Chapter One- Equity Securities

I. Securitya. Investment

i. Represents equity or debt1. Debt= bonds2. Stock= equity

a. Primary means of raising business capitalb. Holders vote board of directors

b. Purchased on exchangei. NYSE

c. Purchased OTCi. NASDAQii. Linked to other NASD member firms

II. Equitya. Balance sheet summarizes company

i. Assets, liabilities, equity b. Net worth/ Equity= Assets – liabilities

III. Common Stocka. Authorized= specific number of shares authorized to sell

i. Often sells only portion to raise capitalii. Charter must be amended to sell more than authorized

b. Issued= authorized and distributed to investorsi. Leftover from authorized shares that didn’t sellii. Reasons for added capital- expansion, dividends, options, convertible bondsiii. Un-issued authorized shares not counted toward capitalization

c. Outstanding= company issues, not repurchasedd. Treasury= issued and repurchased from investors

i. Reduce outstanding shares, increase EPS, Inventory, future acquisitions IV. Preferred Stock= features of equity and debt but is equity security

a. Fixed dividend streamsi. Price fluctuates with interest ratesii. Priority over common stock (same if liquidation)iii. Stated in dollar amountiv. Some offer variable= moves with I-rates

b. Non-votingc. No appreciationd. No maturity datee. Categories

i. Straight= stated dividends, missed dividends are not made upii. Cumulative= missed dividends made upiii. Convertible= exchange preferred to common

1. Fluctuates with common stock2. Lower dividend rate

iv. Participating= share of corporate profits1. If common stock dividend increases, preferred stock dividend increases

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v. Callable= company can buy securities backV. Stock Values

a. Par Value= meaningless, no effect market pricei. Money excess of par company receives recorded as APIC on B/S

b. Book Value= how much investor would receive if company liquidatedc. Market Value= price investors pay for stock

i. Supply and demand determines (based on company prospects)ii. Quoted in whole dollars (points) plus cents

VI. Rights of Shareholdersa. Voting rights= BOD, issuance of equity securities (including convertible bonds), big changes in

business, declaring stock splitsi. Not vote on dividendsii. Class A

b. One vote for on sharei. Statutory= one vote for each item on ballot

1. Benefits large investorii. Cumulative= allocate votes in any manner

1. Ex: 200 shares all 200 votes can go to one board member2. Benefits small investor

c. Proxies= absentee balloti. Cancelled if stockholder attends meetingii. Stockholder may revoke proxyiii. Proxy solicitation= company sends proxy to stockholders for specific meeting

1. Must submit to SECiv. Proxy Contest= vote can change control of company

1. Must submit to SECd. Nonvoting stock= raise capital while maintaining management control

i. Class Be. Preemptive rights= offer stock to stockholder before public

i. Anti-dilution provisionf. Limited liability= stockholders can not lose more than they put in g. Inspection of books= stockholders receive annual financial statements and list of stockholderh. Residual claims to assets= if liquidation right to assets after debt (stockholder is lowest priority)

i. Most junior securityVII. Stock Splits

a. High market price, split to make stock more attractiveb. Par value changes c. Forward Split= increases number of shares, reduces price without effecting market value or

ownership interesti. New # of shares= original number of shares * amount received/ previous amount

1. Ex: 100 shares, 5 for 4 split: (100*5)/ 4ii. % Decrease price > % increase shares

d. Reverse split= fewer shares, increase in price, same effect as forward i. New # of shares= original number of shares * amount received/previous amount

VIII. Benefits and Risksa. Long position= investor buys shares

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b. Short= investor borrows shares, sells them, will re-buy, and replace at later datec. Benefits

i. Growth= capital appreciationii. Income= dividendsiii. Property= shares of subsidiary

d. Tax effectsi. Realized gains and cash dividends are taxes, unrealized are not

1. Corporations receive 70% exclusion on dividend taxe. Risks

i. Market risk= price will decline1. Long position= limited to investment 2. Short position= unlimited

ii. Decreasing dividendsiii. Low priority if liquidated

IX. Returna. Cash dividends= automatically deposited to brokerage account

i. Taxed year receivedb. Stock dividends= used by a lot of growth companies

i. Not taxablec. Current yield= dividend yield

i. Annual dividend/ market valueX. Transferability

a. Stock certificate= indicates shares ownedi. Odd lot transactions= share amounts fewer than 100ii. Printed with CUSIP (Committee Uniform Securities Identification Procedures)

1. Identity number for each issue of security2. Helps track securities3. Used in trade confirmations

b. Negotiability= transfer, sell, give with little restrictionsi. Stock Power= to transfer owner must sigh security (must guarantee)

XI. Transfer Proceduresa. Transfer agent

i. Insures securities issued to correct person and maintains ownership recordsii. Cancels old and offers new securitiesiii. Distributes new shares in stock split

b. Registrar= accounts for outstanding shares i. Must be independent of issuing corporation

XII. Exchange Listed Stocks (Printed in Financial Publication)a. Name and dividend (annual) b. 52 week rangec. PE ratio (most recent earning report)d. Number of shares traded during day

i. Round lots of 100e. Ex-Dividend

i. X before volume indicates stock is ex-rights 1. Buyer will not receive next dividend

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f. High and low for the dayg. Net change in price

XIII. OTC/ NASDAQa. NASDAQ National Market (NNM)

i. High national interest (Ex. Microsoft)ii. Listings similar to that of exchange listed securities

b. SmallCapi. Smaller, less heavily traded

XIV. Dividend Departmenta. Collects and distributes dividends

i. Cash, Stock, Splits, etc… b. Dividend Disbursing Agent (DDA)= makes distributionsc. Dividend Disbursing Process= determined by BOD (except X date)

i. Declaration date= board approves dividend, designates payment date, and record date1. At least 10 days before record date

ii. Ex-dividend date= based on record date, if stock purchased after X date investor will not receive dividends

1. At least 2 days before record datea. Settle regular way= 3 business days

i. Ex: dividend declared Wed. the 21st, X date is Mon. the 19th ii. Must purchase stock 3 days before record date to receive dividend

2. Cash trades are same daya. X date day after record date

3. Stock price reduced by dividend4. Determined by NASD

iii. Dividend record date= stockholders receive dividends if owner on dateiv. Payable date= checks sent to stockholders

d. Stock dividends and splits= same as cashi. Special handling= distribution of 25% or more of stock outstanding

1. X date is day after payable date (or if split is greater than (5 for 4)

e. Due bill= statement showing buyers right to dividendi. Sent if wrong party receives dividend

XV. Rights and Warrantsa. Issuance

i. Rights offering= stockholders purchase stock below market price1. Valued separately from stock2. Trade in secondary market and have theoretical value

a. Cum rights= receives rightsi. Value of right= (Market Price-subscription price)/(# of rights to

buy one share +1)b. Ex-rights= does not receive rights

i. Decrease in stock after X date= (Market Price-subscription price)/(# of rights to buy one share)

ii. Stockholder may sell, exercise, or expire rightsiii. Subscription right= short term privilege to buy additional shares

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1. One right for one shareiv. Terms= stipulated on certificatesv. Standby underwriting= underwriter buys unsold shares and resells them

b. Warrantsi. Certificate granting owner right to purchase security at specified price at later date

1. 1 share of common stock per warrant2. Exercise price>market price

ii. Five year lifeiii. Long termiv. May trade separatelyv. Do not receive dividendvi. Offered as sweetener for another security

1. With bonds and preferred stockXVI. American Depository Receipts (ADR)

a. Security that represents a receipt of stock for non-US Companyi. Facilitate trading foreign stocks in USii. Bought and sold like stockiii. Foreign branches of US banks issue them

1. Registered to banks (on books)iv. Stock remains on deposit as long as ADR is outstandingv. Sponsored by foreign company

1. Provide financialsb. Owners have rights, receive dividends

i. Converted into US dollarsii. No preemptive rights

c. Can exchange ADR for stockd. Subject to currency risk

XVII. Real Estate Investment Trusts (REITs)a. Professionally managed portfolio of real estate investments

i. Dividends and capital gainsb. Traded publicly on OTCc. Avoid being taxed as corporation if:

i. 75% revenue received from real estateii. Distribute 90% of income to investors

d. Pass through income, not lossese. Not direct participation partnerships

i. Do share some characteristics

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Chapter Two- Debt Securities

I. Characteristicsa. Bondholders have no ownership interest or voice in managementb. Issuers= raise working capital or for fund expenditures

i. Corporate= Five years or moreii. Treasury securities= backed by full faith and credit

1. T-bills= 6 months or lessa. Issued at discount of par, pay out face at maturityb. Denominations of $1,000 to One million

i. Maturities= 4, 13, and 26 weeks2. T-notes= 2 years or more

a. Pay interest every six monthsb. Sold at auction every four weeksc. Denominations of $1,000 to One million

i. Maturing from 2 to 10 yearsd. Can be refunded= offer new security with new maturity instead of paying

face at maturitye. Priced as % of par in 1/32s

3. T-bonds= greater than 10 yearsa. Denominations of $1,000 to One million

i. Maturing in 10 to 30 yearsb. Quoted like T-Notes

4. Tax-exempt on state and local level a. Same with agency securities that are not mortgage backed

iii. Municipal= state and local governments1. Tax-exempt on federal level

c. Interest= timing paymentsi. Face/Par Value= $1,000 per bond and will be redeemed at maturity

1. What issuer owes investorii. Coupon= payment calculated from par value (semi-annual)iii. Accrues daily

d. Maturities=date when bond is repaidi. Term= principal of whole issue matures at once

1. Sinking fund to accumulate moneya. May be in indentureb. Used by lower rated issuers

ii. Serial= portions paid out over yearsiii. Balloon= repays portion before security, but major portion at maturityiv. Series Issues= spread out borrowing over years

e. Bond Certificate= physical evidence of bond, traditionali. Registration= record ownershipii. Coupon (Bearer Bonds)= whoever posses coupon sheet gets payment, no proof of

ownership 1. Issues $1,000 and $5,0002. Not issued since 1983

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a. Still trade in secondary market- principal onlyiii. Registered Bond= transfer agent records ownership, buyers name on bond face

1. Issues multiples of $1,000 (up to $100,000)2. Fully= both principal and interest, payments automatically sent to owner of record

a. If bond sold, new certificate issuedb. Payments by mailc. New bonds

3. Principal Only= name on certificate, coupons in bearer formiv. Book Entry= bond owner does not get certificate, transfer agent maintains ownership

records1. Payments by mail2. New bonds

f. Pricing= secondary marketi. At, below (discount), or above par (premium)

1. Affected by financial stability and interest rates a. Inverse relationship between interest rates and price

2. Corporate= stated in % of par in increments of (1/8) a. One point= 1% or 100 basis points

g. Rating and Analyzing= S & P, Moody’s, and Fitch i. S & P= uses all CAPS for bond category (AAA to A)ii. Moody’s= uses upper and lower case letters for bond category

1. Short term muni bondsiii. Basis= existing debt, stability of cash flow, ability to meet payments, asset protection,

management capability1. May change over time

iv. Investment grade= standards set by FDIC, bank grade bonds1. BBB or Baa or higher2. High yield= high speculation, high credit risk

a. Junk bondsb. Higher rating= higher safety= lower yield

3. Safety rankings:a. Highest rating= US government backed

i. Bills, notes, bonds, saving bonds- series EE and HHb. Second highest= through government agencies

i. Not backed by government (except GNMA) c. Third highest= muni-bonds

i. GO bonds= backed by tax revenued. Fourth= corporate debt

i. Covers very safe to very risky 1. Ranked: Secured, debentures, subordinated debentures,

Income4. Liquidity/Marketability= how easy bond can be sold,

a. Determined by: issue size, quality, rating, maturity, call features, coupon rate, issuer, sinking fund

h. Debt retirementi. Debt service= schedule of interest and principal payments

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ii. Redemption= when principal paid1. Sinking fund may be used2. Call feature/option= issuer redeem before maturity date

a. Whole or partial i. Term= issuer picks by lotteryii. Serial= inverse order of maturities (long to short)

b. At particular pricec. Call premium= price higher than pard. Advantages: replace with lower interest rate, reduce debt, replace short

with long (vice versa), force conversione. Tender offer= no call provision, buy in open marketf. Call risk= investor lose stream of income

i. Offer non-callable period= 5 to 10 yearsii. Call protection= advantage given to investors during declining

interest ratesg. Reinvestment risk= investor won’t be able to find similar interest rateh. Bonds continue to trade in market after call notice

i. Once called can either return or sell in market at discount3. Refunding= sell new bonds to retire old bonds (usually all at once) 4. Prefunding/Advanced refunding= new issue sold at lower coupon before original

issue can be calleda. New issued proceeds placed in escrow of government securities and used

to pay off original b. High ratingc. Defeasance= termination, not counted as debtd. During call protection periode. High marketability

5. Puttable bonds= lower interest rate for right to redeem at par whenever investor wants

a. Muni bondsb. Protect against interest rate risk c. Won’t trade much below par

II. Bond Yieldsa. Yield= interest payments in relation to value

i. Bonds quoted in yield and % of parb. Comparing yields

i. Nominal/Coupon yield= fixed % of bonds par value1. Annual income/current market price

ii. Current yield= coupon payment relative to market price1. Coupon payment/market price

iii. Yield to maturity (YTM)= annualized return if bond held to maturity1. Difference between price paid for a bond and par value

a. Discount increases returnb. Premium decreases return

2. [Annual interest- (Premium/years to maturity)]/average price of bond a. Average bond price= (price paid for bond + amount due at maturity)/2

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iv. Yield to call= return takes early redemption and discount or premiums 1. Sooner bond called, sooner premium paid is lost2. If called at par then less then nominal, CY, and YTM

v. Ranking from lowest to highest at discount: nominal, CY, YTM, YTC1. Premium is exact opposite

c. Yield curve= difference between short term and long term ratesi. X= years to maturity

Y= yield1. About 3 percentage points2. Economic expansion

ii. Short term rates= long term rates then flat1. Economy is peaking

iii. If short term rates are high then inverteda. Rates will decline

iv. Can be used to compare spread between bonds1. Wide gap between government and corporate bonds= recession

a. Narrow gap= expansiond. Rate changes= inverse relationship between rate and price

i. Long-term prices move more than short term pricesii. Two bonds have same maturity, bond with lower coupon will move more in price

III. Corporate Bondsa. Secured bond= issuer offer specific assets as collateral if they default

i. Mortgage bonds= highest priority, different classes exist (1st mortgage claim has top priority)

1. Open-end indentures/senior lien bonds= corporation may issue more bonds of same class and collateral

2. Closed-end indentures= corporation may not issue more bonds same class and have subordinated claims

3. Prior lien bonds= take claim over mortgage bonds, but must have approval from mortgage bond holders (not likely)

ii. Collateral trust bonds= own securities in other companies and used as collateraliii. Equipment trust certificates= issued serially so outstanding amount goes down with

decreasing value of equipment1. Amount borrowed less than full value of property

b. Unsecured bond= no specific collaterali. Debentures= backed by general credit

1. Below secured and above subordinated debenturesii. Subordinated debentures= subordinated to other creditors thus offer higher yields or

conversion factorsiii. Liquidation hierarchy: unpaid wages, IRS, secured debt, unsecured debt, subordinated

debt, preferred stock, common stockc. Guaranteed bonds= backed by company other than issuer (parent)d. Income/Adjustment bonds= pays interest only if enough income and does not pay missed

paymentsi. Companies coming out of bankruptcy

e. Zero-coupon bonds= no coupon payment, offer at deep discount of par and mature at par

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i. More volatile (longer YTM bigger volatility)1. Price changes more than regular bond

ii. Small investmentiii. Price reflects interest rate climateiv. Issued by corporations, municipality, and US or may be created from other types of

securitiesv. Advantages= small investmentvi. Owe income tax each year on straight line basis

1. If held to maturity no capital gain2. If sold before may be capital gain or loss

vii.No reinvestment riskIV. Trust Indenture

a. Trust Indenture Act of 1939= issues > than 5 million dollars or sold interstate sold with indenture (issuer’s obligation, bondholder’s rights)

b. Trustee= usually a bank to act on behalf of bondholdersi. Federal and muni bonds exempt (some muni bonds do= marketability)

c. Protective covenants protect bondholdersi. Closed-end= senior claim to assetsii. Open-end= subsequent issues have equal liens

V. Trading Corporate Bondsa. NYSE= provides central marketplace for trading bonds

i. Bid and ask pricesii. Bond brokers= execute trades on client behalves

b. Convertible bonds= bonds converted into stock, if not redeemed at face valuei. Market: higher payment than dividend, priority over stock, price moves with stock price

(more volatile), no tax liability if converted ii. Features: Lower interest rates, conversion price higher than market price, if conversion

over time no adverse effect on stock price, no immediate EPS impact, if converted dilutes equity and loss of leverage, raises tax burden (less interest costs), may shift control

iii. Conversion price= price at which bond can be converted1. Stated in price, not number of shares2. Adjusted for stock splits and dividends

a. Conversion price lowerediv. Conversion ratio/ rate= # of shares that will be converted into

1. Conversion Ratio= par/conversion pricev. Parity= two securities have equal value

1. Market price bond/conversion ratio= parity price of stock2. Market price stock* conversion ratio= parity price of bond

vi. Rising market= convertible value risesvii.Declining market= price levels off with price of nonconvertible bondsviii.Anti-dilution covenant= requires adjustments for splits, dividends, and issuance of new

sharesix. Forced conversion= issuer calls convertible bonds and it is in the best interest of the

bondholders to convert to stockVI. US Government and Agency Securities

a. Marketable government securities= T-bills, T-notes, T-bonds

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i. Treasury receipts= broker/dealer buys treasury securities, places them in trusts, and sells receipts

1. Securities used as collateral2. Not backed by full faith and credit3. Priced at discount= like zero-coupon bond

ii. STRIPS= Separate Trading of Registered Interest and Principal Securities1. Stripping interest into interest and principal components2. Offered by banks and dealers

iii. TIPS= Treasury Inflation Protected Securities1. Fixed interest rate, principal adjusted semi-annually for inflation

a. Adjusted due to CPIb. Interest payment adjust to new face valuec. Sold at lower interest rates

b. Agency issue securities= have higher yields than direct obligation but lower yields than corporate bond and traded in secondary market as % of par

i. Ginnie Mae (GNMA)= Government National Mortgage Association1. Buys mortgages (from FHA and VA) and auctions them to private lenders, thus

pooling the mortgagesa. Prepayment risk= homeowners pay off mortgages early

i. Reinvestment riskb. Extended maturity risk= mortgages will remain outstandingc. Interest rate risk, thus move with interest rates

2. Guaranteed by federal governmenta. Still pay higher interest rates

3. Minimum denominations of $25,000 4. Pass-through= payments from mortgage holder to investor

a. PC= mortgage participation certificatesi. Principal and interest payments once a monthii. GNMA

b. GMC= guaranteed mortgage certificatesi. Interest payments twice a year, principal payments once a year

5. Taxed at all levelsii. FCS= Farm Credit System

1. Provides agricultural financing and credit a. Raises funds for loans by selling securities

2. Privately owned and government sponsored3. Maturities are from one day to 30 years4. Exempt from state and local tax

iii. Freddie Mac (FHLMC)= Federal Home Mortgage Corporation1. Public, stock trades on NYSE 2. Buys residential mortgages and packages them into mortgage backed securities

a. Promotes secondary mortgages3. Pass-through4. Taxed at all levels

iv. Fannie Mae (FNMA)= Federal National Mortgage Association1. Publicly held

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2. Provides mortgage capital3. Purchases mortgages from agencies (FHA and VA)4. Issues debentures, short term notes, and mortgage backed securities

a. Denominations of 5k, 25k, 100k, 500k, and 1m5. Taxed at all levels

v. Sallie Mae= Student Loan Marketing Association1. Provide student loans2. Publicly traded3. Issues

a. Short-term floating ratesi. Six month maturities

b. Discount notes4. Taxed at federal level, exempt at most state levels

c. Issuance of government securitiesi. Exempt from registrationii. Sold through action

1. Competitive bids= placed by dealersa. 20 banks and brokers designated as primary dealers

i. Required to bid at auctionsii. Bids made in yield

2. Noncompetitive bids= placed by non primary dealersa. Stop out price= price all bidders will pay is lowest accepted competitive

bid (highest bid, lowest yield)i. For both competitive and non competitive ii. Dutch auction

b. Bids made in yieldi. Bids always filled

3. Ex: 25m in bonds to be auctioned, noncompetitive bids= 5m, thus 20m available for competitive bid

a. Settlement on Thursday of auction4. Agencies issued through underwriters

VII. Accrued Interest Calculationsa. Trade and interest= buyer pays market price+ accrued interest from last payment (last interest

payment day is counted)i. Coupon dates= payment date

1. Semi-annually and on 1st or 15th

ii. Dated date= date from which interest is accrued 1. Receive interest up to, but not including settlement date

b. Trading flat= bond trades with out accrued interesti. Zero-coupon, income bonds, bonds in default, and bonds that settle on interest payment

dayc. Corporate and muni bonds= 360 day method

i. (Principal* interest rate* elapsed days)/360= accrued interestii. Regular way settlement

1. Sell on April 15th, settle on April 17th d. Government bonds= 365 day method

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i. (Principal* interest rate* elapsed days)/365= accrued interestii. Next business day

VIII. Collateralized Mortgage Obligations (CMO)a. Mortgage backed securities that pool together mortgages

i. Structure them into tranchesii. Relatively safeiii. Issues in 1k incrementsiv. Yields estimate of historical data from Public Securities Association (PSA)v. Issued privately, backed by government agenciesvi. Interest rate risk

1. Prepayment risk= interest rates fall2. Extension risk= interest rates rise

vii.Maturity, interest, and principal received not guaranteed1. Suitability statement= customer signs to acknowledge that rate of return will vary

b. Pays principal and interest monthlyi. Principal to only one tranche a month

1. Principal payments maid in 1K incrementsii. Short-term tranche receives all principal payment before next tranche

c. Plain vanilla CMO= pays all tranches interest at same time, but principal to only oned. Principal only CMO= sells at discount to par, rises as interest rate fallse. Interest only CMO= cash flows decline over time, value increases as interest rates rise

i. Hedge interest rate riskf. Planned amortization class CMO (PAC)= targeted maturity dates, retired first thus reduced

prepayment or extension riskg. Targeted amortization class CMO (TAC)= transfers prepayment risk to another tranche, but not

extension riski. Higher yield than PACs

h. Zero-tranche CMO= no payment until all other tranches retiredi. Most volatile

IX. Nonmarketable US Government Securitiesa. No secondary market

i. Direct between investor and agents of the government (banks)b. Series EE bonds= issued 50% face value and reach maturity in 30 years

i. Interest paid semiannually added to current value1. 90% of average 5 year treasury yield

ii. Reach face in 17 years, can hold to 30 yearsiii. Taxable only at federal level

1. Deferred until stops paying interest or redeemed 2. Tax free if lower income and not used for college

c. Series HH bonds= no longer in issue, issued at face and pay interest every 6 monthsi. Taxable at federal level when payments are received

d. Series I bonds= sold at face value and interest added monthly paid when bond maturesi. Real rate of return= grow with inflation

1. Variable= inflation rate2. Fixed= interest rate

ii. Up to 30 years

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iii. State and local exempt1. Federal tax deferred

a. Tax free if lower income and not used for collegeX. Money Market Securities

a. Debt issues with maturities of one year or lessb. Money market= fixed income, short term securities with high degree of safety

i. Repurchase agreements (repo)= financial institution raises cash temporarily by selling securities with agreement to buy them back

1. Has repurchase price and maturity datea. Repo rate= difference between sale and repurchase price

2. Open repo= callable at any time3. Interest rate risk

ii. Reverse purchase agreements= dealer buys securities from investor and sells them back later

iii. Bankers acceptance (BA)= payment drawn on bank (prepaid check)1. Between 1-270 days2. Used to finance international trade

a. Holder has lien on goods3. Sold at discount, quoted in yield

iv. Commercial paper/ promissory note= corporation issued, unsecured 1. Rates lower then bank rate loans2. Excellent credit ratings3. 1 to 270 days

a. Most mature within 90 days4. Sold at discount, matures at par, and quoted in yield

a. Issued in book entry formv. Direct paper= commercial paper sold by finance company with out dealervi. Dealer paper= commercial paper sold through dealersvii.CDs= fixed interest rate with minimum face value of 100k and can be traded in

secondary market1. Nonnegotiable CDs= not traded in secondary market, no money market securities2. Negotiable CDs= time deposits with minimum face value of 100k

a. Unsecured promissory note issued by bank3. Brokered CDs= if redeemed before maturity than prepayment penalty

a. Broker/dealer buys CD and then subdivides and resells to customerb. Maturity can be several yearsc. Higher yieldd. Must be sold in secondary market

XI. Interest Ratesa. Federal funds rate= rate banks over each other for overnight loans

i. More than 1mii. Most volatileiii. Barometer of short-term interest ratesiv. Lowest rate

b. Prime rate= interest rate banks charge most creditworthy corporate borrowersi. Highest rate

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c. Discount rate/call loan rate/call money rate= rate FED charges for short-term loans to member banks

i. Second lowest rated. Broker loan rate= interest rate broker/dealer charge on money lent to margin accounts

i. Usually a percentage point above short term rate1. Second highest rate

ii. Callable with in 24 hourse. CD rate= offered on nonnegotiable CDsf. Commercial paper= rate set by finance companies

XII. Eurodollars and Foreign Currency Marketsa. Eurodollars= US dollar deposited in banks outside US

i. Time deposits= short term, overnight to 180 daysii. LIBOR= interest rate usediii. Pay in US dollars

1. Thus no currency riskb. Eurobond= long term debt instrument issued and sold outside country of currency

i. Pay in foreign currency ii. Bearer form= interest paid once a year

c. Interbank market= developed as means of transacting business and consolidating foreign currency deposits

i. Spot trades= delivered in 1 or 2 business daysd. Exchange rates= rate one currency converted into another

i. Valuation= exchange rate changes or floats1. Appreciating= currency rising in value2. Depreciating= value of currency decreasing

ii. Speculation is risky because banks may be unregulated and government policies could effect currency

XIII. Tracking Debt Securitiesa. Description is 9s 2010= bond pays 9% and matures in 2010b. N after the year indicates a treasury note, no letter indicates a bond

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Chapter 3- Municipal Securities

I. Municipal Debt Characteristicsa. Municipal Bonds= securities issued either by state or local governments, US territories,

authorities, and special districtsi. Loaning money for purpose of public works and construction projectsii. Second in safety

1. Lower interest rates then corporate bondsiii. Exempt for filing, but subject to antifraud requirementsiv. Not taxed at federal level

1. Capital gains still taxedv. Tax exempt at state level if you live in state when bond is issued

1. More appropriate for high income investors2. Not suitable for those in low tax brackets

vi. Maturity= less than 1 year to 30 yearsvii.Term maturity= principal matures at single date

1. Some issuers establish sinking fund2. Quoted in price, called dollar bonds

viii.Serial maturity= bonds within issue mature on different dates1. Quoted based on YTM2. Called basis, reflect difference of maturity dates

ix. Balloon maturity= issuer pays part of maturity before final maturity date, largest portion at maturity

1. Type of serial maturityb. Types of municipal issues= GO and revenue

i. General obligation issues (GOs)= issued for capital improvements that benefit entire community

1. Paid by taxes collected by taxesa. Backed by full faith and creditb. Property taxes= ad valorem

2. Statutory debt limits= amount of debt limited by taxpayersa. Voter approval= require voteb. Tax limits= limited by property taxes (expressed in mills, I mill= $.001c. Limited tax GO= Go limited to one tax, thus more riskd. Overlapping debt= debt that tap same tax payer dollars (coterminous debt)

i. State debt never overlapse. Double-barreled bonds= characteristics of GO bonds, but paid from

specific facility’s earningsi. Backed by taxing power of municipalityii. Rated and traded as GOs

3. If default, then bondholders can sue for more taxes to pay off bondsii. Revenue bonds= finance municipal facility that generates sufficient income and interest/

principal payments are only from those specific earnings 1. Not subject to statutory debt limits2. Ensures adequacy of revenue to pay old and new debt

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3. Feasibility study= engage various consultants to prepare report on feasibility of project

4. Sources: utilities, housing, transportation, education, health, industrial, sportsa. Not backed by full faith and credit

5. Trust indenture/bond resolution= trustee to act on behalf of bondholdersa. Municipality must abide by certain covenants

i. Rate= maintains rates sufficient to pay expenses and debtii. Maintenance= must maintain facilitiesiii. Insurance= facility insurediv. Additional bond test= determines whether bond is open or closed

endedv. Sinking fundvi. Catastrophe clause= insurance to pay bonds if facility destroyedvii.Flow of funds= disburse revenue collectedviii.Books and records covenant= outside auditsix. Call features

b. Optional, but makes bonds more marketable6. Types:

a. Industrial development revenue bonds (IDRs/IDBs)= construct facilities which are then leased to corporations

i. Money from leases to meet obligationii. Bonds carry the company’s debt ratingiii. My be subject to alternative minimum tax

b. Lease rental bonds= bonds raise money to finance facility for municipalities use

c. Special tax bonds= secured by one or more designated taxes other than property

d. Special Assessment/special district bonds= finance construction for public improvement

i. Tax property that benefits, uses tax for obligationse. New housing authority bonds (NHAs/PHAs)= develop low income

housingi. Backed by full faith and credit of US government

1. Most secure2. Section 8 bonds

f. Moral obligation bonds= if revenue collections are not sufficient, state backs them

7. If default, then only repaid through legislative appointmentiii. Municipal notes= short term securities for municipality that expects revenues soon and

repaid when revenues are received1. Usually less than 12 months

a. May be 3 months to 3 years2. Categories:

a. Tax anticipation notes (TANs)b. Revenue anticipation notes (RANs)c. Tax and revenue anticipation notes (TRANs)

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d. Bond anticipation notes (BANs)= interim financing that will eventually be created to long term through sales of bonds

e. Tax exempt commercial paper= instead of BANs and TANs, for up to 270 days

f. Construction Loans Notes (CLNs)= interim financing for housing construction

g. Variable loan demand notes= fluctuating interest rate, issued with put option

3. Variable rate municipalities/reset bonds= interest payments (coupon rate) tied to movements of another interest rate

a. Price remains stable4. State and Local Government Securities Series (SLGS)= proceeds from prefunding

placed in escrow accounta. Government securities issued for municipalities

c. Municipal security documentsi. Bond contract= with underwriters and prospective investors

1. Issuer must abideii. Authorizing resolution= authorizes issue and sale of securities and contains descriptioniii. Bond indenture= protective covenant contract between trustee and issuer that is not

required by law but used for marketability 1. Flow of funds statement= establishes priority of payments

iv. Official statement (OS)= signed by officer of issuer which is like a corporate prospectus1. Preliminary official statement= same material except interest rate and price and

used to determine interest v. Legal opinion= on face of every certificate, deal with legality of bond and tax status

1. Qualified= legal uncertainty2. Unqualified= issued by bond council unconditionally

a. Issuers desire3. Ex-legal= no legal opinion and must be stated

II. Issuing Municipal Securitiesa. Negotiated underwriting= appoints investment banker to underwrite offering and establish

interest rate and offering pricei. Revenue bonds

b. Competitive bids= GO bonds awarded to underwriter through bidi. Bid with lowest interest rate to issuer winsii. Official notice of sale= published in newspaper and includes information about the bonds

to solicit bidsc. Sources of muni bond information:

i. The Bond Buyer= publishes information on bond issues1. Friday edition

a. 30-day visible supply= total dollar volume of muni offerings in next 30 days

i. Large visible supply= interest rates will riseii. Small visible supply= interest rates will fall

b. Placement ratio= % of new issues sold vs. % new issues offered

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c. Complies indexes: 40 Bond Index, 20 Bond Index, 11 Bond Index, Revdex 25

ii. Munifacts= subscription wire service of The Bond Buyer1. Up to the minute

d. Formation of underwriting syndicate= investment bankers that want to bid on bonds form together to spread out risk

i. Decisions to participate: demand, presale orders, extent of liability, scale and spread, ability to sell

ii. Syndicate letter/syndicate agreement= formalize relationship in competitive bidiii. Syndicate contract/agreement among underwriters= formalize relationship in negotiated

underwritingiv. Types of syndicate accounts

1. Western account= divided account where each underwriter is responsible for its own allocation

2. Eastern account= undivided account where each underwriter is allocated portiona. Liability may continue after initial allocation

i. Remaining unsold shares allocated between memberv. Establishing syndicate bid= members meet to establish their bid

1. Writing the scale= establishing price for maturitya. Lists different maturities for issue

2. Firm commitment= submitted as competitive bidsa. No profit guaranteeb. Must bid for entire amount

3. Disclosure of fees= fees disclosed to members in advance4. Awarding issue= issuer issues to syndicate with lowest net interest cost or true

interest costa. Net interest cost (NIC)= combines proceeds to issuer with total interest

paidb. True interest cost (TIC)= same as NIC with time value of moneyc. Split rate bids= bids with more than one interest rated. Cover= difference between winning bid and next best bid (cover bid)

i. Expressed in basis points or dollars per bond1. One bond point= $10

5. Syndicate account= keeps books and manages accounta. Sales proceeds and expenses are paid out ofb. Syndicate manage= manages account

vi. Breakdown of spread= syndicates compensation (difference between price paid and reoffering price)

1. Production= total sales dollars earned2. Management fee= price syndicate manager receives per bond3. Total takedown= spread left after management fee

a. Members buy bonds from manager at takedownb. Concession plus additional takedown

vii.Selling concessions= discount selling group receives from syndicate member 1. Additional takedown= syndicate members keep remainder of total takedown2. Reallowance= interested firms buy bonds from syndicate

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a. One half concession amount3. Full spread= if manager is syndicate member

e. Order Allocations= MSRB requires syndicates to establish priority allocation provisionsi. Order period= time set by manager during which syndicate solicits customersii. Allocation priorities= important when bond issue is oversubscribed

1. Presale order= customer enters before syndicate wins bid 2. Group net orders= syndicate member wants customer order to receive priority3. Designated order= priority after group net order, usually institutions4. Member order/member related order= highest priority given to order that benefit

most memberf. Payment and delivery

i. When issued basis= securities are authorized, but not yet issuedii. Order:

1. Awarding issue to syndicate2. Bonds certificates are printed3. Managing underwriter registers bonds with clearing agency4. Syndicate manager gives notice of settlement date5. On settlement date bonds delivered to syndicate who POD

iii. Confirmations= on/before completion of transaction final confirmations sent to customers via underwriters

1. Dated date= issuers assigns bond issuea. Interest begins to accrue

III. Analysis of Municipal Securitiesa. GO bonds= backed by tax revenue, thus reflection of community wealth

i. Includes: Property taxes, retail sales, bank deposits, industry base, populationii. Characteristics= quantitative (objective) and qualitative (subjective)iii. Debt limits= protect tax payers from excessive taxes and limits overall debt

1. Disclosed in official statement2. Mature before project becomes obsolete

iv. Income of municipality1. State= income and sales tax2. Counties/school districts/city= real property tax

a. City also= fines, license fees, assessments, sales, utility, personal property, hotel

3. Ad valorem tax= property based on assessed valuation a. Per value tax established by state or countyb. Backed by power to seize property

4. Analyzing official statementa. May need to issue more debt if: income can’t meet payments, principal

payments to close, inadequate sinking fund, pensions unfunded, make more capital improvements

b. More debt= lower credit rating/higher interest paymentsc. Debt statement= includes full valuation of taxable property and

assessment %i. Total debt= all debt - self supporting debt – sinking fund

1. Revenue bonds not included

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ii. Net direct debt= GOs issued + short term notes issued in anticipation of taxes + overlapping debt

iii. Net total debt/net overall debt=overlapping debt + net direct debtb. Revenue bonds= rated according to how well facility will able to generate revenue

i. Factors: economic justification, competing facilities, dependability of revenue, call provisions, flow of funds

ii. Applications= Interest/principal exclusively from revenue generated by facility1. Flow of funds= issuer pledges to pay expenses in specific order2. Net revenue pledge= operating and maintenance expenses 1st, issuer pays

a. Receipts deposited into revenue fund and disbursed as follows: i. Operating and maintenanceii. Debt service account= pay interest and principal for this yeariii. Debt service reserve= hold enough money to pay one yeariv. Reserve maintenance fund= supplementv. Renewal/replacement fund= create reserve for replacing machinevi. Surplus fund= used for both

b. Most common3. Gross revenue pledge= issuer pays debt first

i. User pays for maintenancec. Muni debt ratios= all with GOs

i. Net debt assessed= 5% per assessed property valueii. Net debt estimated valuation= most analysts prefer over assessediii. Taxes per person= city’s tax income/populationiv. Debt per capita= larger cities have larger debt because tax base is more diversifiedv. Debt trend= indicates if ratios are rising or falling

1. Anticipating long term debtvi. Collection ratio= taxes collected/taxes assessedvii.Coverage ratio/times interest earned ratio= how many times annual tax revenue will

cover debt service1. 2:1 is adequate2. Used for revenue bonds

d. Interest rate comparisons= fluctuate more than government and corporate bondsi. Thinner market

e. Muni bond insurance= interest for interest and principal paymentsi. Insurance from: MBIA, AMBAC, FGIC

f. Bond ratings= Moody’s, S & P, Fitchi. Moody’s= MIG 1 (the best) to MIG 4 (acceptable) to S6 (speculative) ii. S & P= SP1 to SP3iii. Fitch= F-1 to F – 3

IV. Municipal Trading and Taxationa. Quotations= any bid or offer

i. Trade OTC ii. YTM= basis quote

1. Serial maturitiesiii. Dollar bonds= quoted in percentage of par dollar

1. Term bonds= callable before maturity

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iv. Types of quotations1. Most common= bona fide and nominal

a. Nominal/subject= dealers estimate of market valuei. Informational purpose and must be marked as such

2. Bona fide/firm quotes= dealer must trade at specified pricea. Quote must beb. Must reflect dealers best judgment

i. Reasonable to fair market valuec. May reflect firms inventory and expectations of market

i. Not necessarily best priced. Dealer can’t knowingly misquotee. If make quote with out bonds, dealer must know where to obtain them

3. Workable indication= bid price where dealers purchase from other dealersv. Holding a quote= may quote bond that is firm for certain time

1. Out-firm with recall=firm for hour with five-minute recalla. Dealer sells bonds that does not own because they know they can be bonds

at fixed price for allotted timevi. Secondary market joint accounts= formed by group of investment bankers who purchase

blocks from institutions and resell them1. At resell can only give one quote for block

b. Reports of sales= dealers must report trades to other dealers to MSRBi. Include firms names and accrued interestii. Round lot= 100k pariii. Broker’s broker= brokers trading only to institutional clients

1. Help other dealers sell unsold portions2. Act as agents3. Don’t disclose customers

c. Broker/dealer regulationi. Reciprocal dealings= dealer can’t solicit securities from investment company in return for

sales by the dealer of shares in the investment company1. Ant reciprocal Rule

ii. Customer recommendations= make suitable recommendations1. Suitability test= find customers financial status

a. With out information recommendation can’t be made2. Churning= increase commissions through excessive trades

a. Illegal3. Can not misuse securities held for another person4. Can not guarantee against loss

a. Or share in profits or losei. Exception= joint account

5. Control relationship= if dealer is under control with issuer, additional written disclosure required

d. Markups and commissionsi. Agency transactions= executed for a commission

1. Commissions= dealer acts as agent and arranges trades2. Consideration: availability, expenses, value of service, compensation received

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3. Best execution= make best effort to obtain at fair price4. Disclosed on confirmation

ii. Principal transactions= executed at net price, including markup/markdown1. Markup= dealers acts as principal and sell securities2. Markdown= when buy securities3. Consideration: fair market value, expenses, profit, total dollar amount, direction

of overall marketiii. Confirmations= customers receive written confirmation when transaction entered

1. Disclosing yield= if bond’s maturity known, yield shown as YTMa. Yield on confirmation = lower of YTM or YTC

i. Not required for: variable rate bonds, bonds in default, bonds sold at par

b. Zero-coupon= issued at deep discount, thus interest rate of 0 and no accrued interest

2. Required information: security description, trade date, settlement date, accrued interest, firm’s name/address/phone #, firm agent/principal, dated date, Book entry or bearer for, level of registration, amount of commission, tax liability, special qualification, if callable, customer name, trade date, yield, accrued interest, extended principal amount (total amount of all securities the info. covers)

e. Advertising= any material designed for public mediai. Dealer must approve all advertising

1. Never filed with MSRBf. The broker/dealer as financial advisor

i. Financial advisor= muni dealer provides advisory or consulting services to issuer1. Must be documented in writing

ii. Conflict of interest= firm is financial advisor and underwriter1. Competitive bid= issuer must consent in writing2. Negotiated sale= in writing disclose to issuer and issuer acknowledges or if

broker/dealer discloses source of amount and compensation received in writing3. Help with OS= must make copy of official statement to underwriter before other

syndicate members4. Dealer can not use information about bondholders

g. Taxation of municipal securitiesi. Tax reform act 1986= interest is exempt at federal level

1. If 10% of bonds proceeds go to private parties, not automatically granted tax exception

2. Compare yield to that of after tax securitiesa. Tax free benefit= tax free yield/(100%- investors tax rate)

i. What corporate bond must yieldii. Muni yield always less than corporate yield

3. Expenses associated with purchasing or holding muni bonds are not deductiblea. Except banks= max 10m, can deduct 80% of expenses

V. Municipal Securities Rulemaking Board (MSRB)a. Established 1975 governs issue and trade of municipal securities

i. Does not regulate issuersii. No authority to enforce rules

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1. NASD= dealer2. Office of Currency= national banks3. FRB= non-national banks that are FDIC members4. FDIC= non-national banks that are not FDIC members

b. Three categories of rules: legal definitions, administrative rules, general rules and regulationsc. Regulations:

i. G-1= bank has separate department for municipal securitiesii. G-1 and 2= Must qualify by exam (Series 52 or 7)

1. Clerical workers exempt2. If fail can not take for 30 days3. 90 day apprenticeship= may not sell municipal securities

a. May with dealersb. No commission but have salaryc. Must pass with in 180 days

iii. G-6= broker/dealer must maintain blanket of fidelity bonds1. Dollar amount varies for firm size

iv. G-7= dealer must keep file of information about associated personv. G-10= if complaint, must have complaint file and deliver MSRB brochure to customervi. G-11= syndicate must establish priority of orders and conditionsvii.G-12= uniform practices in settling transactions

1. Cash trade= trade day2. Regular way= 3rd business day after trade3. Subject to good delivery requirements

a. If rejected seller must still sellb. Bearer bonds= 1k or 5kc. Registered= 1k with 100k maxd. Mutilated certificates= not good delivery unless validated by issuere. Partial call= not good delivery unless identified when called

viii.G-13= dealers only publish bona fide bids or nominal if identified1. If joint account, no dealer may distribute a quote indicating more than one market

ix. G-15= confirms of trade sent at or before completion with required information (listed previously)

x. G-16= each broker dealer/dealer examined once every 2 yearsxi. G-17= dealers must deal fairly with everyonexii.G-18= dealers must obtain reasonable pricesxiii.G-19= municipal securities firm must obtain financial data about client for suitable

recommendation1. Can not recommend with out information

xiv.G-20= dealers can not give gifts of greater than $100xv. G-21= truthful advertising

1. Principal must approve advertisingxvi.G-22= clients must be informed of conflicts of interestxvii.G-23= firm acting as financial advisor must get approval if acting as underwriter

(depends on type of bids, listed previously)xviii.G-24= dealers may not use client information to solicit tradesxix.G-25= may not misuse securities held for other people

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1. May not guarantee against lossa. Put options/repurchase agreements not considered guarantee

xx. G-27= firms must designate principal to supervise representatives1. Principal must approve: new accounts, every transaction, customer complaints,

correspondence2. Broker/dealer must have FinOp who maintains books

xxi.G-28= dealer employee opens account with another firm, firm opening must notify employer in writing and send confirmations

xxii.G-29= every office must have and provide copy of MSRB rulesxxiii.G-30= markups/markdowns mast be reasonable (take into account previously listed

factors)xxiv.G-31= broker/dealer may not solicit business from investment company based on

broker/dealer’s record of sales in shares of investment companyxxv.G-32= when new issue delivered to customer, OS must accompany it and disclose

information (depends on underwriting listed previously)xxvi.G-33= dealers must calculate accrued interest

1. 360 days year, 30 day monthsxxvii.G-37= municipal firms may not engage in municipal securities business with an issuer

for 2 years after political contribution is made1. Only negotiated underwriting2. Not apply to firms3. $250 or less is acceptable

xxviii.G-39= telemarketers may not call before 8am or after 9pm and must disclose name, firm’s name, firm’s #, and disclose face that it is a solicited phone call

1. Does not apply to established customerVI. Tracking Municipal Securities

a. Listed in financial publicationsi. The Bond Buyer and Wall Street Journal

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Chapter 4- Options

I. The Options Contracta. Option= right to buyer and obligation to seller

i. Terms standardized by Office of the Comptroller of the Currency (OCC)ii. Types: call and putiii. Classes= all calls or puts of one issueriv. Series= all options of one issuer, same class, exercise price and expiration monthv. American style= exercise at any time before expiration datevi. European style= exercise on expiration datevii.Equity options contract contain 100 shares

1. Two parties:a. Buyer= long= holder= owner

i. Rights to exerciseb. Seller= short= writer

i. Obligation at exerciseviii.Three specifications:

1. Underlying instrument= anything fluctuating in valuea. Derivative security= value derived from underlying instrument

2. Price= price at which exercising will occur3. Expiration= expire on specified date

a. Saturday following 3rd Friday of monthb. 9 monthsc. Long-term equity anticipation security (LEAP)= 30 months

ix. Bought or sold during life cycleb. Calls and Puts

i. Calls1. Buy= go long

a. Buyer owns right to buy2. Sell= go short

a. Buyer has obligation to sell3. In-the-money= market price > strike price

a. Not necessarily breaking even4. At-the-money= market price = strike price5. Out-of-the money= market price < strike price6. Intrinsic value= in the money amount

a. Market price- strike priceb. If out/at-the-money no intrinsic value

7. Parity= premium = intrinsic value8. Breakeven point= strike price + premium

ii. Puts1. Buy= go long

a. Buyer owns right to sell2. Sell= go short

a. Seller has obligation to buy3. In-the-money= market price < strike price

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4. At-the-money= market price = strike price5. Out-of-the-money= strike price > market price6. Intrinsic value= in the money amount

a. Strike price- market priceb. If out/at-the-money no intrinsic valuec. Buyers prefer, sellers do not

7. Breakeven point= strike price – premiumc. Options premiums= price of option contract

i. Buyer= ask/offerii. Seller= bidiii. Premium reflects: intrinsic value and time value

1. Time value= market’s perceived worth of the time remaining to expiration2. If option out of the money, price only reflects time value3. Further expiration= greater time value

a. Closer to expiration, option value decreasesiv. Options quotes= per share basis

1. Total premium= quote*100a. Contracts subject to stock splits and dividends

i. May have more than 100 sharesv. Factors affecting premium: volatility, intrinsic value, time until expiration, interest rates

1. Higher volatility= greater price movementvi. Cash paid out= debit (DR)vii.Cash received= credit (CR)

II. Basic Options Transactionsa. Buying calls= bullish, long

i. Speculation= upward movement in stock priceii. Deferring a decision= lock in purchase price until option expiresiii. Diversifying holdings= buys calls on variety of stocks and profit from any rise in the

option premiumsiv. Protection of a short stock position= insurance policyv. Maximum gain= unlimitedvi. Maximum loss= premium paid

b. Writing calls= bearish, shorti. Speculation= downward movement in stock priceii. Increasing returns= additional income from writing calliii. Locking in sale price= unrealized profit in a stock and interested in selling it can write a

call at a strike price to lock in that profitiv. Protection of a long stock= premium collected provides limited downside protectionv. Maximum gain= premiumvi. Maximum loss= unlimited

c. Buying puts= bearish, longi. Speculation= downward movement of stock priceii. Deferring a decision= lock in sale price and protect its appreciation potential iii. Protection of long stock position= insuranceiv. Maximum gain= strike price- premiumv. Maximum loss= premium

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d. Writing puts= bullish, shirti. Speculation= upward movement of stock priceii. Increasing returns= income from writing putsiii. Buying stock below its current price= premium received can offset cost of stock when put

is exercisediv. Maximum gain= premiumv. Maximum loss= strike price- premium

e. Choices at expiration= owner of option has 3 choicesi. Exercise the option

1. If in the money2. Call= buy stock3. Put= sell stock4. Settle regular way5. Option Can no longer be traded

ii. Let option expire1. If worthless

a. At/out-of-moneyiii. Sell option contract

1. For current premium a. Profit/loss= based on increase or decrease of premium option

2. Closing transactions= option sold for premium amounta. Long:

i. Open= buy contractii. Close= sell contract

b. Short:i. Open= sell contractii. Close= buy contact

III. Using Options to Protect a Positiona. Long stock position

i. Offset by purchasing a put or writing a call1. Full protection= best protection is buying put

a. Eliminates downside and stock only reduced by price of calli. Breakeven= stock price + putii. Maximum gain= unlimitediii. Maximum loss= (stock price – exercise price) + premium

2. Partial protection= writing a calla. Generates income and reduces stocks upsideb. Only protected amount of premium received

i. Breakeven= stock price - premiumii. Maximum gain= (exercise price- stock price) + premiumiii. Maximum loss= stock price – premium

b. Short stock positioni. Offset by purchasing a call or writing a put

1. Full protection= best protection is buying calla. Eliminates risk

i. Breakeven= short stock price – premium

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ii. Maximum gain= short stock price – premium iii. Maximum loss= (exercise price- short sale price) + price of

premium 2. Partial protection= writing a put

a. Writing a covered put= limits investor profit and subject to unlimited lossi. Breakeven= short stock price + putii. Maximum gain= (stock price – exercise price) + premiumiii. Maximum loss= unlimited

c. Collar= investor hedge downside risk on long position for no out-of-pocket classi. Buy a put and sell a call

d. Ratio call writing= selling more calls than the long stock position coversi. Premium income, unlimited risk

IV. Multiple Option Transactionsa. Spreads= purchase one option and sale of another in same class

i. Call= long call and short callii. Put= long put and short putiii. Price/vertical spread= different strike prices but same expiration date

1. Most commoniv. Time/calendar/horizontal spread= different expiration date with same strike price

1. Little volatilityv. Diagonal spread= options differ and both time and pricevi. Debit spread= long position premium > short position premiumvii.Credit spread= short position premium > long position premiumviii.Debit call spread= reduce cost of long option position

1. Bullish2. Breakeven= net premium to lower strike price3. Maximum gain= difference between strike prices – net credit4. Maximum loss= net debit5. Wants spread to widen

a. Spread= difference between 2 premiumsix. Credit call spread= reduce risk of short option position

1. Bearish2. Maximum gain= net credit3. Maximum loss= (difference between strike prices) – net debit4. Breakeven point= between the two strike prices5. Wants spread to narrow

x. Debit put spreads= reduce cost of long put position1. Bearish2. Breakeven= Higher strike price – net premium3. Maximum gain= difference between strike prices – net credit4. Maximum loss= net debit

xi. Credit put spreads= reduce risk of short put position1. Bullish2. Breakeven= between the two strike prices3. Maximum gain= net credit4. Maximum loss= (difference between strike prices) – net debit

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xii.Market attitude= determined by the option that is more costly of the 21. Calls= lower strike price is higher premium2. Put= higher strike price is higher premium

b. Straddle= call and put (both must be long or short) with same strike price and expiration monthi. Long straddle= expects volatile stock price but is uncertain of direction

1. Buy call and put2. Breakeven= strike price -/+ combined price of premiums

a. Two breakeven points3. Maximum gain= unlimited4. Maximum loss= combined price of premiums

ii. Short straddle= expects price to not move 1. Sell call and put2. Breakeven= strike price -/+ combined price of premiums

a. Two breakeven points3. Maximum gain= combined price of premiums4. Maximum loss= unlimited

iii. Combination= call and put with different strike prices or expiration months or both1. Cheaper than long straddles if both options are out of the money2. Breakeven= strike price -/+ combined price of premiums

a. Two breakeven points3. Long= makes money if stock outside breakeven points4. Short= makes money if stock is inside breakeven points

V. Nonequity Optionsa. Index options

i. Broad based= movement of entire marketii. Barrow based= movement of market segmentiii. Features:

1. Multiplier= of $100a. Total premium= $100* option priceb. Total dollar value of index= $100* strike price

2. Trading= stops at 4:15 3. Exercise= settles in cash next business day4. Settlement price= based on closing value of index on day of exercise5. Expiration dates= Saturday following third Friday

iv. Strategy= speculates movement of market1. Portfolio insurance= use of index puts as security

a. Systematic/systemic risk= risk of decline in marketv. Beta= volatility of stock relative to market

1. 1= stock has same volatility of market2. Beta > 1= stock moves more than market3. Beta < 1= stock moves less than market

b. Interest rate options= based on yields of T-bills, T-notes, and T-bondsi. Quoted in points ii. European-style exercise

c. Foreign currency options (FCOs)= performance of currencies relative to US dollarsi. Features:

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1. Strike prices= quoted in US cents2. Premiums= quoted in cents per unit

a. Exception= Japanese yen, quoted in 100th of a cent3. Contract size= large because for institutions4. Trading= Philadelphia Stock Exchange (PHLX)5. Expiration date= Friday preceding the third Wednesday6. Settlement= next business day7. American or European style 8. Strategies:

a. Importers buy calls to hedgeb. Exporters buy puts to hedgec. Options on US dollar not available

i. Exporters should buy calls on won currency VI. Option Market Functions

a. Trade on major exchanges and OTCb. Listed options= exchange traded

i. Standardized strike prices and expiration datesc. Features:

i. Trading times= 9:30 to 4:02ii. Expiration= expire Saturday following third Fridayiii. Settlement= settle next business day

1. Stocks as a result of exercise settle regular wayiv. Automatic exercise= in the money by at least $.25

1. Member firms= $.15v. Position limits= 75,000 on the same side of the market

1. Apply to individuals and representativesd. Options trading personnel= most heavily traded on Chicago Board of Options Exchange (CBOE)

i. Order book official (OBO)/board broker= employee of exchange that keeps limit order books and ensures option process moves smoothly

ii. Market makers= registered with exchange and trade for their own accountsiii. Floor brokers= firm’s representatives on flooriv. Order routing system= computerized order routing system used to route customer orders

1. OSS used on CBOEe. Options clearing corporation (OCC)= clearing agent for listed options

i. Determines when contracts should be offered, at what strike prices, and expiration months

1. Market determines premiumsii. Guarantee exercise

1. Assign exercise notice on random basis2. Options traded without certificate

iii. OCC Options Disclosure Document= explains option risks, strategies, and rewards at or before account approval

1. Account must be approved by branch manager2. Customer must sign option agreement no later than 15 days after

a. If they fail to do so then customer can only make closing transactions

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iv. Senior Registered Options Principal (SROP)= developing and enforcing programs provided for sales supervision of customer accounts

v. Compliance Registered Options Principal (CROP)= reviewing firm’s compliance1. Approves any advertising

vi. Option contracts adjusted for stock splits, dividends, and rights offering1. Not adjusted for cash dividends2. Even splits= new contracts created

a. Split ending in 13. Uneven split/fractional split= no new contract, just larger amount of shares

a. Split not ending in 1vii.Opening transaction= establishes position

1. If sale of option must indicate if covered or uncoveredviii.Closing transaction= eliminates positionix. Open interest= number of contracts outstanding

1. Higher open interest= higher liquidity2. Closer to expiration the less the open interest

x. Market manipulation of options is unlawful and occurs when many large positions are at stake

1. Capping= entering sell orders for a stock to keep it from rising higher than strike price

2. Supporting= purchasing orders in stock to prevent it from falling lower than the strike price

3. Pegging= any activity intended to keep stock price from moving4. Front running= taking an option position when a firm has received a block order

but before block order is enteredVII. Tax Rules for Options

a. Capital gains taxes applyi. LEAPs writers must report short-term capital gains at expiration

b. Buy a calli. Option expires= capital lossii. Option exercised= strike price + premium= cost basisiii. Position closed= capital gain or loss

c. Sell a calli. Option expires= capital gainii. Option exercised= strike price + premium= sale proceedsiii. Position closed= capital gain or loss

d. Buy a puti. Option expires= capital lossii. Option exercised= strike price - premium= sale proceedsiii. Position closed= capital gain or loss

e. Sell a puti. Option expires= capital gainii. Option exercised= strike price - premium= cost basisiii. Position closed= capital gain or loss

f. IRS does not allow use of option to postpone sale of stock for purpose of generating long term capital gains

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g. Married put= customer buys stock and put option as a hedgei. Cost basis added upward by premium paid

1. No capital loss on put

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Chapter 5- Customer Accounts

I. New Accountsa. New accounts form= required when new account opened

i. Contains: name(s), date of birth, address, phone number, SS#, occupation, citizenship, annual income, net worth, investment objectives, bank/brokerage references, if employee of another broker/dealer, how account was acquired, person who has authority to make transactions, signature of representative

1. Customer signature not required2. Required by NASD and NYSE

a. Also require is more than 10% stockholder in public companyb. MSRB requires tax status

ii. Accounts may be opened by legally competent person above age of majority iii. Must be approved by principal

1. Can be done after first tradeiv. NYSE Rule 405= know your customer

1. Can only give recommendations if it is suitablev. USA Patriot Act of 2001= verify identity of new customer and maintain records that

verify identity and determine is person is on known terrorist list1. Must obtain: date of birth, name, address, SS# 2. Verification through drivers license

vi. Firm must give customer copy of account form with in 30 days1. Include statement for corrections2. Updating must occur every 36 months

vii.Regulation S-P= firm must provide privacy notice to customerviii.Principal types of ownership: individual, joint, corporate, partnership

1. Trading authorization/power of attorney= Accounts opened with someone other than the owner having authority to buy and sell securities

a. Discretionary= representative given written authority from customer to make trading decisions

b. Custodial= adult who acts on behalf of childi. Beneficial owner

c. Fiduciary= third party legally appointed to carefully manage account on behalf of another person

b. Opening new accounts= must establish payment and one of the delivery instructions:i. Transfer and ship= securities registered in customer’s name and shipped to themii. Transfer and hold in safekeeping= securities registered in customer’s name and the

broker/dealer holds them for safekeepingiii. Hold in street name= securities registered and held by broker/dealer, but customer is

beneficial owneriv. Delivery vs. payment (DVP)= securities delivered to a bank (COD) broker/dealer verifies

arrangement and customer notifies bank of any securities transactionsc. Customer gives firm specific mailing instructions when opening account

i. Firm is permitted to hold customer mail if traveling for 2 months domestically and 3 months abroad

d. Types:

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i. Cash/special= customer pays in full for securities1. Must be opened as cash accounts: IRAs, Keoghs, tax sheltered annuities,

corporate accounts, custodial accountsii. Margin= customer borrows money for investing

1. Margin= minimum amount of cash or marginable securities a customer must deposit to buy securities

2. Most common before 1929 crashiii. Corporate= business must establish legal right to open account, identify limitations, and

establish a who will represent the business in transactions1. Firm must obtain corporate charter

a. Proof firm existsiv. Fee based= charge single fee like a % of assets

1. Not wrap accounta. Wrap account= firms provide services

2. Customer has moderate level of trading3. Must have disclosure agreement

e. Special account situationsi. Numbered accounts= customer request account only identified by #

1. Sign form certifying he owns account2. Celebrities/athletes

ii. Multiple accounts= if both cash and margin then considered one account1. If customer wants another account must disclose to representative that no one else

has any interest in that account and each account guarantees the other iii. Account transfers= transfer account from one representative to another and instructs the

new broker/dealer1. Firm has 3 days to validate instructions then 3 more days to complete transfer2. Account frozen for 7 days (except options) after validation

f. Opening accounts for other brokers’ employeesi. NASD:

1. Margin= notification2. Cash= notification3. Duplicate confirm= upon request

ii. NYSE: 1. Margin= prior permission2. Cash= prior permission3. Duplicate confirm= required

iii. MSRB:1. Margin= notification2. Cash= notification3. Duplicate confirm= required

II. Types of Accountsa. Account registration= when account opened it is registered in one or more person’s name

i. Single= one beneficial owner who controls investments and requests distributions1. Transfer on death (TOD)= transfer account to named beneficiary at death

a. Taxes apply if applicableii. Joint= 2 or more adults are named as co-owners, each with some control

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1. Joint account agreement must be signeda. Require signatures of all ownersb. Distributions made payable and endorsed by all ownersc. Mail to single address

2. Tenants in common (JTIC)= deceased tenants interest goes to estatea. Each party must specify %

3. Joint tenants with right of survivorship (JTWROS)= deceased tenants interest is passed to surviving tenants

4. All parties have undivided interestiii. Partnership= unincorporated association of 2 or more individuals

1. Must complete partnership agreement disclosing who can make transactionsa. If margin account must disclose limitations

iv. Fiduciary/custodial accounts= person other than owner initiates trades1. Trust account= securities in trust for one person but managed by someone else

a. Manager is fiduciaryi. Fiduciary= any legal person appointed to represent another personii. Has no legal control over themiii. Trades must be compatible with investment objectives iv. Prudent man rule= fiduciary must make safe decisionsv. May not share in accounts profits

1. May charge a feeb. Securities must be registered to show custodial relationship is evidentc. Must include trust agreement detailing limitations

i. Rules: proper authorization must be given, no speculative investments, no margin accounts (unless authorized), prudent man rule, list of approved securities

v. Power of attorney= person not named on account to have trading power must file written authorization

1. Full= deposits or withdrawals and investment decisions2. Limited= some but not total control

a. Buy or sell securities, no withdrawalsb. Discretionary accounts= preapproved authority for representative to make transactions with out

approvali. Discretion= what security, # of shares, and whether to buy or sell

1. Does not apply for investment timinga. Market held order

ii. Discretionary authority= filing trading authorization1. Limited power of attorney for broker/dealer

iii. Regulation:1. Discretionary orders must be identified2. Partner must approve each order

a. Not necessarily before 3. Must keep record4. No churning5. Must have supervisor

III. Death of an Account Holder

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a. Mark account deceasedi. Freeze assets until instructions are received from executor of estate

1. Cancel open orders2. Needed documents to release assets: death certificate, inheritance tax waiver, and

letters testamentary3. JTROW account not frozen

a. Documents still required to transfer securities4. In partnership member needs written authority from other partners before

executing any ordersii. Discretionary authority ends

IV. Uniform Gifts to Minors Act (UGMA) Accountsa. Adult to act as custodian to minorb. Any kind of security or cash may be givenc. Characteristics:

i. Donor may not take back gifts and minor may not return gift1. Indefensible title2. When minor reaches age of majority property is transferred

ii. Custodian= manages securities given to minors in account1. Has right to: trade, liquidate, or hold securities and exercise rights2. May use assets in account in any way deemed proper for minor support (i.e.

education)3. Account may only have 14. Minor may have more than 1 account5. Custodian may be custodian for more than 1 account6. Donor can be or appoint custodian7. Parents have no control (unless custodian)

iii. Opening UGMA account= contains custodian’s name, minor’s name & SS#, and state registered in

iv. UGMA securities are registered in custodian’s name for benefit of minorv. Fiduciary responsibility= custodian is charged with

1. Limitations: cash accounts only, must reinvest all cash proceeds, high risk securities inappropriate, options must be exercised or sold, custodian may not grant trading authority to 3rd party, may loan money to account (but not borrow it), custodian can be reimbursed for expenses\

vi. Minor must file annual income tax report and pay taxes every year at parents tax rate until 14

1. At 14 taxed at minor’s tax bracket2. Parent’s responsibility

vii. If beneficiary dies then securities go to the minor’s estate viii.If custodian dies donor or courts appoint new custodianix. Transfer can be delayed until minor reaches 25 (21 in some states)

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Chapter 6- Margin Accounts

I. Types of Margin Accountsa. Long margin account= purchase securities on money borrowed and pay interest until loan is

repaidb. Short margin account= stock is borrowed then sold shortc. Advantages for customers:

i. Purchase more securitiesii. Greater leverage means greater rate of return

d. Advantages for broker/dealers:i. Loans generate interest incomeii. Trade larger positions because of increased trading capital generating higher commissions

e. Margin agreement= three part agreement that customers must signi. Credit agreement= terms of credit extended by broker/dealer

1. Includes interest computation and how rates may changea. Broker call rate= rate at which variable rate paid is based on

ii. Hypothecation agreement= permission to pledge securities as collateral 1. Rehypothecates= after customer pledges securities to broker/dealer, broker/dealer

re-pledges them as collateral for loan from banka. Brokers are limited to pledging more than 140% of customer’s debit

balanceb. Securities held in bank, bank loans money to broker/dealerc. Broker/dealer= nominal/named ownerd. Customer= beneficial owner

iii. Loan consent form= permission to loan customer margin securities to other customers for short sales

1. Can only commingle securities with every customer’s consentiv. Customers must be provided with risk disclosure

1. Customers not entitled to what securities will be sold if maintenance call is not met

2. Customers can lose more than they deposit3. Customers are not entitled to an extension4. Firms can increase margin without notice

f. Regulation T= customers must deposit 50% of market value of securitiesi. Marginable securities= what securities can be purchased on margin

1. Can be used: stocks on exchange, NASDAQ, non-NASDAQ OTC stocks approved by FRB

a. LEAPs must have 75% maintenance requirement2. Can not be used: options, rights, non-NASDAQ OTC stocks not approved by

FRB, insurancea. If writing option the premium received reduce margin requirementsb. Option spreads customers must deposit maximum loss

3. Can not be bought on margin but can be used as collateral after 30 days: new issues, mutual funds

4. Exempt securities: T-bills, T-notes, T-bonds, government agency issues, municipal securities

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a. Subject to firms requirementsii. Margin= amount of equity that must be deposited to buy securities in margin account

g. Initial requirement= minimum amount of equity in 1st purchase i. Regulation Tii. May not be less than 2k

1. If initial purchase < 2k then full amount of securitiesa. If short margin account then no exceptions

h. Deposit must be made in cash or marginable securities if payment is late then file for extensioni. If no extension firm must sell securities on 6th business day and freeze the account for 90

days II. Margin Accounting

a. Must meet minimum requirements after marking to marketb. Long margin accounting

i. Long market value (LMV)= current market value of stockii. Debit register (DR)= amount of money borrowed by customer

1. Never changesiii. Equity (EQ)= customer’s net worth in margin accountiv. LMV-DR= EQv. LMV DR

= B/SEQ

1. If LMV changes then EQ changes by same amountvi. Maintenance requirement= 25% by NYSE/NASD

1. Always based on new market valuea. Same with Regulation T

2. If below then maintenance margin calla. Customer must make deposit to bring account back to minimumb. If not made then securities are liquidated in order bring account back to

minimumc. Value securities can fall before margin call

i. Market value maintenance formula= DR/.753. House minimum may be greater then 25%

vii.Restricted account= equity in account is less than Regulation T but greater than minimum maintenance requirement

1. 50% must be put up to purchase additional securities2. Customer must deposit 50% cash value of securities to withdraw them 3. If securities sold then half of the proceeds must be retained to reduce debit

balancea. Retention requirementb. 50% of proceeds credited to SMA

viii.Excess equity= amount of equity exceeding Regulation Tix. Special memorandum account (SMA)= line of credit customer can borrow from or

purchase securities with1. $1 increase in market value= $.50 increase SMA

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2. Equal to the greater of excess equity or amount already in SMAa. Increase when market value increasesb. Does not decrease when market value declines

3. If excess equity:a. LMV DR SMA=

EQ EE=

4. Can still be used in restricted account as long it does not bring account below minimum

5. Non-required cash deposits= credited to SMAa. Equal to half the amount of depositb. Reduces DR

6. Dividends= credited to SMA a. If customer wants to remove dividends must do so in 30 days

i. If not applied against debit balance b. Stock dividend not credited

7. Stock sold= 50% of proceeds credited to SMA8. Can be used to used to withdraw cash by borrowing against SMA

a. $1 SMA= $1 borrowedb. Reducing SMA and EQ and increasing the DR balancec. As long as it does not cause maintenance call

9. Can be used to meet initial margin requirements on new securitiesa. Gives investor buying powerb. $1 of SMA= $2 of stockc. Reduces SMA and increasing the DR balance and LMV

c. Pattern day trader= executes 4 or more trades in 5 daysi. Minimum equity= 25kii. Minimum maintenance= 25%iii. Buying power= 4 times maintenance margin excess

1. Maintenance margin excess= equity in account > minimum maintenancea. Regular buying power is 2 times SMA

iv. Guaranteed accounts are prohibited1. Cross guarantee= where customer uses money in his account to meet any margin

callsv. Approval: provide risk disclosure and approve account for day trading strategy

d. Short selling margin requirements= short selling always done through margin accounti. Dividends paid to owner of stockii. Short market value (SMV)= current market value of stockiii. Credit register (CR)= amount of money in customer account + margin deposit

requirement1. Security to broker/dealer so they will have cash if value of securities increases2. Does not change

iv. Equity (EQ)= customer’s net worth in margin accountv. CR-SMV= EQ

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vi. CR SMV = B/SEQ

vii.Minimum maintenance requirement= greater of 30% or $5 per share1. Maintenance call < 30%2. If stock trading under $5 then greater of 100% of SMV or $2.50 per share

viii.Excess equity= equity above Regulation Tix. Restricted= less than Regulation T but greater than minimum maintenancex. Maximum market value short sale position can increase before maintenance call

1. Short market value at maintenance= CR/1.3xi. SMA is same as long margin accounting

e. Combined account= has both long and short positionsi. Margin requirements computed separately and added together

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Chapter 7- Issuing Securities

I. The Regulation of New Securitiesa. The Securities Act of 1933= regulates new issues of corporate securities and requires issuers to

provide investors with enough information to make buying decisionsi. Filed with SECii. Published prospectus

1. Ensure public informed iii. Protect public:

1. Require registration of new issues distributed interstate2. Issuer provide fair and full disclosure3. Make available all necessary material4. Regulate underwriting and distribution5. Provide criminal penalties for fraud

iv. Prohibits any fraudulent activity involved in underwritingb. The Securities Exchange Act of 1934= addresses secondary trading of securities

i. Created SECii. Amended by Maloney Act= self-regulatory bodies to police industry

1. National Securities Association of Securities Dealers (NASD)= regulates OTCII. Three Phases of an Underwriting

a. Issue must file registration statement with SECi. Discloses material information about issue

1. Includes prospectus2. Must contain: description of business, names and addresses of officers, officer’s

salaries and amount stock own, individual investors who own > 10%, capitalization (debt and equity), how proceeds will be used, if the company is involved in any legal proceedings

ii. Underwriter may assist in the process1. Accuracy is still responsibility of issuer

iii. Signed by CEO, CFO, CAO, and majority of BODiv. All information becomes public once filed

b. Cooling-off period= following the filing with the SEC period begins for 20 daysi. Usually takes longer than 20 daysii. Deficiency letter= if registration needs revision

1. Cooling-off period resumes after correctediii. Stop order= all underwriting activities ceaseiv. Preliminary prospectus/red herring= allows underwriters to gauge investor interest

1. Made to any investor who expresses interest between registration and approval2. Sales, taking orders, and advertising are prohibited

a. May publish tombstone advertisementi. Shows anticipated gross proceeds of issuerii. Announces new issueiii. May be before or after effective dateiv. Not required

3. Offering price and effective date are missing4. Underwriters have due diligence meeting at the end of the cooling-off period

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a. Examines: use of proceeds, financial analysis, determine company’s stability, determine if risk is reasonable

c. Effective date= date at which registration become effectivei. Final prospectus= issuer amends preliminary prospectus to include offering price and

spread1. Orders may then be taken2. Must be accompanied with all sales3. Must include: description, offering price, discounts, offering date, use of

proceeds, description of underwriting, statement that price may be stabilized, history, management description, financial information, legal opinion about corporation, SEC disclaimer

4. SEC review does not guarantee accuracy, just clears it for distributiona. Prospectus delivery requirement= final prospectus delivered to buyer in

secondary market for specified timei. IPOs= 25 days if on exchange or NASDAQ

1. 90 days for pink sheetsii. Additional offerings= none for exchange or NASDAQ

1. 40 days for pink sheetsIII. The Underwriting Process

a. Underwriter= broker/dealer specializes in investment banking and distribution of new securitiesi. Advise issuer based on market conditions and tax considerationsii. Underwriting syndicate= group of underwriters

1. It is the normb. Investment banking= underwrites new issues

i. Functions: advising companies on how to raise long-term capital, distributing new securities, buying securities from issuer and reselling, help company comply with law

c. Participantsi. Issuer= party selling securities to raise money

1. Responsible for filing registration statement with SEC and states where they will sell (blue-skying) and negotiating security price and spread

ii. Underwriter= assists in registration and distribution of issuer’s securities1. Considerations:

a. Stocks or bonds= determining cheapest price of capital b. Tax consequences= interest is tax deductible and dividends are after-tax

payoutsc. Money-market financing= short-term instrumentsd. Capital-market financing= long-term instruments

2. Required to be NASD member for nonexempt corporate securitiesd. Types of offerings= who is selling securities and if company is publicly traded

i. New issues= companies going public sell common stock for first time in an initial public offering (IPO)

ii. Additional issues= new securities issued by company already publicly owned 1. Can also be classified as final distribution of proceeds

iii. Primary offering= proceeds of underwriter go issuing corporation1. Any time or amount

iv. Secondary offering= major stockholders selling portion of their stock

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1. Underwriter proceeds to stockholderv. Split offering (combined distribution)= combines primary and secondary offeringvi. Shelf offering (Rule 415)== issuer registers new securities without selling the entire issue

at once1. Sell portions over 2 year period2. Both debt and equity securities

e. Public offering= securities sold to public through one or more broker/dealersf. Private placement= securities sold to private investor

i. Institutional investorsii. No solicitation to publiciii. Exempt from registration requirements

g. Underwriting sequencei. Forming syndicate

1. Competitive bid= syndicate assembled first and work together to arrive at bida. Standard for municipal securities

2. Negotiated underwriting= syndicate formed after issuer and underwriting manager have negotiated the terms

a. Terms include amount, price, feesb. Standard for corporate securities

ii. Pricing the new issue= underwriter advises issuer on best price1. Considerations: public interest, market conditions, price syndicate member will

accept, P/E ratios of similar companies, dividend payment record, debt ratio2. Determined by effective date

iii. Stabilizing price= underwriter bids on securities where supply is higher than demand1. Price may be at or below market price

i. Pegging/fixing= bidding price higher than market value1. Illegal

2. Not allowed after sold outa. Syndicate penalty bid= fine if syndicate member’s client turn in shares

after sold out 3. If does not work, underwriter may pull public offering price (POP) and let market

find price levelIV. Underwriting Syndicate

a. Underwriter agreement (UA) contract that establishes relationship between issuer and underwriters

i. Terms and conditions upon which issuer is required to sellb. Underwriting/syndicate manager= investment banker that negotiates with issuer

1. Directs underwriting process2. May have more than 1

c. Syndicate members make financial commitment to bring securities to publici. Firm commitment= underwriters purchase securities from issuer and distribute on agreed

amount of issue (participation or bracket) 1. Syndicate agreement/letter= describes allocation of profits and responsibilities

a. Details commitment and liabilityb. Designates syndicate manager and power he has

ii. Financial liability

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d. Selling group= enlist other firms to help distribute securitiesi. Acts as agent with no commitment to buy

1. No financial liabilityii. Syndicate manager’s responsibility to decide if to use oneiii. Selling group agreement contains: statement that manager acts for all, amount each

selling group will be allocated, tentative public offering price, provisions on how and when payment should be made to managing underwriter, legal provisions

V. Types of Underwriting Commitmenta. Firm commitment= underwriter contacts with issuer, selling investors, or both to buy securities at

a price and datei. Letter of intent (LOI)= where terms outlined inii. Most widely usediii. Losses prorated among membersiv. Market-out clause= specifies conditions which offering may be cancelled

1. May abort if adverse event occursa. i.e. death of CEO

2. May not abort if nonmaterial event occurs that does not affect investment qualitya. i.e. new government law

b. Standby= when stockholders do not exercise preemptive rights in additional share offering underwriter will purchase all unsold shares

i. Firm commitmentii. Issuer assured of selling all shares

c. Best efforts= buy securities from issuer as agent, not principali. No risk for underwriterii. All or non (AON)= underwriter must sell all shares or cancel underwriting

1. Funds held in escrow until final dispositioniii. Mini-max= underwriter must find enough buyers to support minimum but can expand to

maximum once minimum is met1. Funds held in escrow until final disposition

d. Compensationi. Underwriter proceeds= price issuer receivesii. POP= price investors payiii. Underwriter spread consists of:

1. Manager’s fee= for negotiating deala. 10%-20% allocations of fees

2. Underwriting fee= for assuming riska. 20%-30% allocations of fees

3. Selling concession= for placing securities with investorsa. 50%-60% allocations of fees

iv. Firm commitment earns larger spread than best effortsv. Higher marketability= lower spreadvi. Stable stock has lower spread than volatile stockvii.Larger offer size= lower cost per-share

VI. Exemptions From the Securities Act of 1933a. Either because of their credit worthiness or because another regulatory agency has jurisdiction

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i. Includes: US government securities, muni bonds, commercial paper, bankers’ acceptance notes < 270 days, insurance policies, fixed annuities, national and state banks, building and loan (S&L) securities, non-profit anticipation notes

ii. Variable annuities must be registerediii. Securities of bank holding companies not exempt

b. Exempt transactions:i. Regulation A (small offerings)= corporate offerings less than 5m in a 12 month period

1. Issuer files notice of sale/offering circular with SEC to provide to investorsa. Cooling off period of 20 days between filing and effective dateb. Investors must receive final offering circle 48 hours before sale

ii. Regulation D (private placements)1. No registration if privately placed with:

a. Accredited investor i. Net worth > 1mii. Annual income > 200K in each of the last 2 years and has

reasonable expectation for that to continueb. Maximum of 35 investors

2. No limit on capital raised3. Investor must sign letter stating it will hold stock for investment purposes only

a. Lettered/legend stock= private placement stocki. Can’t be transferred with out registration

4. Restricted iii. Rule 147 (Intrastate offerings)= offering that take place in 1 state exempt if:

1. Issuer’s principal office in that state2. 80% of income, assets, and offering proceeds are in that state3. Underwriter is resident of that state and has office there4. All purchasers are residents of that state

a. May not sell stock to resident outside of state for 9 monthsiv. Rule 144= regulates sale of control and restricted securities stipulating holding period,

quantity limitations, manner of sale, and filing procedures 1. Control securities= owned by officers, BOD, or people who own more than 10%

of voting stocka. 10% counts immediate family membersb. Insiders are not allowed to short stock or invest in speculative options

i. May write callsc. Short-swig profits= insider profits in less than 6 months

i. Profits must go to company d. Insider trades must be reported with in 2 business days

2. Restricted securities= acquired by some means other than registered public offering

a. May not be sold unless held for 1 yeari. After 1 year sales subject to in any 90 day period an investor may

sell the greater of:1. 1% total outstanding shares of the same class2. Average weekly trading volume of the last 4 weeks

ii. After 2 years no restrictions for unaffiliated investors

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1. Volume limits still apply for insidersiii. Buyers not subject to any restrictions

3. Form needs to be filed no later than sale of stocka. Good for 90 daysb. Sales amounts < 10k or 500 shares no form needed

4. Current information must be made availablev. Rule 144a= nonregistered foreign and domestic securities sold to institutional investors

in US without holding period1. Buyer must be qualified institutional investor (QIB)

a. Minimum 1m in assetsvi. Rule 145= reclassification of securities, merger/consolidation, and transfer of assets must

be approved by stockholders1. Excludes stock splits and dividends

VII. Antifraud Regulations of the Acts ff 1933 and 1934a. No offering exempt from antifraud provisionsb. NASD Rule 2790= protect integrity of public offering price

i. Ensures:1. Members make bona fide public offering of securities at public offering price2. Members do not withhold securities for own benefit3. Industry insiders do not take advantage of their information

ii. Applies only to new issuesiii. Prohibits member firms from selling new issues to account with restricted persons

1. Restricted persons are: NASD members/employees, finders/fiduciaries, portfolio managers, any person owning more than 10% of member firm

a. Includes immediate family members 2. De minimus exception= interest of restricted persons in account does not exceed

10% iv. Spinning= allocating IPO shares to individuals who are in a position to direct securities

business to firm1. Why portfolio members are restricted

v. Before selling IPO written representation for account that shows account is eligible is required

1. Must be obtained 12 months before sale of new issue2. Held for 3 years

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Chapter 8- Trading Securities

I. The Regulation of Tradinga. The Securities Exchange Act Of 1943

i. Provides: SEC, regulation of exchanges and OTC, FRB regulates credit, registration of broker/dealers, net capital rules, regulates insider trading, regulates client accounts, customer protection rule, filing 10-k and 10-Q, regulation of officers/BOD/primary stockholders

ii. SEC if 5 commissioners appointed by the President and approved by the Senateiii. Requires exchanges files registration statements with SEC and by doing so exchanges

comply and help enforce rules1. Exchange must tell SEC of rules change

iv. Companies that list securities on exchanges on some OTC firms register with SEC II. Securities Markets and Broker Dealers

a. Securities markets= bought and sold in secondary marketi. Exchange/auction market= NYSE and other exchanges where listed securities are traded

1. Listed securities= listed on exchangeii. OTC/2nd market= where unlisted securities trade

1. Dealers connected by computers and telephones2. All municipal and government securities3. Divided into NASDAQ and non-NASDAQ (Pink Sheets)

iii. 3rd market/OTC listed/NASDAQ Intermarket= where exchange listed securities are traded OTC

1. All securities on AMEX and NYSE eligible if trades are reported to Consolidated Tape in 90 seconds

2. OTC market makers in listed securities effect 3rd market transactionsiv. 4th market= institutional investors trade large blocks of stock unassisted by broker/dealer

1. Listed and unlisted securities2. Through electronic communications networks (ECN)

a. Open 24 hours a dayv. Trading hours

1. NYSE/AMEX/OTC= 9:30-4a. Market makers remain open until 6:30

i. After hours less liquid1. Wider spread and greater volatility

b. Listed marketsi. Have central locationii. Double-auction market= floor participants compete to execute bidsiii. Specialists= dealers on stock exchanges

1. Prohibited from dealing directly with public2. Stocks assigned to specialists

c. OTC marketsi. No central location

1. Trading over phone, computer, and trading rooms across country2. Pricing system= market makers compete to post best bid and ask prices

a. Negotiated market

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ii. No stock assigned to a specialist1. Competing market makers

d. Quotes are in terms of bid and aski. Ask > bid

1. Spread= difference ii. Quote= 21.50-21.55 19 x 7

1. Dealer will buy 1.9k shares at 21.50 and sell 700 shares at 21.55e. Broker/dealer= firms engaging in buying and selling securities

i. Brokers= agents that arrange trades and charge commissions1. Not a market maker2. Must disclose role to client and amount of commission

ii. Dealers= principals that buy and sell securities from their own account and charge a markup

1. Called position trading2. May also buy from market maker and charge markup3. Net price= stock price + markup4. May make markets and take positions5. Must disclose role to client and markup

III. The New York Stock Exchange (NYSE)a. Handles 3/4s of all exchange transactionsb. Does not influence pricesc. Requirements= only companies of significant size

i. At least 1.1m shares publicly heldii. 2,000 stock holders each holding 100 or more sharesiii. NYSE reserves right to delist issuers if they fall below criteria

1. Or if they file bankruptcy, have low stock price or trading volumeiv. If company wants to delist than must be approved by BOD

d. Only NYSE member can trade on the floori. Floor/commission house brokers (CHB)= execute orders for clients and for their firm’s

accountsii. Two-dollar broker= execute orders when CHB is busy and charge commissioniii. Registered trader= trade from own accounts

1. If they accept public order than public order gets prioritya. May not execute own trades if public order unfilled

iv. Specialist= facilitate trading and maintain fair and orderly market1. Act is broker and dealer2. Acts as auctioneer

e. Auction/double auction market= buyers and sellers call out best bidsi. Best bid must be at least $.01 higher/lower than current best bidii. Trades awarded in order:

1. Priority= first 2. Precedence= largest3. Parity= random drawing

f. Rules 80A and 80B protect against rapid drops in DJIAi. Program trading and index arbitrage curbed if DJIA increases or decreases by 2% in

given day

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ii. 10% decline in 1 hour then 1 hour haltiii. 20% decline in 2 hours then 2 hour haltiv. 30% decline then halt for the day

g. Arbitrage= profit from temporary price difference between marketsi. Market arbitrage= security sells for 2 different prices in different marketsii. Convertible security arbitrage= convert bonds to stock and sell stock for profitiii. Risk arbitrage= for mergers, buy stock in company being acquired and short stock in the

acquiring companyIV. The Specialist

a. Role is to minimize price disparities by buying or selling stock from own inventoryi. Specialist is a market maker

1. May not buy stock for own account if it would compete with current market priceii. Responsibilities: maintain fair market, stand ready to sell/buy from own account,

maintain price continuity, avoid transacting business, file reports, keep books, trade from own account between bid and ask

iii. Specialist positioned at trading post1. Trading post= horseshoe shaped and surrounded by computer towers2. Any transactions must tale place in front of specialist stock is assigned to

iv. Stops stock= to guarantee a market order will be filled at current bid allowing CHB to go into crowd and find better price

1. Assures broker that he will not miss market2. Only for benefit of public order

v. Crossing orders= using 1 order to fill another1. 2 market orders for same stock, 1 buy and 1 sell for same amount of shares2. Must make sure there is not a higher bid first

V. Types of Ordersa. Market= executed immediately without restrictions and has priority

i. At current market priceii. Buy= executed at lowest market priceiii. Sell= executed at highest bid priceiv. Guarantees execution

b. Limit orders= limits the amount paid or received for securities i. Executed at specified price or betterii. May risk missing trade if market moves away from priceiii. Stock ahead= arranged in order received

1. If not filled, earlier order took precedentiv. Firms holding limit orders not trade ahead of these

1. Firm can not act as principal without filling that orderc. Stop/stop loss orders= protect profit if stock begins to move in wrong directions

i. Stop price= becomes market order once stock trades at priceii. Left with and executed by specialist

1. Orders not immediately executed put in specialists booka. Only round lots

iii. No guarantee that it will be executed at priceiv. Trigger= at or through stock pricev. Execution= stop order becomes market order and is executed at the next price

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1. Price after stop order is triggeredvi. Buy stop order= protect profit in short position

1. Price above market price2. Placed over resistance level3. Establish long position

vii.Sell stop order= protects profit in long position 1. Below market price2. Placed below resistance level3. Establish short position

d. Stop limit order= stop order that when triggered becomes limit orderi. i.e. Sell stock if it falls below 30 but don’t want less than 29.90

1. Stop= 302. Limit=29.953. Market could leapfrog between stop and limit

e. Orders can be reduced on ex-dividend datei. Buy limits/sell stops/sell stop limits lowered by dividend amountii. DNR order= not reduced by cash dividendiii. All orders adjusted for stock splits or dividendsiv. Reverse splits on open orders care cancelled

f. Time sensitive ordersi. Day= open order valid only till close of trading that dayii. Good-till-cancelled (GTC)= valid until cancelled or executediii. At-the-open= executions at openiv. Market-on-close=executed near or possible closing price

1. Entered before 3:40v. Not held (NH)= floor broker not held to particular time and decides on best time to

execute trade1. Not placed with specialist2. Day orders unless marked GTC

vi. Fill-or-kill (FOK)= fill entire order at limit price or better, if not then cancel1. No longer permitted on NYSE

vii. Immediate-or-cancel (IOC)= like FOK except can fill partial ordersviii.All-or-none (AON)= executed in their entirety and do not have to be filled immediately

1. No longer permitted on NYSEix. Alternative Orders (OCO)= 2 orders, one cancels the other

VI. Exchange Short Sale Rulesa. Up tick rule= must be listed as plus tick or zero-plus tick

i. Plus tick= price higher than last different priceii. Zero-price tick= last trade was made at same price as trade before

b. OTC short sale rules prohibit short sale in NASDAQ at or below current inside bid whenever that bid is lower than the previous inside bid

c. Sell orders must be identified as long or shortd. Muni bonds market is too thin too shorte. Regulation SHO= pilot program to suspend tick rule for certain securities

VII. Other Domestic and Regional Marketsa. AMEX= private, not-for-profit

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i. 1/5 of all stocks traded thereii. Also known as the curb

b. Regional= serve the financial communities in different regionsi. Boston, Chicago, Philadelphia, Cincinnati

VIII. Computerized Order Routinga. SuperDot= processes 75% of NYSE orders

i. Sent directly to specialistii. Receives preopening orders

b. SuperMontage= quotation and execution system for NASDAQIX. Consolidated Tape

a. Consolidated tape system open from 9 to 6:30i. Delivers real-time reportsii. Network A= NYSE transactions

1. Includes regional exchanges, 3rd market, and ECNiii. Network B= AMEXiv. Prints prices and volumes

1. In round lots of 1002. Multiples are followed by s

a. 10 share units followed by ss3. Consecutive trades separated with dot (.)

v. Message appear when market is too active making the tape inaccurate or out of sequence1. DIGITS & VOL DELETED= when message appears when both first digit of

price and volume will be dropped2. REPEAT PRICES OMMITED= tape will only show transactions that differ in

price3. SLD= exchange did not report on time4. OPD= initial transaction has been delayed5. HALT= trading for that security has been halted

X. OTCa. Market where broker/dealers negotiate with each other

i. Largest securities market ii. Regulated by both SEC and NASD

b. No centralized marketc. National Association of Securities Dealers Automated Quotation (NASDAQ)

i. Securities traded on: ADRs, stocks, corporate bonds, muni bonds, US government securities, preferred stock, equipment trust certificates, closed-end investment companies

1. Not limited to theseii. Negotiated market= bargain during trade

d. OTC market makers are broker/dealers trading from their own inventoryi. No specialistii. Must register with SEC and NASD

XI. Quotationsa. Firm quotation= price at which market maker will buy or sell at least one trading unit

i. One trading unit is 100 shares of stock or five bonds1. Firm quote always good for 1 round lot

ii. All quotes

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iii. Counter offer/bid= negotiate better price with market maker1. Only way to guarantee trade is at firm quote

iv. Away from quote is violation of NASD trading rulesb. Recognized quote= any public bid/offer for one or more round lots

i. Bidder must buy any round lots at bid pricec. Subject quote= price is tentative and is subject to reconfirmation by market makerd. Qualified quotes= conditions that allow broker dealer to back away

i. Workout quote= approximate figureii. Nominal quote= assessment of where stock might trade

1. Informational only and labeled as suche. Spread

i. Influences: issue’s size, issuer’s financial conditions, amount of activity, market conditions

ii. Wide spread indicates thin trading marketf. Pink sheets/OTCBB use tree-quote rule

i. Must contact 3 dealers before determining priceXII. NASD 5% Markup Policy

a. Guideline only and not a firm rule for non-listed (OTC) securitiesi. May charge more if reasonableii. Municipal and government securities are exempt

b. Markup based on representative market prices if sold from inventoryi. Price at which dealer acquired has no bearing

c. Applies to markups, markdowns, and commissionsi. Does not apply to mutual funds or IPOs

d. Combined commissions must not exceed 5%i. i.e. sell stock to buy other stock

e. Considerationsi. Type of security= more risk, higher markupsii. Inactivity= thinner/volatile market, higher markupsiii. Selling price= higher stock price, lower commissions iv. Dollar amount= small dollar amount, higher commissionsv. Nature of broker/dealer business= higher costs, higher commissionsvi. Pattern of markups= if established patterns, single excessive markup is unfair

XIII. NASD Automated Quotation System a. Three levels:

i. Level 1= registered representatives1. Displays bid and ask2. Can not guarantee price to client

ii. Level 2= NASD=approved subscribers only 1. Current quote and size2. To list must guarantee quote is firm for at least 1 round lot

iii. Level 3= 1+2 and allows market makers to input quotesb. Market makers must report trades with in 90 seconds of execution

i. Include: symbol, # of shares, price, and buy/sell/crossc. Market makers must make daily reports of total volumed. Inside market= best bid/ask in interdealer market

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i. Lead markets

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Chapter 9- Brokerage Support Services

I. Processing an Ordera. A client places an order and is routed as follows:

i. Order department/wire room/order room= transmits orders to marketsii. Purchases and sales department (P & S)= records all transactions from trade ticketsiii. Margin/credit department= handles margin accounts and computes days when clients

must deposit money and for what amountiv. Cashiering department/cage= receives securities and delivers money

1. Delivers money only if instructed to do so by margin departmentb. National Securities Clearing Corporation (NSCC)= simplifies process by providing specialized

comparison clearance and settlement servicesc. Other departments:

i. Reorganization department= handles changes in securities outstandingii. Dividend department= credits customers with dividends and interestiii. Proxy department= sends out statements to clients whose securities are held in firm’s

nameiv. Stock record department= ledger that lists stock owners

d. Representative must be assured customer can pay for or deliver securities i. Must verify securities are in client’s name

e. Representatives fill out order ticks or electronically i. Information includes: account #, representative ID #, if order is solicited/unsolicited, if

order is subject to authority, symbol, # of shares, buy/sell/short, options, price qualifications, type of account, time order was received, time of entry, price at execution

ii. If wrong account # no change can be made with out branch manager1. All changes must be kept in writing for 3 years

iii. Must be approved by principal after executioniv. Representative must check report with order ticket

1. Report received after execution2. Report execution to customer3. If error than contact principal

v. If order executed outside of instructions then trade is not bindingf. Trade confirmation= document that confirms trade

i. Send confirmation to client on settlement dateii. Includes: trade date, account #, representative #, action in trade, #, yield, CUSIP, price,

amount, commission, net amount, agent/principal 1. CUSIP # is assigned to each issue of securities

iii. Don’t know (DK)= if one side does not recognize other in interdealer trade1. Or if wire room does not recognize account #

g. Firms must send clients quarterly statementsi. Includes: activity, positions, and balance ii. If penny stocks, statements sent monthly

h. Upon request firm must deliver balance sheet to customers/member firm with securities or cash on deposit

i. Fees charged must be reasonable, relate to work preformed, and non-discriminatoryi. Reasonable fee= not excessive when compared top other broker/dealers

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O

P

M

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II. Transaction Settlement Datea. Settlement date= date at which ownership changes

i. Uniform Practice Code (UPC) standardizes dates for settlementii. Regular way/T+3= third business day following trade date

1. i.e. trade on TU settles on FRI2. T-bonds, T-notes, T-bills, and options settle next day (T+1)

a. Government agency issues settle regular way3. Interdealer trades that deliver before settlement date can be refused

a. Government securities settle in federal fundsb. Other securities settle in clearing house

b. If customer buys stock before ex-date customer is entitled to dividendi. If mishandled and seller gets dividend then seller will be sent a due bill

c. Cash/same day settlement= delivery of securities on the same dayi. No later than 2:30

d. Seller’s option contract= lock in selling price with out having to deliver until specified date or time period leading up to it

i. No sooner than T+4e. When-issued confirmation= received if purchased muni-bond before issued

i. Must include: description, yield, trade dateii. Does not include: settlement date, accrued interest, total dollar amount

f. Regulation T payment= date customers are required to pay for transactionsi. Two business days after regular way settlement

g. Designated examination authority (DEA)= customer may request extension if before 5th business day

h. Account frozen if securities are bought and sold before paid fori. Client must deposit full purchase price or account will remain frozen for 90 days

III. Proxy Departmenta. Proxy= stockholders vote absentee ballot

i. Revoked if stockholder attends meetingb. SEC requires company to give stockholders information about items if votes solicitedc. Anyone who participates in proxy contest must register with SECd. Firms must alert customers and forward them proxy notices

i. Firms reimbursed by issuers for coste. If proxy not returned then shares are not voted if issues is of major importance

i. If issue is of minor importance member may vote as he feels fitIV. Rules ff Good Delivery

a. Physical condition must be goodi. In interdealer transaction must be accompanied with uniform delivery ticketii. If mutilated then authentication must be obtained

b. 1st rule of good delivery= if proper number of shares is meti. Interdealer partial delivery must be accepted if remainder constitutes a round lot

1. 100-share uniform units= round lots are cleared separatelya. Odd lots must add up to 100.

ii. Delivery of coupon bonds should be in denominations of 1k or 5k 1. Fully registered in multiples of 1K

a. No larger than 100K

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c. Each stock certificate must be endorsed by owner whose name is registered on face of securityi. Once endorsed than negotiable

1. If lost, same as losing a check2. Assignment of stock power= separate piece of paper that when put together with

actual certificate is treated as endorsedii. Alteration must be signed with explanationiii. Must be guaranteed by party acceptable to transfer agent

1. Corporations need fiduciaryd. If failed to deliver then seller will not receive payment

i. May charge seller for any loss causedii. Firm representing seller must by securities in 10 days

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Chapter 10- Investment Company Products

I. Investment Company Purposea. Investment company= pools investor money and invest in securities on their behalf

i. More efficient than individual investors ii. Raise capital by selling sharesiii. Same registration and prospectus requirements

b. Types:i. Face-amount certificate= contract between investor and issuer where issuer grants fixed

sum to investor in the future1. Issuer is face amount certificate company2. Very few today because of tax law changes

ii. Unit investment trusts (UITs)= organized under trust indenture1. Do not trade or manage securities2. Not traded in secondary market

a. Redeemed by trust3. Purchase shares in other investment companies then issue redeemable shares/

units/beneficial interesta. Undivided interest in portfoliob. When shares liquidated proceeds to shareholders

4. Fixed= purchase portfolio of bonds and terminates when bonds are sold5. Nonfixed= purchases shares of mutual funds 6. Must be ready to redeem shares providing liquidity to investors

iii. Management investment companies= manage securities in a portfolio to achieve stated investment objective

1. Actively trade stocks2. Closed-end investment company= raise capital through common stock offering

a. Initial offering of fixed # of sharesi. Anyone can buy or sell shares on secondary marketii. Supply and demand determine priceiii. Must purchase full shares

b. Fixed capitalization c. Can also issue bonds and preferred stock d. Ex-date set by NASD

3. Open-end investment company= does not specify # of sharesa. Continuous offeringsb. No bonds or preferred stockc. Sold and redeemed by fund onlyd. Priced by NAV + sales chargee. Ex-date set by BOD

4. Diversified investment company= 75-5-10 testa. 75% of assts issued by companies other than investment companies

i. Of 75 % no more than 5% of total assets in one company and no more than 10% of issuer’s outstanding stock

5. Nondiversified= fails 75-5-10 testa. Specializes in single industry

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i. Specialized/sector fundsii. May still be diversified if passes test

II. Investment Company Registrationa. Company must register with SEC as investment company if:

i. In the business of investing/trading securitiesii. 40% or more of its assets are invested in securities

b. May not issue shares to the public unless it meets the following requirements in 90 days:i. At least 100k net assetsii. 100 investorsiii. Clearly defined investment objectives

1. Changes only by majority votec. Open-end companies must have minimum asset-to-debt ratio of 300%

i. May borrow money if meets the 300% minimumd. Must file registration statement and disclose: type of investment company, plans to raise money,

investment intentions, plans for investing in real estate, conditions where investment policies may be changed, name and address of affiliated people, description of business experience of officers

i. Two part of the registration statement1. Part 1/N1-A/summary prospectus= prospectus

a. Furnished to whoever it offers securities tob. Also discloses performance history

2. Part 2/statement of additional information (SAI)= document made available for public inspection

a. Additional information that is useful to investorb. Expanded history, policy, and financial statements

ii. Both for open and closed ended1. Closed end only at IPO

e. Mutual funds can not be purchased on margini. May be used as collateral if they have been paid for 30 days

f. Mutual funds may not engage in activities that are not outlined in registrationi. Must disclose in prospectus: buy securities on margin, selling shirt, participating in joint

investment/trading accounts/ or distributor (unless underwriter)g. Changes requiring majority vote of shareholders: changes in borrowing, issuing other securities,

purchasing real estate, sub classification, changing load policy, changing nature of business, changing investment policy

III. Management Investment Companiesa. BOD= Majority must be noninterested people

i. Tasks: defines type of fund, fund’s objectives, approves transfer agent, custodian, investment advisor, and underwriter

b. Investment advisor= outside of fund contracted by BODi. Tasks: invest cash, implement strategy, identify tax status, manage day to day tradingii. May not have been convicted of a securities related felonyiii. May not be loaned money by fundiv. May not transfer responsibilityv. Must be registeredvi. 2 year contract and subject to shareholder approval

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vii.Earns fee1. % of portfolio value and incentive bonus

c. Custodian= who securities placed with i. Tasks: keep assets segregated, restrict assets ii. Handles clerical functionsiii. Receives feeiv. Insures safekeeping

d. Transfer agent= may be fund custodian i. Tasks: issuing or redeeming or cancelling shares, handling name changes, sending

customer information, fund distributions, recording outstanding sharese. Underwriter/sponsor/distributor= sells and markets shares to public

i. Prohibited from maintaining inventory in open-ended fundii. Fund may not act as own underwriter

1. Exceptions are no-load and 12b1 funds IV. Information Distributed to Investors

a. Prospectus= before or during solicitation of saleb. Financial reports= received semi-annually

i. Must be audited once a year ii. Includes: balance sheet, valuation of securities, income statement, compensation paid to

BOD, total amount of securities purchasedc. Additional disclosures= factors materially affecting performance, line graphs comparing

performance with index, people responsible for day-to-day management V. Characteristics of Mutual Funds and the Mutual Fund Concept

a. There is always a willing buyer i. Given shares are redeemed at NAV

b. Investors equally share in gains and distributionsc. Money is constantly moving d. Most funds offer minimum investment of $500 and additional purchases of $25e. Automatically reinvest capital gainsf. Liquidate portion without disturbing diversificationg. No preemptive rightsh. Ex-dividend day after record date i. Reduced sales charges by offering break points

i. Larger deposits, LOI, rights of accumulationj. Each year fund distributes 1099 formk. Various withdrawal plans

i. May reinvest withdrawn funds within 30 days with one costVI. Investment Objectives

a. Must match objective stated in prospectusb. Stock funds:

i. Growth funds= invest in companies that are growing, reinvesting profits, and generating capital gains

ii. Income funds= invest in companies with strong dividends (utilities, blue chips, preferred stocks)

iii. Combination funds= combine both growth and income companiesiv. Specialized/sector funds= specialize in economic sector

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1. High risk, high appreciationv. Special situation funds= buy companies that benefit from change within or economy

(takeover or turnarounds) vi. Index funds= mirror index

1. Low turnovervii.Foreign stock funds= invest in companies with principal business outside US

1. Long-term capital appreciationc. Balanced funds= stocks for appreciation and bonds for incomed. Asset allocation funds= split investments between stocks for growth, bonds for growth, and

money market for cashi. Switch allocation according to performance

e. Bond funds= income is main objectivei. May pursue capital appreciation by investing in high yield bonds ii. Tax free bonds= invest in muni bonds that produce tax exempt income iii. US government and agency security funds

f. Dual-purpose funds= closed end fund listed separatelyi. Investors seeking income purchase income shares and receive all interest and dividendsii. Investors seeking capital gains purchase gains shares and receive all the gains

g. Money market funds= temporary holding tanks for investors concerned with liquidityi. No-load and open endedii. Interest rates are not fixed

1. Computed dailyiii. NAV= $1 per shareiv. Restrictions: may not be guaranteed by government, no assurance of stable NAV,

maturities < 13 months, average maturity < 90 daysv. T-bills, commercial paper, banker’s acceptance

VII. Comparing Mutual Fundsa. Performance= funds must disclose annual performance for 1,5, and 10 years

i. Must reflect loads with no discountsb. Costs= loads, management fees, and operating expenses

i. Sales loads= 1. Front-end= at beginning

a. Historically 8.5%2. Low load= 2-5%3. Back load= at withdraw4. 12b-1= ongoing fees

a. Charged quarterly and approved annuallyii. Expense ration= (management fees and operating expenses)/compared to assets

1. Between 1 and 5%2. Bond funds between .5 and 1%

iii. Portfolio turnover= reflects cost of buying and selling securities1. 100% holds securities for less than 1 year

a. All gains are subject to maximum tax rateb. More aggressive funds

2. 25% holds securities for 4 yearsiv. Services offered

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VIII. Mutual Fund Marketing and Pricinga. Public offering price (POP)= price fund is sold to customer at

i. Customer= anyone not an NASD memberii. Only nonmembers may purchase shares at discountiii. POP= NAV + sales charge

1. Customer sells back at NAViv. Sales charge %= sales charge/POPv. POP= NAV/(100%-sales charge %)

b. Marketing mutual fund sharesi. Fund to underwriter to dealer to investor

1. Investor gives order for fund to dealer2. Dealer places order with underwriter3. Fund sells shares to underwriter at NAV4. Underwriter sells shares to dealer at NAV + concession5. Dealer sells shares to in investor at POP

ii. Fund to underwriter to investor1. Underwriter acts as dealer2. Investor give order to underwriter3. Fund sells to underwriter at NAV4. Underwriter sells shares to investor at POP

iii. Fund to investor1. Open-end fun distributes directly to public

a. No-load= no sales chargesi. 12b-1 fees of less than .25% are considered no-load

iv. Fund to underwriter to plan company to investor1. Plan companies= organizations that sell plans of periodic payments of funds

c. NAV calculated once per business dayi. Redeemed shares the next day NAV

1. Forward pricingii. Uses fund’s total assets iii. Increases when securities increase or when income payment

1. Does not change when shares are redeemedd. NASD prohibits members from charging more than 8.5% sales charge

i. Funds typically lessii. Includes redemption feesiii. Will be reduced to 6.25% if these features are not offered:

1. Breakpoints= discounts for quantity purchased a. Features: rules vary across family, must be disclosed, may include

purchases in various accounts, shares in same family fund may be aggregated, lump or continued investment

b. LOI= increase overall sales charge if agree to invest additional funds to meet breakpoint in 13 months

i. Only binds the fundii. Extra shares held in escrowiii. Dividends are not counted toward breakpoints iv. May backdate for up to 90 days

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c. Breakpoint sales= representatives prohibited from selling fund below breakpoint

d. Not allowed for investment clubs or child approve majority 2. Rights of accumulation= reduced loads on additional purchases

a. Features: does not apply to initial transactions, does not impose time limits, may use prior share appreciation

i. Higher of NAV or total prior purchases 3. Automatic reinvestment= reinvestment into fund of dividends and income

a. May buy full or fractional sharesb. Conditions: customer not involved in another reinvestment plan, described

in prospectus, no additional costs, shareholders notified once a year c. All new funds offer

4. Other benefits that are offered but do not have to be offered to qualify for the maximum 8.5% load

a. Combination privilege= combine funds from separate investments i. Conversion/exchange privileges= convert one fund for another

with no charge b. Classes of shares

i. A= front load, reduced by breakpoints1. Long term investor

ii. B= backload, reduced over time1. Can not have breakpoints

iii. C= 12b-1 charged quarterly1. Can not have breakpoints

iv. Closed-end= no sales charge but brokerage commission or markupv. Open-end= all sales commissions and expenses paid from charges

1. Front-end load= charges included in POPa. Charges added to NAVb. Most common

2. Back-end/contingent deferred load= charges at redemptiona. Declining percentage reduced annually

i. Drops to 0 after an extended period of time 3. 12b-1= determined by annual amount or flat percentage of NAV

a. Only funds that can act as disturberi. Permitted to collect fees for promoting and sellingii. Fees represent what would have gone to underwriter

b. Maximum is .75%c. Fee must reflect anticipated distribution servicesd. Restrictions:

i. Must be approved initially and annually ii. May be terminated by BODiii. If more than .25% may not be described as no-load

e. Fund must redeem shares with in 7 days of redemption requesti. Customer’s signature must be guaranteed ii. May be suspended if NYSE is close or restricted or if SEC ordered suspension of

redemption

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iii. Shares cancelled and never reissuediv. If redemptions fees, they go to underwriter

IX. Mutual Fund Distributions and Taxationa. Conduit theory= funds may avoid taxation on net investment income if distributions go to

shareholdersi. Net investment income= income + dividends – expensesii. Investors taxed at 15%iii. Subchapter M qualifications= regulated investment companies

1. Distribute 90% of net investment income2. Fund pays taxes on remaining 10% undistributed income

a. If distributes 89% of net investment income then pays taxes on 100%b. Long-term capital gains taxed as they are realized and passed on to shareholders

i. Distributions may not be made more then once a yearii. Taxed at 15%iii. Short-term gains taxed at ordinary income rates

c. Cost base= amount of money investedi. At liquidation is return on capital

1. Not taxed againii. Includes cost, distributions, sales chargesiii. If gain occurs from the shares that are being transferred to another family then gain is

taxed iv. Accounting methods:

1. FIFO= cost of shares held the longest used the longest to determine gaina. Adverse tax consequences in rising marketb. IRS assigns unless told otherwise

2. Share identification3. Average cost basis

d. Withholding tax= 31% of distributions are withheld if no SS #e. Fund yield= annual dividend paid/ POP

i. Must disclose: direction of market, beginning and ending NAV, % change ii. Income and dividends only

1. Usually once a quarteriii. Must disclose source

f. In investor purchases share right before ex-dividend date the shares will decrease in value and investor will be charged on taxes

i. Selling dividends is illegalg. Form 1099= sent to shareholders and discloses income and capital transactions

X. Mutual Fund Purchase and Withdrawal Plansa. Voluntary accumulation plan = periodic, regular investment program

i. May have minimum purchaseii. Not penalized for missed paymentsiii. Dollar cost averaging= investing identical amounts

1. Purchase more share when price is low2. Average cost per shares is lower then average price per share

b. Lump sum withdrawal= sell all shares at oncec. Systematic withdrawal= sell shares over time

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i. Free service ii. Fixed dollar amount= liquidates enough to send that sumiii. Fixed %/shareiv. Fixed time= liquidate holdings over time

1. Require minimum worth2. Discouraged for continued investment

v. Representative must: not guarantee gain, stress possibility of over exhausting account (especially in down market), never use charts

XI. Tracking Investment Company Securitiesa. Newspapers carry NAV (bid) and POP (ask)

i. The difference between the 2 is the loadb. Standard & Poor’s Depository Receipts (SPDRs, Spiders)= index funds that track the

performance of investments in portfolio i. Traded on AMEXii. Quarterly cash dividend after expensesiii. Trade like a stock and create additional shares

1. Open and Closediv. Uses: asset allocation, following industry trends, portfolio balancing, speculative trading,

hedgingv. Different from mutual funds: trade during day, can be bought on margin, can be sold

shortvi. Low turnover and expenses

c. Qs= performance of NASDAQ 100

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Chapter 11- Retirement Plans

I. Qualified Plans a. Features: tax deductible contributions, approved by IRS, can not discriminate, tax on

accumulation deferred, withdrawals are taxed, plan in a trustII. Nonqualified Plans

a. Features: non-tax deductible contributions, does not need to be approved by IRS, can discriminate, tax on accumulation deferred, withdrawals in excess over cost based is taxed, plan in not a trust

b. Deferred compensation programs= employee agrees to defer receipt of current payment to retirement

i. BOD not eligibleii. Risky because company may fold

1. May forfeit benefits if leave before retirementc. Payroll deduction plans= deduct payment from paycheck and placed into retirement plan

III. Individual Retirement Accounts (IRA)a. Annual contributions of up to 4k (5K in 2008) or 100% of earned income

i. Catch up contribution of 1K added to maximum contribution starting at age 50ii. Earned income= income from work (includes alimony)

1. May contribute until 70iii. 6% contribution penalty if exceeds 4kiv. Made by April 15th

b. Spousal IRA= If nonworking spouse then 8k contributioni. Must file joint tax return

c. Distributions with out penalty after 59.5i. Must begin by April 1st the year after 70.5

1. If not then 50% insufficient distribution penaltyii. If early then 10% penalty + income tax

1. Except: death. disability, education expenses, 1st time home buyer, medical premiums, medical expenses in excess of AGI

iii. Taxed as ordinary income d. Contributions are fully deductible

i. If AGI falls within certain limits then may have 2 qualified plans 1. Will not be deductible if high net worth investor already has another qualified

plana. May still make contribution

e. Not acceptable: collectible, life assurance, aggressive option strategies, and short sales, margin accounts

i. Covered calls and annuities are permittedii. Muni bonds are inappropriate given tax-exempt status

f. IRA rollovers= move funds from one qualified plan to anotheri. Must be completed with ion 60 calendar days ii. Payor of qualified employee plan must withhold 20% taxiii. Owner may not take procession of funds

g. Roth IRA= after-tax contribution of 4ki. Earnings not taxed at distributions

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1. Money must have been in account for 5 taxable yearsii. No minimum distribution after 70iii. Penalty rules before 59.5 applyiv. Can not make payments to Roth and traditional

h. Simplified employee pensions (SEP IRA)= retirement plans for self-employed persons allowing employer to contribute money that their employees set up

i. May contribute 43kii. Employer can take income tax reductioniii. Contributions for employees are also tax deductible

IV. Education Savings Accountsa. Coverdell (Education IRA)= after-tax contributions of up to 2k per student younger than 18

i. Limits reduced for high income taxpayersii. Tax free distributions if used for education iii. If not depleted by 30 then 10% penalty + income tax rate or rolled over to another

education IRAb. Section 529 plans= contributions to any student (not just family)

i. Two types:1. Prepaid= donor can lock in current tuition rates by paying now for future

educationa. More popular

2. College savings planii. Lump sum or periodic paymentsiii. Contributions are made with after tax dollars and considered tax free

1. Earnings accumulate tax deferred2. Limited to 11k a year (22k for spouses)3. May be tax deductible (if used for in state school)4. May be aggregated

iv. Withdrawals are tax free if used for education expensesv. Assets remain under donor’s controlvi. Balances may be transferredvii.No income limitations

V. Keogh (HR-10) Plansa. Qualified plans for self-employed persons and owner employees of an unincorporated business

i. Tax deductible contributions of 43k until 70.5ii. Employer must make contributions of eligible employees

1. Eligible: 1,000 hours a year, one or more years of employment, at least 212. i.e. if max amount contributed into owner’s Keogh then 25% to eligible

employee’s Keogh3. Tax deductible for owner

a. Income from employees is not deductibleiii. 10% penalty for excess contributions

VI. Tax-sheltered Annuities [403(b) Plans]= available for public educational institutions, tax exempt organizations, and religious organizationsa. Employees have completed one year and are at least 21b. Earnings tax-deductible and grow tax-free until distributionc. 10% penalty if distributed before 59.5

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VII. Corporate Retirement Plansa. All administrators have fiduciary responsibility where risk is main concern b. Defined benefit plan= specific benefit at retirement

i. Used to favor old, key employeesii. Pension liability= legal obligation to pay benefitsiii. Unfunded pension liability= adequate reserves have not been set aside to meet obligationsiv. Actuary calculates contribution to me requirements

c. Defined contribution plan= employees contribute specific amount to plani. Profit-sharing plan= allow contributions to be skipped in low profit yearsii. Savings incentive match plans for employees (SIMPLEs)= employees make pre-tax

contribution of up to limit (6k) and employer matches1. Less than 100 employees

iii. 401 (k)/thrift plans= employee contributes % of pre-tax salary and employers are permitted to match

1. Accumulate tax free2. Hardship withdrawals are allowed3. Self-employed 401(k)= business with no full-time employees

a. Higher contribution and greater flexibilityb. Make take out loan from

4. Roth 401(k)= like Roth IRAa. Except: no income limitations, no 5 year of tax-free withdrawals, must

begin withdrawals by 70.5VIII. The Employee Retirement Income Security Act of 1974 (ERISA)

a. To prevent misuse of pension funds including:i. Participation= all employees eligible if 21 and have one year of serviceii. Funding= funds segregated from other corporate assetsiii. Vesting= employees get entire benefit after certain amount of yearsiv. Communication= plan document in writing with annual statement

1. Explains formula to determine contributionsv. Nondiscrimination= all eligible employees treated impartially vi. Beneficiaries= must be named to receive employee’s benefits at death

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Chapter 12- Variable Annuities

I. Types of Annuity Contractsa. Annuity= insurance company product designed to provide supplemental retirement income

i. Stream of income payment guaranteed for life ii. Purchaser makes deposit (in lump sum or over time) and at some point withdraws the

fundsb. 3 types:

i. Fixed= investors pay premiums (which are invested in general account) and is then guaranteed a fixed amount to be paid

1. Features: payments from after tax dollars, fixed income securities, issuer assumes investment risk, not a security, guaranteed rate of return for life, fixed administrative expenses, monthly payments are the same, purchasing power risk (inflation), insurance regulation

ii. Variable= investors pay premiums (which are invested in separate account) and is then receives fluctuating payments

1. Features: payments from after tax dollars, equity/debt/mutual funds, annuit assumes investment risk, not security, return is dependent on separate account performance, fixed administrative expenses, monthly payments fluctuate, protect against purchasing power risk (inflation), securities regulation, guaranteed for life

2. Unit holders have right to vote3. Separate account= objective of achieving growth that will match or exceed

inflationa. Separated from general funds b. If responsibility of management is passed to another party then must be

registered as UIT4. Death benefit provision= if annuit dies then beneficiary receives payments

directlya. Beneficiary liable for taxes

i. No penalty for early withdrawal (even if younger than 59.5)iii. Combination= guarantees payments as well as inflation protection

c. Key differences from mutual funds:i. Earning invested grow tax deferred

1. Tax liability postponed until 59.5a. 10% penalty if withdrawn before

ii. Offer guaranteed income for life iii. Others: no maximum load, unit value calculated once per day, share value depends on

performance of separate account II. Purchasing Annuities

a. Single premium deferred= purchased with one lump sum and benefits are postponed b. Periodic payment deferred= investments over time and benefits are postponedc. Immediate= lump sum with payments starting in 60 daysd. 2 phases:

i. Accumulation phase= growth phaseii. Annuity phase= payout phase

1. Annuitization= take income from account

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e. Accumulation/annuity units= owner’s interest in separate account during accumulationi. Once annuitized # of units received is fixed

1. Total annuitization value= units* unit valueIII. Receiving Distributions From Annuities

a. Can withdraw randomly or in lump sumb. Once annuitized issuer determines annuity units value and amount of 1st payment

i. Assumed interest rate (AIR)= conservative projection of performance of separate account 1. Measures:

a. Separate account performance > AIR; more monthly incomeb. Separate account performance = AIR; same monthly incomec. Separate account performance < AIR; less monthly income

2. 1st AIR comparison is what is used for the rest of the paymentsc. Payout options:

i. Life income= payment for life, when annuit dies no more payments1. Largest monthly incomes of payout options

ii. Life with period certain= guarantee minimum amount of payment are made even if annuit dies

1. 10 or 20 yearsa. Still guaranteed for life

iii. Joint life with last survivorship= payments guaranteed over 2 lives 1. Smallest monthly payout of payment options

IV. Taxation of Annuitiesa. All contributions are after tax unless part of a qualified plan

i. Assume it is nonqualifiedb. Contributions are tax basis

i. Cost basis not taxed when withdrawnii. Earning after cost basis are taxed as ordinary income

c. Tax deferred growth i. Payment considered partial return of tax basis

1. IRS requires LIFO

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Chapter 13- Direct Participation Programs

I. Limited Partnerships (LPs)a. LPs= investment that allows consequences of firm to flow to investors

i. Investors share in income, gains, losses, deductions, and tax creditsb. Unincorporated organization with 2 or more members and is none of the following:

i. Refers to itself as incorporated or joint-stock company, insurance companies, banks, company owned by government, company specifically required to be taxed as corporation, foreign companies, tax-exempt group, REIT, company subject to special treatment

ii. After 1996 LPs must avoid corporate characteristics 1. Most difficult to avoid= centralized management2. Easiest to avoid= continuity of life

a. Freely transferable interestsc. Advantages: investment managed by others, limited liability, flow through of income

i. Biggest disadvantage is lack of liquidityd. Master LPs= listed on OTCe. Report income and losses to IRS and then partners are responsible for reporting their share

i. Double taxation avoidedii. Passive income

1. Can not use losses on ordinary incomeiii. Profit motive= set up DPP with intention of generating tax loss

1. Considered abusive and subject to:a. Back taxes, fraud, interest penalties, prosecution

f. Economic viability is the best reason to purchase LPi. Potential for returns from cash distribution and capital gainsii. Should expect to hold interest until LP is dissolved

g. Selling LPs:i. Private placement memorandum= for LPs sold through private placements to small group

of people1. Must be sold to accredited investors with substantial investment experience

ii. In public offering LPs are sold with prospectus to a larger # of investorsiii. Sydicator= oversee selling and promotioniv. Required documents= certificate of LP, partnership agreement, subscription agreement

1. Certificate requires: name, business, place of business, time it will be in business, current and future investment plans, contribution return date, share of profits to each LP, conditions for LP assignment, whether they will admit more LPs, whether business can be continued by remaining general partners (GP)

a. If changes update must be made in 30 days2. Subscription agreement= investors interested in becoming LPs must complete

a. Appoint GP to act on behalf of LPsi. Includes: investor’s net worth/annual income, statement that

investor knows risks, power of attorney appointing GPii. Effective only in GP signs it

b. Recourse loan= subscribers assume portion of the loan

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v. Rights of general partner: charge management fee, bind partnership into contracts, determine who is included, determine if there will be distribution

vi. At dissolution GP cancels certificate of LP and settles accounts in following order:1. Secured lenders2. Creditors3. LPs

a. Claims to profitb. Claims to capital

4. GPa. Claims for feesb. Claims for share of profitsc. Claims for capital

vii.Selling LP has maximum compensation of 10% h. LPs must have at least one of each (2 types of partners):

i. GPs1. Features: unlimited liability, management/ fiduciary responsibility 2. Can do: make decisions to bind partnership, buy/sell property, maintain financial

interest in partnership (1% min.), receive compensation3. Can not do: compete against partnership, borrow from partnership, commingle

funds with personal assets, admit new GPs or LPs after loss of GP (unless specified)

ii. LPs1. Features: limited liability, no management responsibility, can recover damages

from GP 2. Can do: vote on changes, receive cash distributions, inspect books3. Can not do: act on behalf of partnership, knowingly sign certificate with false

information, have names as part of partnership nameII. Types of LPs

a. Real estate provides: capital growth, cash flow, tax deductions, tax credits i. Types:

1. Raw land= purchase undeveloped land for appreciation value a. Plus side: appreciation potentialb. Downside: no income distributions or tax deductionsc. Tax features: not a tax shelterd. Degree of risk: most speculative

2. New construction= build new property for appreciation value a. Plus side: appreciation potential, low maintenance costsb. Downside: cost overruns, no track record, hard to find permanent

financing, can’t deduct current expenses c. Tax features: depreciation and expense

i. Income after completion d. Degree of risk: less risk than raw land, more risk then existing property

3. Existing property= income from existing properties a. Plus side: income stream, known history b. Downside: high maintenance cost, expiring leases, less favorable

arrangements

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c. Tax features: mortgage interest and depreciationd. Degree of risk: low

4. Government-assisted housing= develop low-income and retirement housinga. Plus side: tax credits and rent subsidiesb. Downside: low appreciation, changing government programs, high

maintenancec. Tax features: tax credits and lossesd. Degree of risk: low

5. Historic rehabilitation= develop historical sites for commercial usea. Plus side: tax creditsb. Downside: cost overruns, no track record, hard to find financing, can’t

deduct current expensesc. Tax features: tax credit, deductionsd. Degree of risk: similar to new construction

b. Oil and gas= speculative drilling programs that have tax advantages i. Types of costs

1. Intangible drilling costs (IDCs)= write-offs for drilling that include any costs that after being incurred have no salvage value

a. Usually 100% deductible in 1st year2. Tangible drilling costs (TDCs)= costs that have salvage value

a. Depreciated over time 3. Depletion allowances= tax deductions to compensate for decreasing supply of oil

a. Can only be used if LP is making moneyii. Types:

1. Exploratory (wildcatting)= locate undiscovered reservesa. Plus side: high rewardsb. Down side: few new wells producec. Tax features: high IDCs (immediate)d. Degree of risk: high

2. Developmental= drill near existing fieldsa. Plus side: less risky than wildcattingb. Down side: few new wells producec. Tax features: medium IDCs (immediate)d. Degree of risk: medium to high

3. Income= immediate income from selling oila. Plus side: immediate cash flowb. Down side: oil prices, well stopsc. Tax features: depletion allowancesd. Degree of risk: low

4. Combination= allocates money between income and exploratoryiii. Sharing arrangements= costs and revenues

1. Overriding royalty interest= receives royalties but no partnership risk a. i.e. landowner selling mineral rights

2. Reversionary working interest= GP bear no cost, receives no revenue until LPs have recovered their capital

a. LPs bear all the cost

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3. Net operation profits interest= GP bears non of the costs but gets % of profits a. LP bears all costsb. Only through private placement

4. Disproportionate sharing= GP has small % of costs but high % of revenues5. Carried interest= GP shares in TDCs but receives no IDCs

a. LP= immediate deductionsb. GP= depreciation deductions

6. Functional allocation= revenues are shared a. LP= IDCsb. GP= TDCsc. Most common

c. Equipment leasing programs= purchase equipment and lease to other businessesi. Income from lease paymentsii. Write-offs from operating, interest, and depreciation expenses iii. Primary objective is tax sheltered income

III. Analysis of Limited Partnershipsa. Measuring economic viability

i. Cash flow analysisii. IRR= PV of future cash flows

b. Tax featuresi. Deductionsii. Depreciation write-offs (can’t be land)= straight line or accelerated

1. Accelerated= depreciation reduced in later yearsa. Depreciation recapture= if LP sells share and depreciation is in excess of

straight line then difference is taxed at ordinary level iii. Depletion allowances

c. Tax credits= dollar for dollar reductionsi. Biggest tax benefitii. Cross-over point= point where program begins to generate taxable income instead of

lossesiii. LPs must keep track of basis

1. Basis= liability assumed by LPa. Can not lose more thanb. Investment in partnership + share of recourse debt - distributions

2. Adjusted cost basis accounts for: cash contributions, property contributions, recourse debt, nonrecourse debt

3. Adjusted every year4. Can not deduct lower then their basis

a. Losses carried forwardi. May be added to basis at sale

5. Gain/loss= sale - basisd. Other: management ability, blind pool (less than 75% of assets are specified for use), time frame,

lack of liquidity, revenue projections, start up costs

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Chapter 14- Economics and Analysis

I. Economicsa. Study of supply and demandb. Business cycles:

i. Expansion= increased business activity thought economy until it reaches upper limit1. Characteristics: increased demand, increased production, rising stock prices,

increased GDP2. Always starts with

ii. Peak= upper limit of expansioniii. Contraction= business activity declines from peak

1. Characteristics :rising bankruptcies, higher debt, falling stock prices, rising inventories, decreasing GDP

a. Recession= short-term contractioni. Six month decline in GDP

b. Depression= long-term contractioni. 18 month declining of GDP

iv. Trough= business activity stops decliningc. GDP/GNP= annual economic output

i. Includes: personal consumption, government spending, private investment, foreign investment, total value of outputs

d. Consumer price index (CPI)= computes price levels each monthi. Constant dollars= adjustments in GDP to account for changes in prices

1. Inflation= increase in pricesa. Mid inflation encourages economic growth

i. Always in growing economyb. High inflation reduces buying powerc. Drives up inflation ratesd. Barometer for price levels

2. Deflation= decline in pricesa. Sever recession when unemployment is on the rise

e. Economic indicators= serve as barometers for business cyclei. Leading indicators= where economy is going

1. Money supply (M2), building permits, unemployment compensation, new orders for goods, average work week for manufacturers, changes in inventory, changes in sensitive material prices, stock prices, changes in borrowing

ii. Coincident indicators= vary directly with business cycle1. Number of hours worked, employment levels, nonagricultural employment,

personal income, industrial production, sales, GDPiii. Lagging indicators= change after new cycle

1. Corporate profits, average duration of employment, labor cost per unit, inventory sales ratio, loans outstanding, credit to personal income

f. Keynesian theory= governments responsibility to manipulate demand by changing levels of taxing and spending

i. Fiscal policy determines economic healthg. Monetarist theory= quantity of money determines price levels and is controlled by FRB

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h. Supply side economics= government should allow market forces to determine prices i. Laffer curve= relationship between tax rate and tax revenues

1. As tax rate increase so do tax revenues until point where people will have no incentive to work and tax revenue falls

II. Economic Policy a. Money supply

i. M1= all currency in circulation and checking accounts (demand deposits)1. Used for ordinary purchases

ii. M2= M1+ savings accounts+ CDs+ MM funds+ repurchase agreementsiii. M3= M1+ M2+ time deposits of more than 100K and repurchase agreements of greater

than 1 dayb. Federal Reserve Board (FRB)= determines monetary policy by taking actions

i. Includes: acting as agent for treasury, regulating money supply, supervising printing of money, clearing fund transfers, examining members

ii. Affects money supply by:1. Open-market operations= buying/selling government securities

a. Federal Open Market Committee (FMOC)b. Most commonc. Buys securities to increase/expand/loosen money supply

i. Increase in reserves allows banks to make more loansii. Lowers inertest ratesiii. Used to stimulate slow growthiv. Vice versa for decreasing/contracting/ tightening money supply

2. Discount rate= interest rate Fed charges to member banks for short-term loansa. Federal funds rate= rate banks charge each other

i. Fluctuates daily, thus more volatile and move quicker1. Long-term bond prices move more than short term bond

pricesii. Not set by FRB

b. Determined by supply and demand for moneyc. Lowering rates indicates deposits are growing

i. Increases demand for loans1. Money supply increases

ii. Used to stimulate slow growthiii. Vice versa for declining rates

3. Reserve requirement= banks certain % of depositors’ money with the Feda. Most drastic because of multiplier affectb. Raising requirements= less money for banks to lend

i. Used to stimulate slow growthii. Vice versa for lowering requirements

III. Fiscal Policya. Actions of Congress and the Presidentb. Governmental budget decisions

i. Government can control unemployment by adjusting overall demand for goods1. Changes in: federal spending, money raised through taxes, budget surplus/deficit2. Takes time thus inefficient for short term problems

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ii. Lower taxes are bullish for stock market1. Like FRB lowering interest rates

iii. Disintermediation= flow of money from low to high yield investment without bank intermediary

1. When FRB tightens money supply c. International monetary factors

i. Balance of payments= flow of money between US and other countries1. Surplus or deficit 2. Balance of trade= largest component3. Debits: imports, spending/investments/loans abroad, foreign aid4. Credits: exports, foreign spending/investments in US5. Weak dollar= exports increase6. Strong dollar= imports increase

IV. Technical Analysisa. Predicts direction of prices based on historic models

i. Market timers= technical analysts b. Market averages

i. Stock prices move together1. Rise in bull2. Decline in bear

ii. Trading volume= above normal signifies pattern in direction of prices and beginning of trend

iii. Market breadth= issues closing up or down on a specific day1. Bull= advances > declines2. Bear= declines > advances

c. Charting stocksi. Trendlines= over time stock price moves in one direction and thus connects lows in an up

trend with highs in a down trend1. Hard to reverse2. Bull= upward3. Bear= downward4. Consolidating= stock prices moves in narrow range and trendline is horizontal

a. Reversal= stock price moves in opposite direction of trend linei. Between 2 trend lines consolidation occurs and stock price levels

offii. Saucer= reversal of down trendiii. Inverted saucer= reversal of uptrendiv. Head and shoulder top pattern= beginning of bear market

1. Trendline looks like: stock price rises, reaches a plateau, second advance pushes price higher, price falls back to plateau and continues down ward, price rises again, falls back and continues to decline

v. Head and shoulder bottom pattern= bullish indicator1. Reversal of head and shoulder bottom pattern

ii. Support and resistance levels= move with in narrow range1. Support= bottom level

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a. When stock declines to it attracts buyerb. Bearish breakouts= decline

i. Signal of new trend2. Resistance= top level

a. When stock rises to it attracts sellersb. Bullish breakout= rise

i. Signal of new trendd. Overbought= indexes are rising, but # of declining stocks relative to # of advancing stocks is

risinge. Oversold= market is declining, but # of advancing stocks relative to # of declining stocks is

risingf. Technical market theories

i. Dow= confirm end of market trend1. Three types of changes

a. Primary= 1 or more yearsb. Secondary= 3-12 weeksc. Short-term= hours or days

2. Bull market= primary trend prices up but prices in secondary may move down for 12 weeks

a. Trough of secondary trend higher than trough of previous downward trendb. Primary trend= higher highs and lower lows

3. Bull market= primary trend prices down but prices in secondary may move up for 12 weeks

a. Prices that move up are successively lowerb. Primary trend= lower highs and lower lows

ii. Odd-lot= small investors buy and sell at wrong times, so odd-lot traders do opposite of small investors

iii. Short interest= # of shares being shorted1. Reflects mandatory demand because stocks must be repurchased

a. Bearish= high short interestb. Bullish= low short interest

iv. Modern portfolio theory (MPT)= relationship of all investments in portfolio1. Select mix of investments weighted to emphasize economic trends

v. Random walk theory= direction of market is unpredictable1. Efficient market theory= stock market is perfectly efficient

g. Indexesi. Dow Jones Industrial Average= 30 stocks

1. Oldest and most widely usedii. Dow Jones Composite= 30 industrial, 20 transportation, and 15 utility stocksiii. Value Line Index= 1,700 NYSE, AMEX, and OTC stocksiv. Wilshire 5000= all NYSE, AMEX, and NASDAQ stocks

1. Most broadv. S & P 500= 500 most widely held companies with respect to market size, liquidity, and

industrial sectorV. Fundamental Analysis

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a. Concerned with broad-based investment trends including: industry, quality of business, finances, management

i. Also look at: historical earnings trends, projected growth vs. growth of competitors, capitalization, working capital

b. Industry analysisi. Defensive= least affected by business cycle

1. Non-durable goods (food, medicine, etc…)2. Decline less in bear market than other stocks

ii. Cyclical= sensitive to business cycle and inflation trends1. Durable goods (machinery, cars, etc…)2. Counter cyclical= rise when economy is down

iii. Growth= grow faster then economy as a wholeiv. Special situation stocks= unusual profit potential because of non-recurring circumstances

VI. Corporate Analysisa. Balance sheet (B/S)= snapshot of companies position

i. Assets-liabilities= net worth/equity1. Assets= what firms owns in order of liquidity

a. Current asset= cash and assets expected to be converted into cash in less than a year

i. Includes: cash, accounts receivable, inventory, prepaid expensesb. Fixed assets= not easily converted into cash

i. Includes: plant, property, equipment c. Other assets= intangible

i. Includes; formulas, contract rights, trademarks, goodwill 1. Goodwill= value that firm’s reputation adds to book value

2. Liabilities= what firm owes in order of liquiditya. Current liabilities= debts due in a year or less

i. Includes: accounts payable (debt to suppliers), wages payable, current long-term debt (long-term due with in a year), notes payable (debt due on equipment), taxes payable

b. Long-term liabilities= debts due after 1 yeari. Includes: mortgages, promissory notes, bondsii. Funded debt= debt of greater than 5 years

3. Stockholder’s equity/net worth= stockholder’s claim to assets after creditors are paid

a. Includes:i. Capital stock at par= arbitrary value assigned to stockii. Capital in excess of pair/additional paid in capital/paid in surplus=

amount over par company received from selling stockiii. Retained earning/earnings surplus= total earning paid out – total

dividends- total lossesii. Capitalization= debt + equityiii. Liquidity= measure of working capital

1. Working capital= cash company has availablea. Current assets- current liabilities

iv. Changes that effect B/S

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1. Double entry book keeping= offsetting changes in books2. Depreciation= declines value of asset over time

a. Affect B/S:i. Accumulated= reduced value of assetsii. Deduction= reduces income

b. Accelerated= depreciates more in early yearsi. Larger deduction in early years and smaller in later years

b. Capital structure= long-term debt + capital stock (common and preferred) + capital in excess of par + retained earnings

i. Inventory valuation= can increase or decrease retained earnings1. FIFO= first in, first out

a. During inflation sales are inflated and fair inventory valuesi. Reduces cost of goods

2. LIFO= last in first outa. During inflation sales are fair and inventory is understated

i. Raises cost of goods ii. Issuing securities= equity and cash increaseiii. Bond redemption= liabilities reduced and cash is reducediv. Dividends= when declared lowers retained earnings and increases liabilities

1. Once paid lowers cash and liabilitiesv. Stock dividends/splits= have no effect on equity

1. Only effect is on par value per share and shares outstandingvi. Financial leverage= use long term debt to increase return on equity

1. Highly levered= high long-term debt to stocka. More aggressiveb. High returns but high risk

i. Increase EPSii. Default riskiii. Affected by change in interest rates

2. Industrial companies are highly leveredc. Income statement= summarizes revenue for fiscal period

i. Operating income/profit/margin/earnings= profit before interest and taxes (EBIT)1. Profits from operation

ii. Interest expense= interest paid to bondholders1. Not considered operating expense2. Reduce taxable income3. Pretax income= operating income- interest expense

iii. Net income after taxes1. Dividends paid out from this

iv. Earnings per share (EPS)= earnings available to common/ # of outstanding shares1. Earnings available to common= what remains after interest, taxes, and preferred

dividendsv. Retained earnings= earning available to common- dividends

1. Earnings surplus= what is not paid out in dividendsVII. Financial Ratios

a. Capitalization ratios= asses bankruptcy risk by studying leverage in its overall capitalization

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i. Debt-to-equity= long-term debt/ equity1. Most common measure of leverage

ii. Bond/debt= long-term debt/ capitalizationiii. Common stock= equity/ total capitalizationiv. Preferred stock= preferred stock/ capitalization

b. Liquidity ratios= firm’s ability to meet current financial obligationsi. Current= current assets/ current liabilitiesii. Quick assets= current assets- unsold inventoryiii. Acid test/quick= quick assets/ current liabilities

1. Most stringent measure of liquidityiv. Cash assets= cash and equivalents/ current liabilities v. Debt service= EBIT/ (annual interest + principal payment)

1. Ability to meet payments on bondsvi. Book value per share= (assets- liabilities-intangibles- par value of preferred stock)/ # of

shares outstanding1. Book value= theoretical liquation value

a. Tangible dollar amount per share if company liquidatedc. Valuation ratio= compare company with industry

i. EPS/primary earnings per share/basic earnings per share1. Relates to common stock only

ii. EOS after dilution= earnings available to common/ # of shares outstanding + # of convertible shares

iii. Dividends per share= cash dividends on common stock/ # of shares outstandingiv. Current/dividend yield= dividends per share/ market value per sharev. Dividend payout = dividends per share/ EPS

1. Older companies (utilities) have high ratiovi. Price/earnings (PE)= market price per share/ EPS

1. Growth companies= high PE2. Companies subject to cyclical fluctuations= low PE3. Be aware of extremely high and low PEs

a. Speculative stocksChapter 15- Ethics, Recommendations, and Taxation

I. Ethical Business Practicesa. Rules that guide relationship between members of securities industry and others are set by SEC,

NYSE, NASD, and othersi. Practices that provide unfair advantage are prohibitedii. All broker/dealers are required to maintain written supervisory proceduresiii. A principal is responsible for enforcing rules of broker/dealeriv. Broker/dealer may have more stringent rules

1. But never lessv. NASD conduct rules deal with treatment of customer

b. Prohibited business practicesi. Manipulative and fraudulent devices to induce security sale

1. Statue of limitations of 3 years of incident and within 1 year of discovering it

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ii. Outside business activity= associated person can’t work for any other business without employer knowledge

iii. Private securities transactions/selling away= sale of securities outside of regular business1. Does not include passive investments2. May enter if: provide written notice, describe transaction/, role in transaction/

compensationa. With compensation= enter transaction on own books

i. Employer may disapproveb. Without compensation= employer must acknowledge written notification

and require person to certain conditionsi. Excludes immediate family members

iv. Recommendations= must consist of customer needs and be explainedc. Conduct rules= require broker/dealer to inquire customer’s situation

i. Violations= recommending unsuitable investments, short-term mutual fund trades, fictitious accounts, unauthorized transactions, recommending purchases that customer can’t afford, fraudulent acts (i.e. forgery), guaranteeing against loss

ii. Excessive trading/churning= generate commissions instead of achieving customer’s financial need

1. Safeguard= principal must review all tradesiii. Broker/dealers may not distribute compensation to employees of other member firms

1. Exceptions: compensation not conditional on sale, employing member’s approval, value does not exceed limit

iv. Lending arrangements between representatives and customers must have written procedures, provide prior written notice, and approval

1. 5 types permitted: immediate family member (no permission), customer is a bank, both are registered persons of same firm, customer and representative have personal/business relationship

2. Misrepresentation= representatives may not misrepresent themselvesa. Covering: qualifications, education, experience, nature of services offered,

feesv. Representatives are prohibited from presenting client research reports prepared by others

without disclosing the name vi. Representatives are prohibited from sharing in loss/gain

1. Unless joint account with written approval and proportionate gains/lossesa. Not proportionate for family members

vii.Advisor must establish policies to prevent use of nonpublic informationviii.Information regarding customer securities are treated with confidentiality

d. Unethical trading practicesi. Painting the tape= sell a stock to another party with understanding that stock will be

repurchased on later date for same price1. Looks like more activity

ii. Marketing the close= falsely reporting tradesiii. Influencing market price by paying for favorable reviewsiv. Promoting false informationv. May not place order if they have information of impending block order

II. Investment Considerations and Suitability

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a. NYSE Rule 405= know your customeri. Nonfinancial considerations: age, marital status, dependents, employment status of

customer/family members, current and future financial needsii. Risk tolerance/investment goals: risk, liquidity, tax considerations, long or short term

investments, investment experience, investments currently heldb. Customer investment outlook

i. Preservation of capital1. For many most important

ii. Current income1. Fixed-income securities

iii. Capital growth iv. Tax advantages= reduce or defer taxes

1. i.e. using IRAs, muni bondsv. Diversificationvi. Liquidity= sell it quickly

1. Liquid= stocks, bonds, mutual funds2. Illiquid= DPPs, annuities CDs, real estate

vii.Speculation= higher returns for higher riskIII. Suitability: Analyzing Financial Risks and Rewards

a. Unsolicited statement= customer wants investment that representative feels us unsuitable i. Not requiredii. Explain why trade is unsuitable

b. Investment risks= investment will not earn expected rate of returni. Inflation/purchasing power= effect of rising prices on investment

1. Bond yield < inflation rate purchasing power diminishesii. Capital= investor will lose some or all of their moneyiii. Timing= risk that investor will buy/sell at wrong timeiv. Interest rate= sensitivity of investment to rate changesv. Reinvestment= difficult to invest proceeds from redemption at same level without raising

risk1. Declining interest rates

a. Mortgage-backed securities because of refinancingb. Bonds

2. Not subject: zero-coupon bondsvi. Call= bond may be called before maturity and will be unable to reinvest at comparable

rate1. Call protection period= period when bond can’t be called

vii.Market/systematic= investors lose capital because of price volatility in market1. Can’t be diversified away

a. Nonsystematic/selection risk can be minimized2. It can be hedged by purchasing market puts

viii.Liquidity/marketability= client may not be able to sell investment quickly1. Muni bonds are less marketable

ix. Legislative/political= legal changes will affect investmentc. Risk measurements

i. Beta= stock’s volatility relative to market

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1. How stock moves:a. 1= moves with marketb. >1= moves more than market

i. More volatile, thus greater loss in declining marketsii. Aggressive

1. Includes technology and carsc. <1= moves less than market

i. Less volatile, thus less loss in declining marketsii. Conservative

1. Includes utilities and drug2. Measures market risk3. Treynor measure= portfolios benefit to risk ration

a. Average return in excess of risk-free rate/ betaii. Correlation= securities move in same direction

1. Correlation coefficient is from 1 to -1a. 1= perfectly correlatedb. 0= unrelatedc. -1= perfectly uncorrelated

iii. Standard deviation= volatility of stocks potential returns1. 5.5= stock may differ 5.5% above or below predicted return2. Larger standard deviation= larger returns are expected from average return3. Lower standard deviation= lower risk4. Sharpe measure= portfolios benefit to risk ratio

a. Average return in excess of risk-free rate/ standard deviationiv. Duration= time in years it takes a bond to repay itself

1. % change price= +/- duration* change in interest ratea. (-)= increase in interest ratesb. (+)= decrease in interest rates

IV. Portfolio Managementa. Portfolio= combined investment holdings

i. Aggressive strategy= maximize returns with higher risk1. Includes: selecting volatile stocks, buying on margin, option strategies

ii. Defensive strategy= safety is top priority1. Includes: blue chip stocks, AAA bonds

b. Modern portfolio theory= determining the relationship between risk and rewardi. Quantify and control riskii. Derived from Capital Asset Pricing Model (CAPM)

1. Pricing of stock take into account systematic and unsystematic riskiii. Diversification= buying different types of securities to spread out risk

1. Diversified by: type of security, industry, companies in industry, length, investment rating, geography

2. Most used iv. Dollar cost averaging= periodic purchases of fixed dollar amount in one or more stocks

1. Average cost is always less than average market pricev. Constant ratio plan= buy/sell securities to keep portfolio balanced between equity and

debt

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vi. Constant dollar plan= buy/sell securities to keep set dollar amount invested at all timesc. Measuring volatility

i. Speed and degree which stock’s price will change1. Alpha= change in price independent of market related factors

a. If market factors remain equal and alpha = 1.5, then stock should increase by 50%

2. Betad. Asset allocation= balancing different asset classes to get mix of assets

i. Strategic= proportions of investments that should compromise long-term portfolio1. i.e. 100-age= % of portfolio should be invested in stocks

ii. Tactical= short-term portfolio adjustments in consideration of market conditions1. i.e. market is up allocate more assets to stocks

e. Active management= relies on managers stock picking and timingf. Passive management= no management style will outperform market

i. i.e. construct portfolio of index fundsg. Growth portfolio= focus on stocks whose earning grow faster than other stocks

i. Buy stocks at 52-week highh. Value= concentrate on undervalued securities

i. Buy stocks at 52-week lowV. Federal and State Taxation

a. Regressive taxes= levied equally regardless of incomei. i.e. sakes, payroll, property, etc…

b. Progressive tax= increases tax rate as income increasei. i.e. estate, income, etc…

c. Types of income i. Earned= from salary, bonuses, or active participation in businessii. Passive= individual not actively involved in

1. i.e. rental property, LPs, etc…a. GPs income in LP is earned income

2. Passive losses can only offset passive gainsiii. Portfolio income= derived from securities

1. Taxed in year it was received2. Capital losses can only offset capital gains

d. Taxation on portfolio incomei. Interest:

1. Corporate bonds= taxable at all levels2. US government securities= taxable at federal level only3. Agency issues= taxable at federal level only

a. Mortgage-backed government issues= taxable at all levelsi. i.e. Freddie Mac and Fannie Mae

4. Accrued interest= included as income when investor receives a bond between payment dates

a. Taxable to sellerb. Deduction for buyer

5. Municipal securities= exempt at all levelsa. If purchased in state/municipality where investor is resident

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i. Always tax free at federal levelb. All territories c. Private purpose bonds= issued to meet nonessential government needs (i.e.

industrial revenue bonds)i. Most are tax exempt

1. tax preference for alternative minimum tax (AMT)ii. Dividends= taxed at 15% as long as customer has satisfied 61 days holding period

(begins 60 days before ex-dividend date)1. From mutual funds whether cash or reinvested:

a. Muni bond funds= federally tax freeb. Corporate bond funds= taxable as ordinary incomec. Stock funds= taxed at 15%d. Long-term capital gains= taxed at 15%e. Short-term capital gains= taxed as ordinary income

2. Foreign dividends are taxed in which investor is a citizena. If foreign tax is withheld on distribution then investor gets tax credit

e. Taxable upon receipt= taxable in year they are receivedf. Cost basis= price at which securities were bought at + commission

i. Adjusted for stock splits and dividendsii. Capital gain= security sold for higher price than basisiii. Capital loss= security sold for less than basisiv. Net capital gain/loss= long-term capital gains/losses + short term capital gains/losses

1. Losses are deductible for maximum of 3ka. May be carried over

v. Which shares to sell:1. FIFO= used by IRS2. Average basis= average price of share3. Share identification

a. Most flexiblevi. Wash sale rule= may not use capital loss to offset gains if security sold for a loss or

similar security was repurchased 30 days later 1. Applies to short sales2. Muni tax swaps= investors sell depreciated bonds to generate loss and buy new

bonds with higher ratesa. To avoid wash rule investor must change 2 of the following: issuer,

coupon, maturity3. Applies if investor sells a loss then writes puts

g. Adjusting cost basis on muni bonds= only will have tax effect if capital gaini. Bought at premium= must amortize the premium over life of the bond using straight line

1. Reduces cost basis2. Reduces reported income

ii. Bought at discount= must be accreted by adjusting the basis back up to par 1. Increases cost basis2. Increases interest income

a. If bought in secondary market [not original issue discount (OID)] then accretion taxed as ordinary income

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i. After-tax yield= between stated YTM and couponh. Adjusting cost basis on corporate bonds

i. If bought at discount annual accretion is taxable as ordinary income ii. If bought at premium investor has option to amortize

1. If no amortize and help to maturity then loss2. If customer amortizes then no capital loss but lower interest income

i. Donations i. To charity

1. Donor’s deduction= market valuea. No taxes due on appreciation unless security was held short term

2. Recipient’s cost base= higher current market valueii. To others

1. Donor’s deduction= none2. Recipient’s cost base= original value of securities

iii. Inherited1. Recipient’s cost base= fair market value up death

j. Estate and gift taxes are progressive taxes i. Tax is due on estate when person dies

1. Payable by estate2. Excludes first 1.5m (3.5m in 2009)

a. Unlimited if entire estate is transferred to spouse ii. Tax is due when person receives a gift

1. Payable by donor 2. Progressive tax3. 11k per year to any # if individuals without tax4. Interspousal are not subject to tax

k. Margin interest in tax-deductiblei. Except on muni bonds

l. Short selling against the box= lock in capital gain that was to be deferred by holding shares long (instead of selling them) and then shorting the same shares

i. Customer is taxed when borrowed shares are replaced with shares the customer owns1. 5% margin requirement2. Can’t be used to stretch short-term gain into long-term gain

m. AMT= high income taxpayers don’t escape paying taxesi. Adds items back into taxable income: accelerated depreciation on property (after 1986),

some costs with DDPs, local tax and interest on investments that don’t generate income, tax-exempt interest on private purpose (after 1986), stock options exceeding fair market value

ii. Taxpayers required to add ATM to regular taxn. Dividend exclusion rule= dividends from 1 company to another are 70% exempt

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Chapter 16- US Government and State Rules and Regulations

I. Overview of Federal and Securities Legislationa. The Securities Act of 1933= first legislative response to crash of 1929 that requires issuers to full

and fair disclosure of nonexempt issuesi. Includes: registration statements with SEC, must provide prospectus, prohibits fraud

b. The Securities Act of 1934/People Act regulates secondary market, outstanding securities, trading activities, and persons involved with securities on behalf of customers

i. Includes: creation of SEC, registration of all person that trade OTC, regulation of OTC market, regulation of credit (by FRB), regulation of trading activities/insider trading/short sales/client accounts, customer protection rule, net capital rule, reporting requirements for issuers

ii. Certain securities exempt1. Non is exempt from anti-fraud provision

iii. Tender offer= company makes cash offer for another company1. Shareholders of target company may tender their shares only to extent of their net

long positiona. May not borrow (short) stock to tender borrowed shares

iv. Maloney Act of 1938= amended Act of 1934 by allowing SEC to create SROs/designated examining authorities (DEAs) for monitoring brokers

1. NASD is SRO for OTCa. Thus registering with NASD, registers representative with SEC

c. Trust Indenture Act of 1939 protects corporate bondholders and requires issuers to appoint a trustee to ensure covenants

i. Applies to corporate bonds that issue more than 5m in a year and have maturity of 9 months or more

d. The Investment Company Act of 1940 regulates investment companiesi. Requires them to: register with SEC, state investment objectives, net worth of 100k

before offering shares, owned by at least 100 shareholders, comply with standardsii. Established 3 classifications: FACs, UIT, and management companies

e. The Investment Advisors Act of 1940 required that anyone who gives investment advice for compensation to register as investment advisor and pass exam

i. Not charging does not require registrationf. The Securities Investor Protection ACT and the SPIC was passed in 1970 to protect customer

from broker/dealer failure, intensified broker/dealer financial requirements, and created Securities Investor Protection Corporation (SPIC)

i. SPIC= independent, government-sponsored corporation that collects assessments from broker/dealers to create insurance fund incase of failure

1. All broker/dealers registered with SEC must be members a. Except those only handling mutual funds and annuities/insurance

2. Investment advisors are not broker/dealers thus not members 3. Violation of net capital

a. If fall below requirements, then SRO will petition court for liquidation trustee and order of events follows:

i. Securities in customers name delivered to owner

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1. Valuation date is day proceeding start/day trustee was appointed

ii. Street name securities distributed on pro rata basisiii. SPIC fund are distribute to meet remaining claimsiv. Customer with excess claims become general creditors

4. SPIC coverage is a maximum of 500k per customer with cash claims not greater than 100k

a. Margin account is equity in accountb. Individual, joint and custodial accounts are counted separatelyc. Does not cover futures or commodities

5. SPIC must be used in broker/dealer advertising, but not overstated6. Blanket fidelity bond= protects against employee theft

a. Members must have and review once a yearb. Minimum coverage is 25k

g. The Securities Acts Amendments of 1975= established MSRBh. Insider Trading and Securities Fraud Enforcement Act of 1988 amends provisions and penalties

for insider tradingi. Insider= anyone who has access to nonpublic informationii. Both tipper(person who gives tip) and tippee (person who receives tip) are liable

1. Key elements: information is material and nonpublic, does tipper have fiduciary duty to company, does tipper get personal benefits, does tippee know information was inside

2. Violation only if the information is usediii. Broker/dealers must establish written procedures prohibiting the misuse of inside

information and must restrict flow on inside information between departments1. Chinese Wall/firewall/informational barrier= restricts information between

departmentsiv. SEC may impose fines of 300% of profits and 10 years in jail

1. If violator is employee of broker/dealer than fined greater of 1m or treble damages

2. Bounty of 10% for informersv. Contemporaneous trader= enters securities trade at same time as insider

1. May sue if insiders violate regulations for up to 5 yearsi. Penny stock cold calling rules prevent abusive sales of high risk/speculative securities

i. Stocks that are less than $5ii. Representative must first determine suitability and then customer must sign suitability

statement1. Representative must disclose: name of stock, # of shares, current quote, amount of

commission2. If account holds penny stocks, monthly statement must be sent3. Established customers are exempt from suitability statement

a. Held account for at least one yearb. Made at least 3 penny stock purchases of different issuer on different date

4. Provisions only apply to solicited transactionsj. Bank Secrecy Act established the Treasury as the lead agency for developing regulation in

connection with anti-money laundering programs

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i. Requires broker/dealers to detect abuses1. Regulations require

a. Deposits of 10k or more must be reported to IRSb. File a suspicious activity report (SAR)

2. Red flags: lack of concern regarding risk, frequent large deposits, large # of wire transfers, excessive activity between accounts, structuring of currency deposits

ii. Regulators are more concerned with where funds are goingiii. 3 money laundering stages:

1. Placement= assets moved into systema. Easiest to detect

2. Layering= conceal source of funds3. Integration= illegal money mixed with legal money to appear legit

II. State Securities Regulationsa. Blue-sky laws= state laws pertaining to the trading and issuance of securitiesb. The Uniform Securities Act provides legal framework for state registration of securities

i. 3 ways to register:1. Coordination= with state and SEC at same time

a. Only used for IPOs2. Filing (notification)= issuer met criteria and filed in previous state it may notify

state of intentionsa. If no response registration effective 5th business day

3. Qualification= issuer must respond to qualificationsa. Only when ordered by state

ii. Broker/dealers that make or receive calls in or from that state must register in that state 1. Or if they live in that state2. Or if they solicit business in that state

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Chapter 17- Other SEC and SRO Rules and Regulations

I. Registration and Regulation of Broker/Dealersa. SEC= primary regulatory body

i. If broker dealer does not comply subject to: censure, limits on activities, suspension, revocation, fine, barring member from other members, imposition

1. Associated persons may also be disciplined, If barred then they can not be hired by broker/dealer without permission

2. Broker/dealers must have fingerprint records for all employeesa. Exceptions: not involved in securities sales, do not handle cash, do not

superviseb. Self-regulatory organizations (SROs)

i. NASD= regulates matters that relate to investment banking and trading in the OTC market

ii. NYSE= regulates matters related to trading on NYSEiii. MSRB= regulates underwriting and trading of municipal securitiesiv. Chicago Board of Options (CBOE)= regulates trading of options

II. National Association of Securities Dealers (NASD)a. Purposes: promote investment banking, standardize principals, promote commercial honor,

encourage observance of laws, provide communication medium, enforce NASD Conduct Rules, promote self-discipline

b. Characteristicsi. Districts= divided into 11 each with own commissionerii. Dues, assessments, and other charges

1. NASD funded by annual membership feesa. Includes: membership fees, assessment based on income, fee for each

principal/representative, charge for each branch office iii. NASD members may not use NASD name in manner that looks like NASD endorses a

firm memberc. NASD Manual= describes 4 rules

i. Conduct Rules= set fair trading practices that member firm followii. Uniform Practice Code (UPC)= establishes uniform trade practices iii. Code of Procedure= how NASD handles member violationsiv. Code of Arbitration Procedure= governs resolution of disagreements

d. National Adjudicatory Council (NAC)= establishes rules and membershipi. Broker/dealers registered with SEC, people affecting trades, and muni bond firms may

apply for membership with NASD or1. Membership agreement= comply with rules/laws and pay dues 2. All applications go to main office

ii. Associated persons associated with NASD firm engaging in investment banking must be registered as such

1. Must be sponsored by member firma. Must certify that investigation and credentials are in order

e. Postregistration rules i. Registered persons are required to attend education programs

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1. Regulatory element= complete training session with in 120 days of second registration and every 3 years after

2. Firm element= firms prepare annual training planii. Registration is nontransferable upon leaving firm

1. Must be terminated on U-5 and reapplied for on U-4 2. Representative leaving firm may continue to receive commissions if contract is in

place iii. Member firm must notify NASD if associated person is subject to discipline by 1 of the

following: national securities exchanges, clearing corporation, commodity futures market regulations, federal or state commissions

1. Must contain name and nature of actioniv. If registered person is terminated firm must notify NASD with in 30 days

1. If under investigation employee must not be terminated until investigation is resolved

f. Qualifications examinationsi. Registered representatives= persons engaged in investment banking and securities

business1. Includes: officers that are not principals, supervisors, solicitors, trainers, anyone

involved in securities business2. Series 7 allows representatives to sell securities

a. Need Series 3 to sell commoditiesii. License become void if person is unaffiliated for 2 yearsiii. Registered principal= anyone who manages member’s investment bank

g. Disqualification: expelled from membership by any other SRO, under SEC order, found to be cause of other broker/dealers expulsion, misstatements, felony conviction, misdemeanor conviction involving securities, court injunctions

III. Investigation: Code of Procedure and Code of Arbitrationa. If person under investigation NASD requires member firm to: provide information, testify, give

access to books b. Code of Procedure= deal with violations of NASD rules, MSRB rules and federal securities law

i. After investigation if person violated rules then Enforcement will issue a complaint1. If complaint is filed against representative then supervisor is usually mentioned as

wellii. Offer to settle must: describe rule violated, describe acts, include statement consenting to

finding of facts, propose sanctions 1. Uncontested offer= respondent waives right to hearing and appeal2. Contested offer= offer is contested and submitted to hearing officer who may

order a settlement conferencea. If offer rejected it may not be used as evidence

3. If respondent does not refute allegations Enforcement requests respondent sign letter accepting finding of violation and consenting to sanctions and waving right to hearing

4. Minor rule violation (MRV) that respondent does not dispute Enforcement may request respondent sign MRV letter accepting finding

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a. MRVs: have advertisement approved, maintain file of advertising, file advertising with NAD, file timely reports on short positions, keep books, submit trading data

b. Fine not to exceed 2.5kiii. Hearing resembles courtroom and at conclusion panelists convene and within 60 days

render a decision iv. Sanctions if guilty

1. If suspended person may not remain associated with firm and may receive salary or commission

2. sanctions effective as of date of decisionsv. Appeals can be made by either side and must be made within 25 days of decision

1. May appeal again by taking case to federal court2. Stays effective date of any decisions

c. Code of Arbitration mediates disputes involving: member vs. member, member vs. associated person, associated person vs. associated person

i. Customer can force member to arbitration but not vice versa1. All new accounts contain a predispute arbitration clause

ii. Class action claims are not subject to arbitrationiii. Statement of claims= party describes dispute in detail dispute

1. Initiates proceedingsa. Includes check for claiming feeb. May seek injunction

2. Respondent has 45 days to respond and specify defensesiv. Mediator will preside over discussions before hearing

1. May not serve on arbitration panelv. Nonpublic arbitrator= associated with broker/dealer

1. If customer involved then will be publicvi. Simplified arbitrator= dollar amount of 25k or less

1. Decision within 30 days 2. Both parties must agree

vii.Awards paid with in 30 days of decision date 1. If not paid then interest will accrue

viii.Statue of limitations is 6 yearsIV. SROs: The NYSE Constitution and Rules

a. NYSE is corporation operated by BOD consisting of 10 of each exchange member and public representatives and a chairperson

b. NYSE membership is fixed at 1,366i. Seats are thus negotiatedii. Only individuals may own seats

c. Allied member= holders of more than 5% of member’s voting stocki. Not allowed to trade on exchange floor

d. Salespersons of NYSE member firms must be registered through there firmsi. 120-day training programs

e. Representatives must have firm’s permission before taking a second job f. Representative may be paid in salary or commission

V. Communication with the Public: Advertising and Sales Literature

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a. Advertising has no control over audience i. Generic advertising= promotes securities as investment medium but does not refer to

specific security1. Includes: securities investment company offers, nature of investments, services

offered, explanations of investment companies, descriptions of exchange, where public can go for more info

a. Must contain name and address of representativeii. Recruitment advertisements do not have to disclose firm’s name

1. May not emphasize salary of top-paid salespeopleb. Sales literature has target audience

i. Correspondence does is not require principal approval 1. Includes group emails to customers

ii. Public appearances require principal approvaliii. Must identify firm’s name, person that prepared material, and the date it was first usediv. Proposals that include recommendations must have basis

1. If stock then provide current stock’s price,a. References must reveal: price range, market’s direction, availably of

information, recommendations of similar securities made in the last year, all recommendations made over time in questions

b. Must disclose conflict of interest2. If mutual fund then: use charts, reveal source, separate dividends from capital

gains, not state that mutual fund is safer, reveal highest sales chargea. Periodic payments then: profit is not assured, don’t proved protection

against losses, plans involve continuous investment, consider their financial ability

b. Advertisements that feature total return must explain how it is calculated3. If written recommendation then requires principal approval

a. Not needed for individual recommendationc. Advertising and literature must be approved by principal d. All advertisements and literature must be kept on file for 3 years

i. Easily accessible for 2 years ii. A firm in its 1st year must file10 days before useiii. Investment company must file 10 days after useiv. Options/CMOs filed 10 days before use and must be accompanies with OCC documentv. DPPs must file 10 days after usevi. Prospectuses are excluded from filing

e. Spot checks= submit all advertising material to NASD upon requesti. Except for those relating to muni bonds and investment companies

f. Opinions passed off as guarantees are prohibitedg. Endorsements must not mislead

i. Must indicate that: past performance does not guarantee future performance, disclose the fact that a fee was paid (if it was), person has qualifications

h. Offers of free service may not include obligations of any kindi. Ambiguous references to NASD must not be madej. Use of members’ names must: clearly state firm’s name, describe relationship with NASD, not

use degree in misleading manner

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i. Fictional name is permitted if filed with NASDii. Generic/umbrella name may be used: displayed with NASD member name, relationship

is clear, no implication umbrella is broker/dealeriii. May designate portion of its business (i.e. division)

VI. Research Conflicts of Interest:a. Research and investment banking

i. Rules prohibit: investment banking departments from supervising research analysts, investment banking personnel from discussing research reports before issuance, tying analyst compensation to transactions

b. Research analysts and issuersi. Rules: analysts may not show drafts to issuers, analysts may not withhold good ratings to

induce future business, 40 days quiet period for IPOs/10 days for additional issuesc. Research reports and public appearances

i. Rules: firms must explain ratings, analysts disclose if compensation tied to revenues, disclose if they or employer have a financial interest in the security > 1% , disclose if they have received fees from investment bankers

d. Analysts and associated personsi. Rules prohibit: analysts from investing in securities before IPO (if covered by analyst)/30

days before and 5 days after report is issued, analysts from trading against recommendation

VII. Telephone Communicationsa. Telephone Consumer Protection Act of 1991 (TCPA) was enacted by FCC to protect consumers

from unwanted solicitationi. Telephone solicitation is call initiated for the purpose of encouraging investment ii. Telemarketers must: maintain a Do-Not-Call list and not call them for 10 years, institute

written maintenance procedures, train representatives, record names and #s of prospects who don’t want to be called, cold calls inform firm’s name, call between 8 and 9

1. Exempt: established business relationship, non-profit organizations, not for commercial purpose, made for debt collection

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