1 Finance Unit One: Capital Market I Notes

Basic Definitions
Board Lot A standard trading amount, usually 100 shares, which has been agreed upon by stock exchanges Broker The party that mediates between a buyer and seller. Capital Gain/Loss Profit/loss from the sale price of an asset being higher/lower than its purchase price (E.g. Stocks, house etc.) Collectible Items bought with the hope/intention that it will increase in value. Carries more risk because there is a good chance that item will NOT increase in value. Commission A payment method where you make a portion of the amount you sell Dividend A cash payment using profits that is announced by the companys board of directors to be distributed among shareholders (Per share). Earnings per Share Net income for a specific period divided by number of outstanding shares Market Close Time of day that a stock market closes. Marketplace Place where buying and selling takes place and the laws of supply and demand operate. P/E ratio Current market value per share divided by EPS. Indicates future earnings Share A certificate representing ownership in a company Shareholder One who owns shares of a company, etc. Share Price The price of one share of stock Stock Shares in the ownership of a corporation that are a claim on its earnings and assets Stock Exchange A place that brings together users and providers of capital Trade an exchange where buy and seller agree on a price Trader One who buys and sells securities for his/her personal account, not on behalf of clients Trading Floor Place on an exchange where trading takes place Yield Return on an Investment

Warren Buffet Video Brief Overview

Warren Buffet had a net worth of 40 billion, Donated 37 Billion Depression period in Omaha, Nebraska, learned a lot from parents, First stock at 11 Views stock as a part ownership of company, represents the business Berkshire Hathaway textile company, became a holding company, holds other companys assets When stock market boomed in 1960s, He offered investors cash or shares to dissolve partnership Average lifestyle, Investing strategy based on judging business first

The Capital Market Introduction (p.6)

The capital market is similar to that of a shopping mall. Investors are like shoppers, Corporations/Governments are the merchants, and securities are like the products. The capital market is the MOST efficient way for companies and governments to raise cash by selling securities. Two types of securities Equity and Debt. Equity Buying shares of a company, entitled to portion of profits

Debt Loaning money, to receive interest payments for the use of the money

2 Finance Unit One: Capital Market I Notes

Primary and Secondary Security Markets

Equity Securities Primary Market Common stock shares of a company are sold for the first time in a process called an IPO. Secondary offerings can be issued. Stock splits can happen. Issue is facilitated by investment dealers Secondary Market The stock exchanges; where investors buy and sell issued shares. Based on bid and ask* Brokers represent investors for a fee. Companies dont actually see/get any of the money traded here. Some e.g, TSX, MX, NYSE, etc. There are listing requirements to be traded on the stock exchanges Tertiary Market/OTC Market off-exchange where bonds, stocks and other commodities are traded directly. OPPOSITE of exchange trading. Usually stocks that cannot be listed on the exchanges are on here and are quite risky. Fourth Market Trading network among investors interested in buying and selling LARGE blocks of stocks -> private trades Debt Securities Primary Market Companies and governments sell bonds to institutional investors Secondary Market Primarily over the counter, bonds and other debt securities are traded but not on a central exchange. The Money Mart is the OTC for cash-equivalent securities that are very liquid and short term (GICs, T-bills, etc.). Liquidity is very important, and that is why Cash is king. Its usually more productive to place cash in short term cash equivalents than in a bank account. **There may be some confusion over what is primary and secondary. Just understand that most debt securities (Particularly bonds) are traded in the secondary markets and there are some cash-equivalents you can get that are considered primary.

The Economy and You Project Summary

Interest Rates go up and down with the economy. Saving, borrowing and Investing are affected by interest rates. Inflation goes up and down with the economy. Inflation rates affect REAL interest rates that are the nominal interest rate less the inflation rate. A 5% interest rate during 3% inflation rate is actually 2%. Foreign Exchange Rates are based on the demand for the Canadian dollar. If the dollar decreases, exports will be cheaper but imports will by pricier and vice versa for increases. Our Saving and Spending is affected by many factors including the economy and there are trends for population demographics. Financial Markets are good barometers of the economy. All markets are interconnected, interest rates affect financial markets. Bank of Canadas role immensely impacts the financial market. They control the interest rates and inflation rates with their bank rate. The Government Role in our economy is important because of taxation, and especially their debts/deficits affect our available income. Global Forces play a factor because of we trade internationally (Export + Import), especially America.

3 Finance Unit One: Capital Market I Notes

How Equity Securities are Traded

Publicly owned firms divide their ownership into many shares/stocks and each share is a promise by a company to the owner for a share of the companys profits. Shares are sold on organized markets. There are two types of stock, common and private. Common Stock A share of a public company Different classes possible Dividends possible Limited Liability Generally, voting rights Preferred Stock Promised fixed cash dividends paid before dividends to common stockholders Often without voting rights Rank below creditors but above common stockholders in terms of who to pay back first

Factors Effecting Stock Price Primary, future (expected) profits of the company, and what effects them drive stock prices up or down. Supply and demand, profit/dividend outlook, general economic conditions, capital market conditions, industry conditions, speculators/analysts, management, worldwide events If you were to give 4 profit, dividends, perception, risk Fees and Costs and Brokerage Operations Only licensed individuals have a seat on the stock exchange and can buy and sell securities (brokers). When we the investors, want to buy or sell, we have broker represent us and we must pay commission for each service every time (buy, sell). Commission rates differ based on stock price. E.g. 10$ or more is 20$ + 0.03*shares. This is important for calculating P&L. Brokerage firms have inventory of stocks that we buy and sell from. There are fullservice brokers who offer order execution, information on markets/firms, and investment device but are more expensive compared to discount brokers which just execute the order. Brokerage Account Types: Cash Account (Laurier Competition) Invest pays 100% of the purchase price for securities

Margin Account Investor borrows part of the purchase price from the broker. Margin/collateral refers to the amount of funds the investor must personally provide. The rate is always the loan rate.

********************************************** More on Margin Accounts: Exchanges/brokers set minimum required deposits of cash or securities to protect the broker/exchange. Investor will pay part of the investment. The rate given for longs is how much you can borrow (Loan rate), the margin is how much you pay. No loan is made to the client in a short shale. The client must put up more than the value of the stock (Total value in account is cost of stock + additional margin) ***********************************************

4 Finance Unit One: Capital Market I Notes Orders Day orders: Buy/sell requests good that if are not met, will expire at end of the trading session Market Order: Order to buy at best current selling price Limit Order: Setting a limit order protects you from buying a stock too high (Setting maximum Buy price) or selling too low (Setting minimum sell price). Stop Order: An order to buy or sell at a specified price, it becomes a market order when price is reached. Buy if it grows to a certain point; sell if it drops to a certain point. *Bid/ask is used for orders in the OTC market. Bid price is the highest offer price to buy (Relevant when you are selling). Ask price is the lowest price will to sell (Relevant when you are buying). Short Sales Making money from a stock price GOING down. How it works: Contact your broker and declare your intentions to short Your broker will loan you securities out of its inventory You sell borrowed securities in the market like normal The proceeds (Gain) from the sell are put into your account You deposit additional collateral/margin When you end the short, you buy the securities in the market for a price (Cost) and trade it for the original sell price. So if you put it at a lower price, you make profit.

You dont own the stock when you short, so you must pay lender of stock any dividends. Canadian Regulatory Environment Self-Regulatory Organizations (SROs) regulate their own activities Canadian Investor Protection Fund (CIPF) was established to protect investors Investment Dealers Association of Canada (IDA) is the national trade association for the investment industry Canadian Securities Institute (CSI) is the national education body of the Canadian securities industry

Profit, Loss, ROI Calculations for Long and Shorts Cost of Investment = (No. Shares)*(Share Price) + Commission Gain of Investment = (No. Shares)*(Share Price) Commission Profit/Loss = Gain Cost Return on Investment = Profit/Loss / Cost of Investment For long positions, the share price for cost is the price at which you buy the stock at and the share price for gain is how much you sell it for. For short positions, the share price for cost is how much you close the short at and the share price for gain is how much you first borrowed it at. **If you have a certain amount of money to invest, and the dealer offers you 50% margin, you can actually buy 2x as many stocks as you can afford

5 Finance Unit One: Capital Market I Notes

Risk and Return

Investments defined: Investments is the study of the process of committing funds to one or more assets with an emphasis on holding financial assets and marketable securities to increase in value. Primary Objectives: Safety of principle, income, growth of capital Secondary Objectives: Liquidity, Tax minimization, Time Safety: The chance of not losing your investment or a negative return on principle Income: Periodic cash payments from the investment (Dividends) Growth: Increase in the value of the principle investment (Capital Gain) Liquidity: The ability to easily convert investment into cash Tax: Tax minimization (Investments protected from tax) Time: Investment time horizon Risk/Return Tradeoff Return: expected return is not usually the same as realized return Risk: the possibility that the realized return will be different than the expected return As expected return increases, so does risk.

Investment Constraints Legal, Moral, Emotional, Income, Ability to Afford Losses, Realism, Others (illness, divorce, etc.)

Two-Step Process of Investment Decision Process 1. Security Analysis Necessary to understand the security and apply to estimate price or value 2. Portfolio Management Mixture of Investments, match securities to investment goals, balanced and diversified to limit risk, evaluation of returns

6 Finance Unit One: Capital Market I Notes Factors Affecting Process Ex post/After the fact returns dominates decision process Future unknown so this must be estimated. You dont know whats going to happen Intelligence Information how efficient are financial markets in processing new/immediate information Diversification Foreign Financial Assets Opportunity to enhance return and/or reduce risk

Diversification Based on the fact that different investments behave differently in the same conditions Business Risk Market/Systematic Risk Risk specific to one firm or industry State of overall market tough to diversify Diversify: Asset type, industry, geography

Probability Video
Expected Rate of Return weighted average of all possible returns Investment Periods Boom, normal, recession Risk Difference of ER AR, use standard deviation to measure risk

7 Finance Unit One: Capital Market I Notes

Bond Investments
When purchasing bonds, an investor is a creditor to the issuer. As a creditor, a bond holder has a higher claim on assets than a stock holder in the event of a bankruptcy.

The Appeal of Bonds Income Source: Periodic interest cash payments Diversification: Adding fixed income to portfolio Safety: High quality bonds are considered very safe. Not all bonds offer same level of security though Choice: Investors have a wide range of issuers to choose from. There are way more bonds than stocks to choose from.

Bond Value Face Value/Par Value: The amount of money a bond holder receives back from the issuer on the bonds maturity date. Face value and actual price often differ. A bond trading below face value is at a discount A bond trading above its face value is a premium A bond trading at face value is at par value

Bond Price Bond Prices are always quoted as a percentage of face value. So a bond trading at par value would show 100. If a bond was quoted at 94.50, it is trading at 94.5% of its face value. If the bond face value was $1000, it would cost $945 to buy it. Coupon The coupon is the rate of interest the bondholder will receive as a percentage of face value. Usually these interest payments are given out semiannually. A $1000 face value bond will pay $30 dollars every month and $60 dollars every year. Most bonds pay fixed coupon rates but some may have varying rates. Some dont pay at all until maturity.

8 Finance Unit One: Capital Market I Notes Yield Two types: Current Yield and Yield to Maturity Current Yield: The annual return on the dollar amount paid. It is calculated by dividing annual interest payment by its purchase price. So a $1000 face value bond with a 6.50% coupon, purchased at $950, would have a current yield of 6.84% (0.065*1000/950). Yield to Maturity: This tells you the total return you will receive by holding the bond until it matures. YTM equals all the interest payments (if you reinvent these interest payments at the same rate as the current yield on the bond), plus any gain (If you purchased the bond as a discount) or loss (If you purchased the bond at a premium). YTM is useful because it allows you to compare bonds with different maturity dates. Basis Point: 1/100th of a 1% of the yield. 1% = 100 basis points. Accrued Interest: Interest that has accumulated from last interest payment is accrued interest. Settlement Date: When the purchaser pays for the bond. Types of Bonds Government Bonds Federal, provincial, municipal governments issue bonds as a way of raising capital. They are considered VERY safe but offer low return/yield. Debentures Secured solely on creditworthiness of issuer Corporate Bonds Corporations raise capital by issuing bonds, debentures and notes. Strip Bonds Zero-coupon bonds whose coupon are stripped and are sold separately; bought below face value. Real Return Bonds Securities that pay the holder a rate of return adjusted for inflation. Canada Savings Bonds Are issued and backed by the Government of Canada; VERY liquid. Convertible Bonds Gives option to exchange bonds at a future date for a predetermined amount or security. Callable Bonds Gives issuer the option to retire the bond and payback bondholder (Mainly due to inflation). Step-up Bonds Pays investor coupon that increases over the life of the bond. Extendible/Retractable Bonds Short-term bonds whose maturity can be extended or retracted at the discretion of the issuer; riskier due to uncertainty. *The lower the bonds coupon rate and the longer its to maturity, the greater the impact interest rates changes will have on the price. Bonds prices are most volatile at this time. *Bonds features that affect price are current interest rates, coupon, term to maturity, and individual risk factor Yield Curve: The direct link between maturity and the yield. They are said to be flat when the difference between short and long term bonds are small. They are said to be inverted if yields on short-term issues are higher than longer-term issues. Yield curve can give a sense of where the market expects interest rates to be headed. An inverted yield curve indicates longer-term interest rates to decline.

9 Finance Unit One: Capital Market I Notes Risks with Bonds Purchasing Power (Inflationary Risk): If market interest rates have fallen since the initial bond has purchased, the bonds on the market now may offer lower yields/coupon rates. This affects people who rely on bonds cash flows for their day-to-day living. Liquidity Risk: Investors sometimes need to sell their holdings but an insufficient secondary market may prevent the sale. People who own corporate bonds are most affected by this risk. Credit (Default) Risk: A bond issuer is in default by failing to repay the principal in a timely manner. This is the risk that the creditor will default. You can get credit ratings on websites. Junk Bonds: AAA rating is lowest level of risk. Junk bonds are BB rated and offer high-yield but very high risk. Trading Bonds There is no central exchange for these securities with the exception of convertible debentures. Most bonds trade Over-the-counter which means over the phone.

Stock Indexes
The stock market was up today refers to an index doing well. An index is a specific group of stocks that are representative. No index tells everything. Some wifely used ones in the US are: Dow Jones (30 top), S&P 500, NYSE composite Index. Canadian Markets S&P/TSC composite Index and the S&P/Venture Composite Index

Finance Unit Two: Capital Market II Notes

MUTUAL FUNDS
Essentially, mutual funds are pre-packaged portfolios of investments that have different securities managed by a professional. Mutual funds pool the capital of investors. When you invest in mutual funds you are buying a small piece of every securities in the funds portfolios units. There are three ways to make money from a mutual fund: 1) Income is earned from dividends and interest from stocks or bonds. The fund will usually pay all of these to investors. 2) Fund sells securities for a capital gain; they will usually distribute these to investors. 3) Value of units in fund increases, if you sell them you can profit. Types of Mutual Funds There is currently over 10,000 mutual funds. There are THREE fundamental types of mutual funds Money Market, Fixed Income (Bond), and Equity funds (Finance Notes say there are 2: Short term and long term). At the end of the day, every mutual fund will have a variation of those 3 asset classes. Money Market Fund Deal with short-term debt instruments like treasury bills. Safe fund for principal and is more productive that putting money in a savings account. Bond/Income Fund These funds aim to provide steady income by investing in government and corporate debt. Of course these funds can vary in risk e.g. junk bonds and etc. They are subject to interest rate risk; when interest rates go up the value of bonds go down. Equity Fund Funds that invest primarily in equity securities and stocks. Generally the objectives are long term capital growth. Most funds are equity funds. There are many different types, balanced, ethical, global, index, International, mortgage, sector, small cap, specialty etc. that fit different investment styles and objectives Advantages of Mutual Funds Simplicity - Many places to buy, minimum investment is small Diversification - By owning many stocks, the risk is balanced so if some stocks are doing bad it wont affect you too hard Professional Management - Get investment expertise when you may not have skill or time Liquidity Disadvantages of Mutual Funds Professional Management - You have no choice, managers pick the securities, they might make mistakes Diversification - By limiting risk, you are also limiting returns. Management Fees and Expenses

Finance Unit Two: Capital Market II Notes Expenses and Fees We will be looking at two types of fees: MER and Loads. MER: (Management Expense Ratio) Management expenses and costs as a percentage of the funds total value. They cover hiring managers, administrative fees and etc. Load: Sales commission just to buy fund. You can have front end loads, back end loads where the fees are paid at the beginning or end. There are also no-load funds. Back-end loads can be beneficial because of a sliding scale (Holding it longer decreases load). Right of Redemption: Have the rig ht to sell your units back to the funds itself (Costs may be associated with this though) NAVPS: (Net Asset Value Per Share) Fund manager will buy back units at NAVPS. This number is calculated by dividing the funds total net value by the number of units in the fund. Volatility and Beta: Volatility is the relative rate at which the price of a security moves up and down. BETA is a measure of volatility. ETF: A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.

OPTIONS
An option is a contract that gives the right to the buyer of the option the right to buy OR sell an underlying1 asset at a specific price at a specific date. An option is also a security Due to the speculative nature; options can be very risky (Or safe if you are hedging). There are two types of options: Calls and puts. A call gives the holder the right to buy a fixed number of shares of a stock at a predetermined price (Strike/Exercise Price) at a specific date. Buyers of calls hope for the stock price to increase. A put gives the holder the right to sell a fixed number of shares of a stock at a predetermined price (Strike/Exercise Price) at a specific date. Buyers of puts hope for the stock price to drop. There are 4 participants in the options market: buyers of calls, buyers of puts, sellers of calls, and sellers of puts. People who buy options are called holders and people who sell are called writers. The holders have all the choice when it comes to the contract and the writers have no choice.

Options are one type of Derivative underlying assets

Finance Unit Two: Capital Market II Notes Option Terminology Strike/Exercise Price The price at which the underlying asset can be bought for is the strike price. For call options, options are in the money if the stock price is greater than the strike price. For put options, options are in the money if they stock price is less than the strike price. All of this must happen before the expiration date. Price/Premium The price of the option/contract Expiry Date When the option becomes valueless (American: exercise at anytime, Euro: Expiry date). Determining the premium is beyond the scope of this course. Intrinsic Value Indicates how much an option is in the money. For calls, Intrinsic Value = Max [(S0 E), 0]. For puts, Intrinsic Value = Max [(E-S0), 0]. Basically, for calls you want the price to be greater than the exercise, and for calls you want the price to be below the exercise, that is how this calculation works. Time Value Options have a limited lifespan. Time value decreases (nonlinearly) to zero as time goes on. This is because the more time there is, the more opportunity for a stock to go up or down. The volatility affects the time value by increasing the premiums. Therefore if two options had the same strike price, the one with a further expiry date will be worth more. Time value = Option Price Options Intrisnic Value. ** Stock option contracts usually consist of 100 shares. ** ** Options expire on the third Friday of the month ** **Breakeven and in the money are not the same. Options can be in the money but you might still have a loss due to the premium. Option Pricing Factors Include: Time Value, Intrinsic value, Stock and market Volatility, Dividends, Interest Rates, Supply and Demand Commission: We will be neglecting this in calculations but brokers will charge this on options. Bearish vs. Bullish Strategies Bullish Strategies With Options Buying Calls when stocks go up, you can use calls to buy stocks at a low price and sell for higher. Selling Puts Write put primarily for the income. The buyers hope for the stock to go down but they never do so you get the keep the premium.

Bearish Strategies With Options Buying Puts when stocks go down, you buy a put contract and can buy stocks at the end of the contract for low and sell them for a profit Selling Calls Write calls primarily for income. The buyers hope for the stocks to go up, but they never do so you get to keep the premium.

Other types of options: Stock-index options, Interest Rate (Bond) options, Currency options (Value based on value of currency e.g. Canadian)

Finance Unit Two: Capital Market II Notes Naked vs. Covered Options - For buying calls, its always naked because you will be buying the stock at a low agreed price and selling it for a higher market value price. - For writing calls, it can be naked or covered. For covered call writing, you are doing this on bearish market you are doing it for the income. You think the price will go down and the stock will not be exercised. Even if it is you are still going to get the strike price no matter what so this can be done for hedging. For naked call writing, you promise to sell a stock that you dont have. You still want the price of the stock to go down but these are riskier and are done based on speculation. - For buying puts, it can be naked or covered. For covered puts, you are promising to sell stock that you already own at a specific price. This is a form of hedging, protecting your money. If the price goes down, youre protected because you dont have to exercise and all you have to pay is the premium. If the price goes up, the stock is not in the money so you cant exercise and you pay the premium. There is an opportunity cost but either way you are paying a premium to be able to sell at the strike price no matter what. For naked puts, you are hoping for the price to go down so you can buy it at market value and sell for the predetermined higher strike price. - For writing puts, you really have no options. Its always naked because you never have the stock and receive premiums and may or may not have to buy the stock depending if stock prices go up or down. However, you want it to go up, so the buyer will not exercise and you just receive the premium. Why buy options? Options are bought for their versatility. Its all about leverage the use of a small investment to gain a very high return in relation to the investment. As mentioned before, you could also hedging and protecting your money and limiting your losses. A look at an option chart E.g. Apple Currently trading at 300.98

These are the November options for Apple. There are strike prices on the side that vary. For our calculation we will be using the LAST PRICE as the cost of the premium. But just fyi, bid is what you want to know if youre selling and ask is what you want to know if youre buying.

Finance Unit Two: Capital Market II Notes Investopedia Example Let's say that on May 1, the stock price of Cory's Tequila Co. is $67 and the premium (cost) is $3.15 for a July 70 Call, which indicates that the expiration is the third Friday of July and the strike price is $70. The total price of the contract is $3.15 x 100 = $315. In reality, you'd also have to take commissions into account, but we'll ignore them for this example. Remember, a stock option contract is the option to buy 100 shares; that's why you must multiply the contract by 100 to get the total price. The strike price of $70 means that the stock price must rise above $70 before the call option is worth anything; furthermore, because the contract is $3.15 per share, the break-even price would be $73.15. When the stock price is $67, it's less than the $70 strike price, so the option is worthless. But don't forget that you've paid $315 for the option, so you are currently down by this amount. Three weeks later the stock price is $78. The options contract has increased along with the stock price and is now worth $8.25 x 100 = $825. Subtract what you paid for the contract, and your profit is ($8.25 - $3.15) x 100 = $510. You almost doubled our money in just three weeks! You could sell your options, which is called "closing your position," and take your profits - unless, of course, you think the stock price will continue to rise. For the sake of this example, let's say we let it ride. By the expiration date, the price drops to $62. Because this is less than our $70 strike price and there is no time left, the option contract is worthless. We are now down to the original investment of $315. To recap, here is what happened to our option investment: Date Stock Price Option Price Contract Value May 1 $67 $3.15 $315 May 21 $78 $8.25 $825 $510 Expiry Date $62 worthless $0 -$315

Paper Gain/Loss $0

The price swing for the length of this contract from high to low was $825, which would have given us over double our original investment. This is leverage in action. Exercising Versus Trading-Out In reality, a majority of options are not actually exercised. Most options are traded. About 10% of options are exercised, 60% are traded out, and 30% expire worthless.

Finance Unit Two: Capital Market II Notes

FUTURES TRADING
Future contracts are derivative instruments just like options where there is an underlying asset. For future contracts, two parties agree to execute a set of physical commodities for future delivery at a particular price. Commodities are best defined as a natural resource used in production of goods for everyday use. E.g. corn, wheat, gold, steel, cotton, beef, currency, etc. Futures contracts are speculative meaning that you buy and sell based on how you think the price of the commodities will change. It is mostly speculative; it is rare for the investor to actually hold the physical commodity, just the piece of paper. They are like options that MUST be exercised. Users Suppliers: Producers of commodities. E.g. Petro-Canada. Users: Manufacturing Industry. E.g. Tropicana. History Before futures trading, farmers would be at the mercy of the dealer when it came to selling their wheat and products. Futures trading created a system in where farmers and dealers could make contracts for the purchase of a certain amount of wheat at a certain date for a certain price and of a certain quality. Advantages vs. Disadvantages Advantages: leverage, only paper investment, Make money quickly, Fair markets, Liquidaty in markets, small commission Disadvantages: High risk, volatility The Market and the Mechanics Spot/Cash Market: Current price to buy a commodity now Forward Market: A commitment of a price for delivery of commodity in the future Futures Market: Organized central market for a standardized forward market (Amount, date quality, etc.) The performance is guaranteed by a clearinghouse. Buyers and sellers settle with clearing corporation, not with each other. Buyers and sellers agree to these contracts through open-outcry. Short Position (Seller): Commits a trader to deliver an item at contract maturity Long Position (Buyer): Commits a trader to purchase an item at contract maturity. No restrictions on short selling. Contracts can be settled in two ways: 1) Delivery (Less than 1% - Hedgers) 2) Offset Liquidation of prior position by an offsetting transaction in the same company. 3rd party settles future contracts.

Finance Unit Two: Capital Market II Notes

Futures Margin There is a good faith deposit made by both buyer and seller to ensure completion of the contract. The initial margin is usually less than 10% of the contract value. Investors can gain/lose 100% of the total contracts value because even the smallest increase or decrease plays a huge factor into the contract price.

Economic Impact Hedgers shift price risk to speculators. Price discovery conveys information, the future values are based on information like supply + demand and etc. The Players There are hedgers and speculators Hedgers: Can be suppliers who want to sell for a certain price or users who want to buy for a certain price. They dont want this risk so they transfer the risk and reward to speculators. Hedging acts as a way of insurance for the suppliers and users. Theyre forgoing some profit to reduce risk. Speculators: They never seek to own the commodity, but trade the contracts to earn a return. They think the price of commodities will go up or down and that is the rationale they have to buy or sell contracts. Speculators are encouraged by leverage. Trader Short (Sell) Secure a price now to protect The Hedger against future declining prices The Secure a price now in Speculator anticipation of declining prices Investopedia Examples Going Long When an investor goes long - that is, enters a contract by agreeing to buy and receive delivery of the underlying at a set price - it means that he or she is trying to profit from an anticipated future price increase. For example, let's say that, with an initial margin of $2,000 in June, Joe the speculator buys one September contract of gold at $350 per ounce, for a total of 1,000 ounces or $350,000. By buying in June, Joe is going long, with the expectation that the price of gold will rise by the time the contract expires in September. By August, the price of gold increases by $2 to $352 per ounce and Joe decides to sell the contract in order to realize a profit. The 1,000 ounce contract would now be worth $352,000 and the profit would be $2,000. Given the very high leverage (remember the initial margin was $2,000), by going long, Joe made a 100% profit! Long (Buy) Secure a price now to protect against future rising prices Secure a price now in anticipation of rising prices

Finance Unit Two: Capital Market II Notes Of course, the opposite would be true if the price of gold per ounce had fallen by $2. The speculator would have realized a 100% loss. It's also important to remember that throughout the time that Joe held the contract, the margin may have dropped below the maintenance margin level. He would, therefore, have had to respond to several margin calls, resulting in an even bigger loss or smaller profit.

Going Short A speculator who goes short - that is, enters into a futures contract by agreeing to sell and deliver the underlying at a set price - is looking to make a profit from declining price levels. By selling high now, the contract can be repurchased in the future at a lower price, thus generating a profit for the speculator. Let's say that Sara did some research and came to the conclusion that the price of oil was going to decline over the next six months. She could sell a contract today, in November, at the current higher price, and buy it back within the next six months after the price has declined. This strategy is called going short and is used when speculators take advantage of a declining market. Suppose that, with an initial margin deposit of $3,000, Sara sold one May crude oil contract (one contract is equivalent to 1,000 barrels) at $25 per barrel, for a total value of $25,000. By March, the price of oil had reached $20 per barrel and Sara felt it was time to cash in on her profits. As such, she bought back the contract which was valued at $20,000. By going short, Sara made a profit of $5,000! But again, if Sara's research had not been thorough, and she had made a different decision, her strategy could have ended in a big loss.

oStock ABC: price = $100 per share

Options

Put Strike : $95 Sell Sell a put: Think the price will go up or stay the same, you earn the premium. You can be forced to buy the shares from the buyer. Buy Buy a put: Think the price will go down. You pay the premium to get the right to exercise the option. Meaning you can sell the shares to the writer at the strike price, and buy at the market. Sell

Call Strike: $105 Buy

Sell a call: Think the price will go down or stay the same, you earn the premium. You can be forced to sell your shares to the buyer.

Buy a call: Think the price will go up. You pay the premium to get the right to exercise the option. Meaning you can buy the shares from the writer at the strike price, and sell at the market.

Bullish because you want it to go up.

Bearish because you want it to go down.

Bearish because you want it to go down.

Bullish because you want it to go up.

Finance Unit 2 Test Prep

Futures Commodities are specific assets used in the production of items we use every day. Examples of commodities include: Wheat, corn, lumber, cold, oil, cotton, cocoa, pork bellies, cattle. Suppliers of commodities are commodity producers. The user of commodities is the manufacturing industry. Why buy or sell? Hedging Producers spend money on production long before their product goes to market -> guaranteed revenue amount with use of futures, thus reducing risk Hedging Consumers need to budget, knowing their unpcoming costs -> futures lock in their costs, and this insurance reduces risk.

Futures Markets Spot or cash market: The current price to buy a commodity NOW! Forward market: Commitment of a price for delivery of a commodity in the future (delayed delivery) Futures market Organized, central marketplace for standardized forward markets -> amounts, delivery dates and quality

Characteristics Centralized marketplace, investors trade with each other. Performance is guaranteed by a clearing house Buyers and sellers settle with the clearing corporation, not with each other. There are valuable economic functions: Hedgers shift price risk to speculators Price discovery conveys information

Finance Unit 2 Test Prep

Futures Contract A futures contract is an obligation to buy or sell a fixed amount and quality of an asset on a specified future date at a specified price set today. It is like an option that must be exercised! Trading means that a commitment has been made between the buyer and seller for a specific grade of the underlying commodity at a specific date Trading Through open-outcry (no longer done at TSX, but still done at some exchanges) seller and buyer agree to take or make delivery on a future date at a price agreed on today. Short position: (seller) commits a trader to deliver an item at contract maturity. Long position: (buyer) commits a trader to purchase an item at contract maturity. Contracts can be settled in two ways: -Delivery: (less than 1% of transactions) meaning that the underlying commodity is physically delivered, -Offset: liquidation of a prior position by an offsetting transaction in the same commodity Each exchange establishes price fluctuation limits on contracts There are no restrictions on short selling. Margin Good faith deposit made by both the buyer and seller to ensure the completion of the contract The initial margin is usually less than 10% of the contract value

But the investor gains or loses 100% of the total contracts value -> leveraged! Using contracts Hedgers: -At risk with a spot market asset and exposed to unexpected price changes -Buy or sell futures to offset the risk -Used as a form of insurance -Willing to forgo some profit in order to reduce risk -Hedged return has a smaller chance of low return but also smaller chance of high return 2

Finance Unit 2 Test Prep

Hedging Short (sell) hedge: Cash market inventory exposed to a fall in value Sell futures now to profit if the value of the inventory falls Long (buy) hedge Anticipated purchase exposed to a rise in the cost Buy futures now to profit if costs increase Speculators Buy or sell futures contracts in an attempt to earn a return Absorb excess demand or supply generated by hedgers Assuming the risk of price fluctuations that hedgers wish to avoid, more risk, higher returns Speculation encouraged by leverage, ease of transacting, low costs Financial Futures Contracts on equity indexes, fixed income securities, and currencies Opportunity to fine-tune risk-return characteristics of the portfolio Non powerpoint details History Before Futures Trading, any producer of a commodity (e.g. a farmer) was the mercy of a dealer when it came to selling the product. The system needed to be legalized in order for a specified amount and quality of a product to be traded between producers and dealers at a specified date. Contracts were drawn up between the two parties specifying a certain amount and quality of a commodity that would be delivered in a particular month, and futures trading began. In 1878, a central dealing facility was opened in Chicago, USA where farmers could deal in spot grain, i.e. immediately deliver their wheat crop for a cash settlement. Futures trading evolved as farmers and dealers committed to buying and selling future exchanges of the commodity. For example, a dealer would agree to buy 5000 bushels of a specified quality at a specified date. The farmer knows how much hell pay in advance, and the dealer knows his costs.

Finance Unit 2 Test Prep

Until twenty years ago, futures markets consisted only of a few farm products, but now they are joined by a huge number of tradable commodities. Also metals such as gold, silver and platinum; livestock like pork bellies and cattle; energies like crude oil and natural gas; foodstuffs like coffee and orange juice; and industrials like lumber and cotton, modern futures markets include a wide range of interest-rate instruments, currencies, stocks, and other indices such as the Dow Jones, Nasdaq and S&P 500. Hedgers trade futures to protect themselves against price changes, they are the producers. Speculators are investors who trade futures contracts to earn a profit on the contracts themselves. Banks, institutions, individuals. Advantages -highly leveraged -paper investment, no physical possessions -can make money quickly -usually fairer than other markets -most futures markets are very liquid -small commission charges Disadvantages -Very high risk on investment based on speculation, if investing a 10% security you could lose ten times your investment. -Margin call: A broker's demand on an investor
using margin to deposit additional money or securities so that the margin account is brought up to the minimum maintenance margin.

IPOs
Definition: Initial Public Offering: a corporation's first offer to sell stock to the public. Description: Bring new issues to the market. (going public) Common stock being sold for the first time. Advantages Financial benefit of raising capital (quickly and effectively). Public awareness. o Can lead to an increase in market share. Trust increases; have to reach the standards of an exchange. Can assist with exit strategy. Disadvantages Disclosure regulations and requirements. o High Cost. Added pressure of the market. o In the short and long term

Why go Public? Because of the increased scrutiny, public companies can usually get better rates when they issue debt. As long as there is market demand, a public company can always issue more stock. Thus, mergers and acquisitions are easier to do because stock can be issued as part of the deal. Trading in the open markets means liquidity. This makes it possible to implement things like employee stock ownership plans, which help to attract top talent. Basic Procedure for a New Issue: Obtain the Board of Directors Approval: o Create a Company Charter for share issue. o Shareholder vote (private companies still have shareholders, just very few) Select an underwriter: a financial institution to help with the IPO (i.e. Goldman Sachs) Steps to an IPO: 1. Prepare and distribute a preliminary prospectus to the SEC/OSC for approval. 2. Red Herring a copy of the prospectus* without prices etc. before OSC approval. 3. Find potential investors, and calculate a feasible range of price. 4. Road Show advertise offering to large institutional investors/wealthy clients etc. 5. Ontario Securities Commission (OSC)/Securities Exchange Commission (SEC) review and approval, and a date of issue is set. 6. The company and underwriter sit down and decide on a price; this is b the company, the

7. success of the road show and, most importantly, current market conditions 8. Issue final prospectus: with set IPO price etc. 9. Issue shares. *Prospectus: Legal documents that contain relevant financial statements about the proposed use of the funds raised by the stock issue, future growth plans and other relevant info. regarding the share issue. Individuals and IPOs Most people will not be able to get stock at the IPO price. If the underwriter feels an IPO will be successful, they will probably pad the pockets of their favorite institutional client with shares at the IPO price. Risk/things to watch for when getting into an IPO: No History: Seeing that there is no history, it is very hard to analyze a IPO company. The main source of data is the red herring: o Information about the management team and how they plan to use the funds. Lock-Up Period (only applicable for company insiders): Lock-up agreements are legally binding contracts between the underwriters and insiders of the company, prohibiting them from selling any shares of stock for a specified period of time. o The period can range anywhere from three to 24 months. Ninety days is the minimum period stated under Rule 144 (SEC law) but the lock-up specified by the underwriters can last much longer. o When lockup expires, all insiders sell, puts a downward pressure on the stock. Flipping: Reselling a hot IPO stock in the first few days to earn a quick profit. o Will be stongly discouraged by brokerage; but not illegal. Companies want long term investors, not traders. o Can get you blacklisted from future offerings. The Hype: Investment Banks hype up all IPOs; but one should look into the company before they invest. Tracking Stocks: A large company spins off one of its divisions into a separate entity. The rationale behind the creation of tracking stocks is that individual divisions of a company will be worth more separately than as part of the company as a whole. Advantages: o Company keeps control, but can separate revenues and expenses. Can be used to separate a profitable side of a company from the rest of it which may be failing. Company can make acquisitions using the tracking stock instead of cash. Difference between stock and tracking stock: o Usually have no voting rights. o No separate board of directors.

The Underwriter: Underwriting: The process by which investment dealers purchase an issue of securities from a firm and resell it to the public. Issuer: First it is the originating investment bank. To reduce risk, the investment bank may distribute the shares among other banks, forming an underwriting syndicate (group of investment bankers). The Selling Group is composed of the underwriting syndicate as well as any selected retail brokerage house. Types of Underwriting agreements: Firm Commitment: The underwriter guarantees that a certain amount will be raised by buying the entire offer and then reselling to the public. Best Efforts: The underwriter sells securities for the company but doesn't guarantee the amount raised.

Corporate Governance and Ethics

Corporate Governance: Set of processes, customs, policies, laws and institutions affecting the way a corporation is directed, administered, or controlled. Values: The difference between right and wrong on a personal level; ones own emotional investment. Morals: Values which hold a greater social element; more broadly accepted. Externally imposed upon a person. Ethics: Set of values which are formalized, codified, and internally defined and adopted. Stakeholder: Someone with a vested interest in the performance of the company. Principle Stakeholders in a company: Shareholders. Other Stakeholders: Employees. Customers. Banks. Regulators. Environment. Community. Information about Corporate Governance: Regulated by corporate and security laws. Sarbanes/Oxley Act: restored public confidence in corporate governance. CSA rules (national instruments and policies) impact corporate governance. Why an Investor Should Care: Impacts other investors confidence. Generally seen that a well governed management leads to higher returns. Lower risk of financial mismanagement. Better returns. Helps society. Economy will profit from steady cash flow (greater good).

TSX Guidelines for Corporate Governance (Paraphrased): 1. 2. 3. 4. 5. Board of Directors should have an independent majority. Need to appoint a chair/lead director who is independent. Independent directors must hold regularly scheduled meetings. Company must have a written board mandate. Company must have position and duty descriptions for: a. Chairman. b. Chairman of individual committees. c. CEO. Must provide each director with an orientation and continuing education opportunities. Must adopt a written code of business conduct/ethics. Must have a nominating committee of just independent directors. Board must have a process for determining the competencies and needs of board members for hiring. Must have a compensation committee entirely made of independent directors. There must be regular assessments of the boards effectiveness, as well as the effectiveness/contribution of each committee/member.

6. 7. 8. 9. 10. 11.

Parties involved in CG: Regulating Body: CEO. Board of Directors. Management. Shareholders. Auditors. Others: Suppliers. Employees. Creditors. Customers. Community. Responsibilities of the BoD: Endorse the companys organizational strategy. Develop directional policy. Appoint/supervise/remunerate senior executives. Esnure accountability to owners and authorities. *the company secretary, or Chartered secretary (ICSA) upholds the companys corporate governance policy.

Elements of good corporate governance: Honesty. Trust and integrity. Openness. Performance orientation. Responsibility/accountability. Mutual respect. Commitment to organization. Principles of corporate governance: Rights and equitable treatment of shareholders: respect rights of shareholders. Interest of other stakeholders kept in mind. The board should have/be: o A mix of executives and non executives. o A range of skills to understand and challenge executives. o An appropriate size. Integrity and ethical behavior. Disclosure and transparency. Issues with corporate governance: Internal controls and auditors. Independence and quality of external auditors. Oversight/management of risk. Oversight of financial statement preparation. Review of executive compensation. How many resources directors are allowed. Board nominations. Diversity policy. Internal Controls of a Company Monitoring by the BoD. Internal auditors. Balance of power president and treasurer are different people. Remuneration performance based pay. External Controls of a Company External stakeholders and competition. Debt covenants. Demand for and assessment of performance. Government regulation. Managerial labour market. Media pressure. (Potential for) Takeovers.

Definitions: Rules vs. Principles: Rules are cut and dry, while principles have room for interpretation. Enlightened Board: A board that goes above and beyond. Helps management lead a company.

Financial Analysis
4 Types: 1. 2. 3. 4. Income Statement: Revenue and expenses for a period of time. Statement of Owners Equity: Changes in Owners Equity for a period of time. Balance Sheet: Assets/Liabilities/Owners Equity at a specific time. Cash Flow Statement: summarizes cash inflow (cash receipts, expenses etc.) for a period.

Notes on a financial statement are key in understanding them! Relationships between statements: IS/Statement of OE: Net Income from IS is added to OE. Statement of OE/BS: Final OE is shown on BS. BS/CF: New cash shown on CF Statement. Ratios Needed Ratio Current Ratio Quick Ratio Working Capital A/R Turnover Inventory Turnover Debt Ratio Equity Ratio Debt to Equity Ratio EPS Book Value Return on Assets Return on Equity Gross Profit (after COGs) Rate Net Income Rate Dividend Yield P/E Ratio Calculation Current A/Current L Quick A/Current L Current A Current L 365/(NS on Credit/Avg A/R) COGs/Avg inventory Total L/Total A *100% Total OE/Total A *100% Total L/Total OE NI/# of (common) Shares OE/# of (common) Shares NI/Total A *100% NI/Total OE *100% Gross Profit/Net Sales *100% Net Income/Net Sales *100% Dividend/Market Price *100% Market Price/EPS Suggested 2:1 1:` +tive 30-45 Days Industry (Higher Better) Lower Better (<50%) Higher Better (>50%) Lower better (<1) Higher Better Higher Better Higher Better Higher Better Higher better Higher Better Higher Better Higher Better