency risk for US organizations
• Currency risk applies to foreign issuers and investors
• Not subject to SEC jurisdiction or registration

Nominal yield

• $\text{NY} = \frac{\text{Annual income}}{\text{Par}}$
• Measures the interest paid annually to investor
• Never changes over the life of the bond
• Also known as:
  • Coupon
  • Interest rate
  • Stated rate

Current yield

• $\text{CY} = \frac{\text{Annual income}}{\text{Market price}}$
• Measures overall rate of return based on the current market price
• Discount bonds CY > coupon
• Premium bonds CY < coupon

Yield to maturity (YTM)

• Measures overall rate of return if the bond is held to maturity
• Discount bonds YTM > coupon
• Premium bonds YTM < coupon

Yield to call (YTC)

• Measures overall rate of return if the bond is held until called
• Discount bonds YTC > coupon
• Premium bonds YTC < coupon

Discount bond yield relationships

• Current yield, YTM, and YTC are higher than the coupon
• Order of all yields (lowest to highest)
  • Nominal yield (coupon)
  • Current yield
  • Yield to maturity (YTM)
  • Yield to call (YTC)

Premium bond yield relationships

• Current yield, YTM, and YTC are lower than the coupon
• Order of all yields (lowest to highest)
  • Yield to call (YTC)
  • Yield to maturity (YTM)
  • Current yield
  • Nominal yield (coupon)

Par bond yield relationships

• All yields are the same

Price volatility

• Measures how fast bond prices move when interest rates change
• Bonds with the most price volatility:
  • Long maturities
  • Low coupons
• Bonds with low price volatility:
  • Short maturities
  • High coupons

Duration

• Measures the amount of time necessary to recoup the original cost
• Bonds with longer duration:
  • Long maturities
  • Low coupons
• Bonds with shorter duration:
  • Short maturities
  • High coupons

Corporate bond interest

• Subject to federal, state, and local taxes

US Government bonds interest

• Subject to federal taxes
• Exempt from state and local taxes

Municipal bond interest

• Exempt from federal taxes
• Subject to state and local taxes
• Exempt from all taxes if a resident

Typical municipal bond investor

• Investors seeking income
• Wealthy investors at high tax brackets

Tax-free equivalent yield

• TFEY = Corp. yield x (100% - tax bracket)

Opportunity cost

• Lost returns from a missed investing opportunity

Discounted cash flow

• Tool for determining the present value of future cash flows
• Factors in opportunity cost

Present value

• Value of future cash flows in today's dollars

Present value formula

• $\text{PV} = \frac{\text{FV}}{(1 + \text{DR})^n}$

Bond benefits

• Primary benefit is interest income
• Interest payments are a legal obligation of the issuer
• Capital appreciation may occur, especially if interest rates fall

Interest rate risk

• Interest rates rise, forcing bond market prices down
• Most susceptible bonds:
  • Long maturities
  • Low coupons
• Avoided by variable rate bonds

Purchasing power (inflation) risk

• Prices of goods and services rise, forcing bond prices down
• Typically results in higher interest rates due to Federal Reserve actions
• Avoided by short-term securities

Default risk

• Also known as credit or repayment risk
• Issuer unable to make required interest and/or principal payments

Bond ratings

• Only consider default risk
• Three bond rating organizations:
  • Standard & Poors (S&P)
  • Moody's
  • Fitch
• Investment grade bonds:
  • BBB or above
  • Low default risk
• Speculative (junk) grade bonds:
  • BB or below
  • High default risk

Liquidity (marketability) risk

• Security is difficult to sell or requires a large discount to sell
• Typically affects municipal bonds

Legislative risk

• New domestic law or regulation negatively affects a security

Political risk

• Foreign government instability negatively affects a security

Reinvestment risk

• Market returns reinvested at lower rates
• Occurs when interest rates fall
• High coupon bonds are most susceptible
• Avoided by zero coupon bonds

Call risk

• Bond called when interest rates fall
• The worst form of reinvestment risk

Bond typical investors

• Seeking income
• Generally older, risk-averse (conservative)

Investment companies

• Financial institutions that invest their customers' money
• Regulated by the Investment Company Act of 1940

Investment company classifications

• Management companies
• Unit investment trusts (UITs)
• Face amount certificates

Management companies

• Open-end management companies
  • A.k.a. mutual funds
• Closed-end management companies
  • A.k.a. closed-end funds

Unit investment trusts (UITs)

• Fixed portfolios of securities

Closed-end management company securities

• During IPO:
  • Sold in the primary market
  • Prospectus delivery required
• After IPO:
  • Traded in the secondary market (negotiable)
  • No prospectus delivery is required

Closed-end fund transactions

• Purchased at market price
• Subject to commissions
• NAV represents the fund's book value
• Market price could be:
  • Higher than NAV
  • Same as NAV
  • Lower than NAV

Interval funds

• Unique type of closed-end fund
• Do not trade in the secondary market
• Sold to investors daily at NAV plus a potential sales charge
• Considered redeemable securities (subject to repurchase offer limits)
• Redeemable at specific intervals (monthly, quarterly, semi-annually, or annually)
• Subject to considerable liquidity risk
• More capability to invest in illiquid investments with high returns
• Tend to be subject to high:
  • Sales charges
  • Expense ratios (high management fees)
  • 12b-1 fees
  • Redemption fees

Unit investment trusts (UITs)

• Redeemable portfolios of fixed assets
• No ongoing portfolio management
• No management fees

Exchange traded funds (ETFs)

• Usually structured as open-end management companies (a few are unit investment trusts)
• Negotiable securities

Passive investing

• Track the performance of indexes
• Pursues the return of the overall market

Passive ETFs

• Aim to match the returns of a benchmark index
• Low expense ratios

Active investing

• Picking the best individual securities in the market
• Attempts to outperform indexes

Active ETFs

• Aim to outperform the returns of a benchmark index
• Higher expense ratios than passive ETFs

Specific ETFs

• "Spyders" = S&P 500 ETF
• "DIAmonds" = Dow Jones Industrial Average ETF
• "Qubes"** = Nasdaq 100 ETF

ETFs vs. mutual funds

• Trade status:
  • ETFs are negotiable
  • Mutual funds are redeemable
• ETFs have lower expense ratios
• ETFs are more tax efficient

Inverse ETFs

• Provide an inverse return of an index
• Only suitable for sophisticated investors

Leveraged ETFs

• Provide amplified gains and losses
• Amplify at 200% and 300% rates
• Only suitable for sophisticated investors

Leveraged inverse ETFs

• Provide an inverse return of index with amplified gains and losses
• Amplify at 200% and 300% rates
• Only suitable for sophisticated investors

Exchange traded notes (ETNs)

• Debt instruments
• Promise to pay the return of an index
• Subject to default risk
• Negotiable securities
• Can be bought on margin
• Can be sold short

Growth funds

• Objective: capital appreciation
• Invest mainly in common stock; may include convertible preferred stock/bonds
• Market capitalization categories (size = shares outstanding × market value):
  • Large cap: >$10 billion
  • Mid-cap: $2B–$10B
  • Small-cap: $300M–$2B
  • Micro-cap: <$300 million
• Smaller companies = more risk + more growth potential; large-cap growth funds less volatile than small-cap

Aggressive growth funds

• Growth funds with higher risk/return targets
• Focus on small-cap stocks and volatile/emerging industries

Growth & income funds (blend funds)

• Combine capital appreciation with income-producing stocks (preferred + dividend-paying common stock)
• More conservative than pure growth funds
• Key terms: Conservative = low risk; Aggressive = high risk

Balanced funds

• Mix of growth stock AND income securities (including bonds)
• Key distinction: balanced funds hold stocks + bonds; growth & income funds hold stock only

Income funds

• Invest only in income-producing securities: bonds, preferred stock, dividend-paying common stock
• Goal: consistent income, not growth
• Generally more conservative than growth funds due to lower price volatility
• Types: corporate, municipal, US Government, high yield ("junk"), conservative (investment-grade), international bond funds
• Ginnie Mae/Fannie Mae/Freddie Mac funds:
  • Invest in mortgage-backed securities
  • Ginnie Mae guarantees MBS (doesn't purchase mortgages); Fannie/Freddie purchase mortgages
  • Conservative due to government backing; subject to prepayment/extension risk

Asset allocation funds

• Invest across asset classes per a set allocation (e.g., 60% stock/40% bond)
• Can be static or dynamic mix
• Life cycle/target date funds: shift from aggressive (growth stocks) to conservative (fixed income) over time as investor ages

Money market funds

• Type of income fund; invest in short-term (≤1 year) fixed income securities
• Low risk, low yield, highly liquid
• Priced at constant $1.00/share; pay monthly dividends
• Suitable for short-term time horizons, cash-like holdings

Specialized funds

• Focus on specific industry or region (not growth/income based)
• Also called sector funds
• Risk/return varies widely by focus area

Index funds

• Aim to match performance of a specific index (e.g., S&P 500)
• Represents passive investing (vs. active security selection)
• Indexes exist for broad market, cap size, bonds, and specialized sectors
• Passive investing now >50% of US domestic equity fund/ETF assets (2024)

Real estate investment trusts (REITs)

• Invest directly in commercial real estate properties and mortgages
• Negotiable securities

Equity REITs

• Invest directly in commercial real estate properties
• Income (from leases) and capital appreciation potential

Mortgage REITs

• Invest directly in commercial real estate mortgages
• Primarily seek income

Hybrid REITs

• Combination of equity and mortgage REIT
• Invest directly in commercial real estate properties and mortgages

Non-listed REITs

• Trade solely in the OTC markets
• Can be subject to liquidity risk

Private REITs

• Offered to select investors
• Avoids SEC oversight
• High level of liquidity risk

REIT suitability

• Provides a hedge to the stock market
• All REITs provide income potential
• Equity REITs provide capital appreciation potential
• Add diversification to portfolios
• Unlisted and private REITs only suitable for sophisticated investors due to liquidity risk

Cash dividends

• Taxable income received from stock or mutual fund investments

Qualified dividends

• Tax rates
  • 0% (low income)
  • 15% (moderate income)
  • 20% (high income)
• To be considered qualified:
  • Distributed by a US corporation or qualified foreign corporation
  • The investor must meet a specific holding period

Non-qualified dividends

• Tax rate equal to federal marginal income tax bracket (up to 37%)

Capital gain

• Securities sold for more than the basis
• Subject to capital gain taxation

Capital loss

• Securities sold for less than the basis
• Provides a tax deduction

Long-term capital gain

• Gain on security held more than 1 year
• Tax rate: 0%, 15%, or 20%

Short-term capital gain

• Gain on security held for 1 year or less
• Tax rate: up to 37% (income tax bracket)

Selling security shares or units

• Investors can utilize FIFO, LIFO, or specific share identification
• Specific share identification results in the lowest tax liability

Average cost, single category

• Shares reflect the average cost for tax reporting
• Only available to mutual funds
• Investors are "locked in" to this method once utilized

Subchapter M

• Tax regulation for certain securities
• Taxable income passed to investors
• Also known as the "conduit" rule
• Must pass 90% of net investment income to qualify

Investment company suitability

• Generally provide instant diversification
• Professional expertise and management

Dollar cost averaging

• Investing fixed amounts consistently over time
• More shares are purchased in market declines
• Results in lower average cost vs. the average price

Alpha

• Measures over or underperformance of a portfolio or security
• Positive alpha = overperformance
• Zero alpha = meeting expectations
• Negative alpha = underperformance

Beta

• Volatility measure as compared to the market (benchmark index)

Futures contracts

• Standardized contracts to perform a future transaction at a fixed price
• Buyer has obligation to buy (bullish)
• Seller has obligation to sell (bearish)
• Trade on futures exchanges (high liquidity)
• Utilized primarily by speculators

Forward contracts

• Customized contracts to perform a future transaction at a fixed price
• Buyer has obligation to buy (bullish)
• Seller has obligation to sell (bearish)
• No trading market (low liquidity)
• Utilized primarily by those working directly with commodity

Long option suitability

• Speculative growth
• Suitable for aggressive investors
• High risk tolerance

Short uncovered option suitability

• Speculative income
• Suitable for aggressive investors
• Very high risk tolerance

Hedging strategy suitability

• Option provides protection
• Suitability dependent on position option covers
• Risk tolerance varies

Covered call suitability

• Provides income in flat/neutral markets
• Suitable for virtually all investors if the stock position is appropriate
• Risk tolerance depends on stock position

Covered put suitability

• Provides income in flat/neutral markets
• Suitable for aggressive investors
• Very high risk tolerance

Futures contracts

• May be used for hedging or speculation
• Standardized and exchange traded (low liquidity risk)

Forward contracts

• Primarily used for hedging
• Customized and non-exchange traded (high liquidity risk)
• Only suitable for those dealing directly with commodity

Direct participation programs (DPPs)

• Pass through business returns and losses to investors
• Investor suitability:
  • Seeking tax benefits
  • Comfortable with liquidity risk

Limited partnerships

• Most common form of DPP
• Must contain:
  • At least one general partner
  • At least one limited partner

General partners

• Manage and run the business
• Have unlimited liability

Limited partners

• Provide funding for business
• Have limited liability

Certificate of limited partnership

• Makes the business official
• LP must file partnership documents with the state
• Received from the state when LP is officially formed

Agreement of limited partnership

• Agreement between general and limited partners
• Establishes rights, duties, and restrictions
• General partners must act in a fiduciary capacity
• Limited partners cannot manage

Subscription agreement

• Application to invest in LP
• Establishes an investor's suitability
• May require certification of investor's knowledge

Liquidation priority of LP

1. Secured creditors
2. Unsecured creditors
3. Limited partners
4. General partners

Real estate limited partnerships (RELPs)

• Invest in commercial properties
• Various investment goals:
  • Capital appreciation
  • Income
  • Tax benefits

Hedge funds

• Unregulated investment funds
• Only accredited (wealthy) investors participate
• High risk and high gain potential
• Subject to lock-up periods
• Typically sold in Regulation D offerings

Special purpose acquisition companies (SPACs)

• Also known as a "blank check company"
• Raise capital from investors with no defined business in place
• Funds used to acquire or merge with a private business
• Invested capital placed in trust into safe securities
• Shareholders must approve proposed business acquisitions

Blind pool companies

• Similar to blank check companies, but provide more transparency
• Typically disclose targeted industries or sectors

Funds of hedge funds

• Portfolio of several hedge funds (diversification)
• Lower investment minimums than individual hedge funds
• Not required to be accredited to invest
• Potential lower liquidity risk (shorter lock-up periods)
• Higher fees than individual hedge funds

Structured products

• Customized financial products
• Typically involve a derivative and debt component
• Subject to credit and liquidity risk
• ETNs only type of structured product not subject to liquidity risk

Limited partnership suitability

• Typically subject to liquidity risk
• Pass through losses to investors
• Limited partners may only lose the basis
• Various risk and benefit profiles depend on the DPP

Hedge fund suitability

• Typically subject to liquidity risk (lock-up periods)
• High risk / high return portfolios
• Most suitable for aggressive, wealthy investors

Structured product suitability

• Subject to liquidity and credit risk
• Highly complex securities
• Most suitable for sophisticated and institutional investors

Venture capital funds

• High-risk, illiquid private investment vehicles
• Exempt reporting advisors who do not have to register with the SEC but have to file financials

Commodity pools

• Combines investable capital to trade in commodity interests
• Structured as private offerings
• Usually only available to accredited or institutional investors because of their complexity and risk

Variable annuities

• Unlimited non-deductible contributions
• Contribution options:
  • Lump sum
  • Periodic contributions
• Offers tax-deferred growth
• Distributions taxable above basis

Immediate annuity

• Investor contributes a large lump sum
• Immediately annuitizes and receives payments

Deferred annuity

• Investor contributes over time
• Takes withdrawals or annuitizes later in retirement

Accumulation phase

• When contributions are made
• Death benefit applies

Death benefit

• Beneficiary keeps GREATER of:
  • Amount invested
  • Account value
• Applies if the account owner dies during the accumulation phase

Variable annuity insurance company risks

• Mortality risk
  • Investor dies earlier than expected, triggering the death benefit
• Expense risk
  • Business expenses rise
• Longevity risk
  • Investor lives longer than expected, forcing annuity payments to be paid longer

Separate account

• Where assets are held
• Customer in control of investing
• Investment choices:
  • Equity-based portfolios
    • Hedge against inflation
  • Debt-based portfolios
    • Subject to inflation risk

Distribution phase

• Investor receives income in retirement
• Non-annuitization options
  • Lump sum
  • Periodic payments
• Annuitization options:
  • Straight life annuity
  • Life with period certain
  • Joint and last survivor
  • Unit refund

Non-qualified annuity taxation

• Growth is taxable as ordinary income
• Withdrawals (non-annuitization)
  • Growth is distributed first (LIFO)
• Annuitization
  • Basis and growth distributed simultaneously
  • Taxed on a "pro-rata" basis (a.k.a. exclusion ratio)
• Not subject to RMDs

Qualified annuity taxation

• All distributions taxed (growth and basis) as ordinary income
• Subject to RMDs starting at age 73

Fixed annuities

• Like a variable annuity, but:
  • Not a security
  • General account instead of a separate account
  • More exposed to inflation risk

Equity indexed annuity (EIA)

• Annuity with both variable and fixed features
• Returns are linked to an equity index (e.g. S&P 500)
• Returns are guaranteed at a minimum level even if the index declines
• Not a security

EIA features

• Participation rate**
  • Percent of index returns credited to the investor
• Cap (ceiling)
  • Maximum return granted regardless of index gains
• Floor
  • Minimum return granted regardless of index declines
• Spread rate (margin, asset fee)
  • Fees deducted from index returns

EIA crediting methods

• Annual reset
  • Beginning value vs. end value after 1 year
  • Typically reset at the anniversary of EIA contract signing
• Point-to-point
  • Beginning value vs. end value
  • Points may vary (monthly, annual, every few years)
• High water mark
  • Beginning value vs. highest index value over a specified period
• Low water mark
  • Low index value vs. ending value over a specified period

Surrender charges

• Fees assessed if withdrawing funds prior to surrender period elapsing

Term life insurance

• Coverage for a specific term
• Fixed premiums
• Fixed, guaranteed death benefit
• No cash value
• Not considered a security

Whole life insurance

• Coverage for the "whole" life of policyholder
• Fixed premiums
• Guaranteed death benefit
• Cash value invested in general account
• Cash value grows at a guaranteed fixed rate
• Insurance company subject to investment risk
• Cash value may be
  • Withdrawn or borrowed
  • Returned to the insurance company upon death
  • Kept upon surrender of the policy
  • Retained and potentially paid with a death benefit
• Not considered a security

Viatical (life) settlements

• Policyholder sells life insurance to a third party
• Typically involves policy holders with terminal illnesses
• Third party takes over premium payments
• Third party receives a death benefit

Variable life insurance

• Coverage for the entire life of policyholder
• Fixed premiums
• Guaranteed minimum death benefit
• No minimum guaranteed cash value
• Cash value invested in the separate account
• Cash value grows based on investment performance
• Policyholder subject to investment risk
• Cash value may be:
  • Withdrawn or borrowed
  • Returned to the insurance company upon death
  • Kept upon surrender of the policy
  • Retained and potentially paid with a death benefit
• Considered a security

Universal life insurance

• Coverage for the entire life of policyholder
• Flexible premiums
• Flexible death benefit (some maintain minimums)
• Cash value invested in general account
• Cash value grows at a guaranteed fixed rate
• Insurance company subject to investment risk
• Cash value may be:
  • Withdrawn or borrowed
  • Returned to the insurance company upon death
  • Kept upon surrender of the policy
  • Retained and potentially paid with a death benefit
• Not considered a security

Universal variable life insurance

• Coverage for the entire life of policyholder
• Flexible premiums
• Flexible death benefit (some maintain minimums)
• No minimum guaranteed cash value
• Cash value invested in the separate account
• Cash value grows based on investment performance
• Policyholder subject to investment risk
• Cash value may be:
  • Withdrawn or borrowed
  • Returned to the insurance company upon death
  • Kept upon surrender of the policy
  • Retained and potentially paid with a death benefit
• Considered a security

Annuities suitability

• Suitable for those seeking retirement income
• Best if utilized as a retirement income supplement
• Suitable for those without beneficiaries
• Fixed annuities:
  • Guaranteed fixed growth of payments
  • Subject to inflation risk
• Variable annuities
  • Variable payments
  • Hedge against inflation

Life insurance suitability

• Suitable for those supporting beneficiaries
• Term life insurance:
  • Suitable for those seeking cheap insurance
• All other forms of life insurance:
  • Suitable for those seeking coverage over their life
  • Suitability depends on the characteristics of life insurance chosen

Real estate investments

• Tend to act as a hedge against market and inflation risk
• Numerous risks related to direct ownership

Precious metals

• Hedge against market and inflation risk
• Could be subject to large fees or fraud

Digital asset

• Any asset that is stored digitally
• Existence and ownership is recorded on an online ledger (blockchain)
• Three primary types:
  • Cryptocurrencies
  • Stablecoins
  • Non-fungible tokens

Blockchain

• Public database (ledger) that captures transaction details

Decentralized finance (DeFi)

• Financial system connecting users without traditional third party involvement

Cryptocurrency

• Convertible virtual currency

Stablecoin

• Type of cryptocurrency that pegs its value to an asset or commodity
• Most stablecoins peg their value to the US Dollar

Non-fungible token (NFT)

• Digital tokens that cannot be duplicated
• All NFTs maintain unique identifiers

Digital asset regulation

• Most cryptocurrencies are considered securities
• Bitcoin is considered a commodity
• Many initial coin offerings (ICOs) are considered unregistered sales of securities (illegal)

Benefits

• Capital appreciation (buy low, sell high)
• Added portfolio diversification

Risks

• Price volatility
• Fraudulence
• Hacked & lost assets
• Market manipulation
• Digital asset platform disasters

Typical investor

• Highly aggressive and speculative
• Long time horizon
• Knowledge and sophistication required to avoid scams

Person

• Any natural person (human being), or;
• Any legal entity

Non-persons

• Minors
• Incapacitated
• Deceased

Exemption

• Regulations do not apply because of ongoing legal exception

Exclusion

• Regulations do not apply because the item or entity is not the subject of the law

Issuers

• Persons that raise capital by offering securities to investors

Securities

• Formal name for an investment
• Common types:
  • Stocks
  • Bonds

Howey test

• Four-prong test determining if a product is a security
• Four requirements:
  • Investment of money
  • Common enterprise
  • Expectation of profit
  • Third-party effort

Issuer transactions

• Issuer receives sales proceeds
• Occur in the primary market

Non-issuer transactions

• Any person other than the issuer receives sales proceeds
• Occur in the secondary market

Broker-dealer

• Any person engaged in the business of effecting transactions in securities for the account of others or for his own account
• Financial firm that helps investors trade securities

Broker/agency capacity

• 'Trading for the accounts of others'
• Connecting buyers and sellers
• Earns a commission

Dealer/principal capacity

• 'Trading for their own account'
• Buying into or selling out of inventory
• Earns markdowns and markups

Agent

• Natural person (human being) representing broker-dealers and issuers
• Effects securities transactions for customers

Investment adviser

• Firms that provide securities advice as a regular part of their business for compensation
• ABC rule:
  • Advice on securities
  • Business activity (regular)
  • Compensation

Discretionary order

• A financial professional chooses any of the following for a client:
  • Action (buy or sell)
  • Amount (how much)
  • Asset (what security)

IA-1092

• Additionally defined as investment advisers:
  • Financial planners
  • Pension consultants
  • Athlete & celebrity advisers

Investment adviser representative (IAR)

• Individual who represents a financial firm in offering securities advice
• Also includes supervisors of IARs

Wrap account

• Account offering a wide range of services, including:
  • Investment management
  • Trade execution
  • Financial planning
  • Securities advice
• All costs "wrapped" into a single fee

Securities and Exchange Commission (SEC)

• Prominent securities industry regulator
• Regulates the primary and secondary markets
• Enforces:
  • Securities Act of 1933
  • Securities Exchange Act of 1934
• Main goals:
  • Protect investors
  • Maintain fair, orderly, and efficient markets
  • Facilitate capital formation

State administrator

• State securities regulator (enforces the USA)
• An office of government employees tasked with regulating the securities markets
• Similar to the SEC, but at the state level

Considered an offer and/or sale

• Bonus offer of securities
• Gift of assessable stock
• Warrants, rights, derivatives, and convertibles

Not considered an offer and/or sale

• Bona fide pledges or loans
• Stock dividends
• Corporate actions

Form U4

• Registration form for IARs

IAR registration disclosures

• List of all current registrations
• Employment & residential history
  • 10 years of employment history
  • 5 years of residential history
• Criminal events
  • Any charges, guilty pleas, no contest pleas, or convictions must be disclosed
  • Guilty pleas, no contest pleas, and convictions of felonies or securities-related misdemeanors in the past 10 years may prevent registration
• Regulatory events
• Court actions
• Financial disclosures
  • Bankruptcy filings
  • Compromises with creditors
• Payment of filing fee

Effective registration

• Must submit the proper paperwork, disclosures, and fees
• IARs of federal-covered advisers only register in states where an office exists
• Typically granted on the 30th day after filing

Financial requirements for IARs

• No minimum financial requirements
• Insolvency may affect registration status

Form U5

• Terminates IAR's registration status
• Filed when an IAR quits or is terminated
• Responsibility of:
  • Investment adviser if the firm is state-registered
  • IAR if the firm is federal-covered
• Administrator may institute disciplinary actions up to a year after withdrawal

IAR exemptions

• Snowbird/vacation rule
  • No place of business in the state
  • Only engaging investors temporarily in that state
• Institution rule
  • No place of business in the state
  • Only engaging institutional investors in that state
• De minimis rule
  • No place of business in the state
  • Engaging no more than 5 retail clients in a 12-month period in that state

IAR continuing education (CE)

• Must be completed annually
• Ineligible for registration renewal if not completed
• Facilitated by authorized providers
• 1 credit = roughly 1 hour of educational material

IAR CE courses

• IAR Regulatory and Ethics Content (6 credits)
  • At least 3 ethics credits
• IAR Products and Practice Content (6 credits)
  • Not required for IARs dual-registered as agents

Agent continuing education

• Imposed and facilitated by FINRA