Chapter One- Equity Securities I. Security a. Investment i. Represents equity or debt 1. Debt= bonds 2. Stock= equity a.

Primary means of raising business capital b. Holders vote board of directors b. Purchased on exchange i. NYSE c. Purchased OTC i. NASDAQ ii. Linked to other NASD member firms Equity a. Balance sheet summarizes company i. Assets, liabilities, equity b. Net worth/ Equity= Assets liabilities Common Stock a. Authorized= specific number of shares authorized to sell i. Often sells only portion to raise capital ii. Charter must be amended to sell more than authorized b. Issued= authorized and distributed to investors i. Leftover from authorized shares that didnt sell ii. Reasons for added capital- expansion, dividends, options, convertible bonds iii. Un-issued authorized shares not counted toward capitalization c. Outstanding= company issues, not repurchased d. Treasury= issued and repurchased from investors i. Reduce outstanding shares, increase EPS, Inventory, future acquisitions Preferred Stock= features of equity and debt but is equity security a. Fixed dividend streams i. Price fluctuates with interest rates ii. Priority over common stock (same if liquidation) iii. Stated in dollar amount iv. Some offer variable= moves with I-rates b. Non-voting c. No appreciation d. No maturity date e. Categories i. Straight= stated dividends, missed dividends are not made up ii. Cumulative= missed dividends made up iii. Convertible= exchange preferred to common 1. Fluctuates with common stock 2. Lower dividend rate iv. Participating= share of corporate profits 1. If common stock dividend increases, preferred stock dividend increases 1

II.

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v. Callable= company can buy securities back Stock Values a. Par Value= meaningless, no effect market price i. Money excess of par company receives recorded as APIC on B/S b. Book Value= how much investor would receive if company liquidated c. Market Value= price investors pay for stock i. Supply and demand determines (based on company prospects) ii. Quoted in whole dollars (points) plus cents Rights of Shareholders a. Voting rights= BOD, issuance of equity securities (including convertible bonds), big changes in business, declaring stock splits i. Not vote on dividends ii. Class A b. One vote for on share i. Statutory= one vote for each item on ballot 1. Benefits large investor ii. Cumulative= allocate votes in any manner 1. Ex: 200 shares all 200 votes can go to one board member 2. Benefits small investor c. Proxies= absentee ballot i. Cancelled if stockholder attends meeting ii. Stockholder may revoke proxy iii. Proxy solicitation= company sends proxy to stockholders for specific meeting 1. Must submit to SEC iv. Proxy Contest= vote can change control of company 1. Must submit to SEC d. Nonvoting stock= raise capital while maintaining management control i. Class B e. Preemptive rights= offer stock to stockholder before public i. Anti-dilution provision f. Limited liability= stockholders can not lose more than they put in g. Inspection of books= stockholders receive annual financial statements and list of stockholder h. Residual claims to assets= if liquidation right to assets after debt (stockholder is lowest priority) i. Most junior security Stock Splits a. High market price, split to make stock more attractive b. Par value changes c. Forward Split= increases number of shares, reduces price without effecting market value or ownership interest i. New # of shares= original number of shares * amount received/ previous amount 1. Ex: 100 shares, 5 for 4 split: (100*5)/ 4 ii. % 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 Benefits and Risks a. Long position= investor buys shares 2

IX.

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b. Short= investor borrows shares, sells them, will re-buy, and replace at later date c. Benefits i. Growth= capital appreciation ii. Income= dividends iii. Property= shares of subsidiary d. Tax effects i. Realized gains and cash dividends are taxes, unrealized are not 1. Corporations receive 70% exclusion on dividend tax e. Risks i. Market risk= price will decline 1. Long position= limited to investment 2. Short position= unlimited ii. Decreasing dividends iii. Low priority if liquidated Return a. Cash dividends= automatically deposited to brokerage account i. Taxed year received b. Stock dividends= used by a lot of growth companies i. Not taxable c. Current yield= dividend yield i. Annual dividend/ market value Transferability a. Stock certificate= indicates shares owned i. Odd lot transactions= share amounts fewer than 100 ii. Printed with CUSIP (Committee Uniform Securities Identification Procedures) 1. Identity number for each issue of security 2. Helps track securities 3. Used in trade confirmations b. Negotiability= transfer, sell, give with little restrictions i. Stock Power= to transfer owner must sigh security (must guarantee) Transfer Procedures a. Transfer agent i. Insures securities issued to correct person and maintains ownership records ii. Cancels old and offers new securities iii. Distributes new shares in stock split b. Registrar= accounts for outstanding shares i. Must be independent of issuing corporation Exchange Listed Stocks (Printed in Financial Publication) a. Name and dividend (annual) b. 52 week range c. PE ratio (most recent earning report) d. Number of shares traded during day i. Round lots of 100 e. Ex-Dividend i. X before volume indicates stock is ex-rights 1. Buyer will not receive next dividend 3

f. High and low for the day g. Net change in price XIII. OTC/ NASDAQ a. NASDAQ National Market (NNM) i. High national interest (Ex. Microsoft) ii. Listings similar to that of exchange listed securities b. SmallCap i. Smaller, less heavily traded XIV. Dividend Department a. Collects and distributes dividends i. Cash, Stock, Splits, etc b. Dividend Disbursing Agent (DDA)= makes distributions c. Dividend Disbursing Process= determined by BOD (except X date) i. Declaration date= board approves dividend, designates payment date, and record date 1. 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 date a. 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 day a. X date day after record date 3. Stock price reduced by dividend 4. Determined by NASD iii. Dividend record date= stockholders receive dividends if owner on date iv. Payable date= checks sent to stockholders d. Stock dividends and splits= same as cash i. 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 dividend i. Sent if wrong party receives dividend XV. Rights and Warrants a. Issuance i. Rights offering= stockholders purchase stock below market price 1. Valued separately from stock 2. Trade in secondary market and have theoretical value a. Cum rights= receives rights i. 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 rights iii. Subscription right= short term privilege to buy additional shares 4

1. One right for one share iv. Terms= stipulated on certificates v. Standby underwriting= underwriter buys unsold shares and resells them b. Warrants i. Certificate granting owner right to purchase security at specified price at later date 1. 1 share of common stock per warrant 2. Exercise price>market price ii. Five year life iii. Long term iv. May trade separately v. Do not receive dividend vi. Offered as sweetener for another security 1. With bonds and preferred stock XVI. American Depository Receipts (ADR) a. Security that represents a receipt of stock for non-US Company i. Facilitate trading foreign stocks in US ii. Bought and sold like stock iii. Foreign branches of US banks issue them 1. Registered to banks (on books) iv. Stock remains on deposit as long as ADR is outstanding v. Sponsored by foreign company 1. Provide financials b. Owners have rights, receive dividends i. Converted into US dollars ii. No preemptive rights c. Can exchange ADR for stock d. Subject to currency risk XVII. Real Estate Investment Trusts (REITs) a. Professionally managed portfolio of real estate investments i. Dividends and capital gains b. Traded publicly on OTC c. Avoid being taxed as corporation if: i. 75% revenue received from real estate ii. Distribute 90% of income to investors d. Pass through income, not losses e. Not direct participation partnerships i. Do share some characteristics

Chapter Two- Debt Securities I. Characteristics a. Bondholders have no ownership interest or voice in management b. Issuers= raise working capital or for fund expenditures i. Corporate= Five years or more ii. Treasury securities= backed by full faith and credit 1. T-bills= 6 months or less a. Issued at discount of par, pay out face at maturity b. Denominations of $1,000 to One million i. Maturities= 4, 13, and 26 weeks 2. T-notes= 2 years or more a. Pay interest every six months b. Sold at auction every four weeks c. Denominations of $1,000 to One million i. Maturing from 2 to 10 years d. Can be refunded= offer new security with new maturity instead of paying face at maturity e. Priced as % of par in 1/32s 3. T-bonds= greater than 10 years a. Denominations of $1,000 to One million i. Maturing in 10 to 30 years b. 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 governments 1. Tax-exempt on federal level c. Interest= timing payments i. Face/Par Value= $1,000 per bond and will be redeemed at maturity 1. What issuer owes investor ii. Coupon= payment calculated from par value (semi-annual) iii. Accrues daily d. Maturities=date when bond is repaid i. Term= principal of whole issue matures at once 1. Sinking fund to accumulate money a. May be in indenture b. Used by lower rated issuers ii. Serial= portions paid out over years iii. Balloon= repays portion before security, but major portion at maturity iv. Series Issues= spread out borrowing over years e. Bond Certificate= physical evidence of bond, traditional i. Registration= record ownership ii. Coupon (Bearer Bonds)= whoever posses coupon sheet gets payment, no proof of ownership 1. Issues $1,000 and $5,000 2. Not issued since 1983 6

a. Still trade in secondary market- principal only iii. 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 issued b. Payments by mail c. New bonds 3. Principal Only= name on certificate, coupons in bearer form iv. Book Entry= bond owner does not get certificate, transfer agent maintains ownership records 1. Payments by mail 2. New bonds f. Pricing= secondary market i. 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, Moodys, and Fitch i. S & P= uses all CAPS for bond category (AAA to A) ii. Moodys= uses upper and lower case letters for bond category 1. Short term muni bonds iii. Basis= existing debt, stability of cash flow, ability to meet payments, asset protection, management capability 1. May change over time iv. Investment grade= standards set by FDIC, bank grade bonds 1. BBB or Baa or higher 2. High yield= high speculation, high credit risk a. Junk bonds b. Higher rating= higher safety= lower yield 3. Safety rankings: a. Highest rating= US government backed i. Bills, notes, bonds, saving bonds- series EE and HH b. Second highest= through government agencies i. Not backed by government (except GNMA) c. Third highest= muni-bonds i. GO bonds= backed by tax revenue d. Fourth= corporate debt i. Covers very safe to very risky 1. Ranked: Secured, debentures, subordinated debentures, Income 4. 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 retirement i. Debt service= schedule of interest and principal payments 7

II.

ii. Redemption= when principal paid 1. Sinking fund may be used 2. Call feature/option= issuer redeem before maturity date a. Whole or partial i. Term= issuer picks by lottery ii. Serial= inverse order of maturities (long to short) b. At particular price c. Call premium= price higher than par d. Advantages: replace with lower interest rate, reduce debt, replace short with long (vice versa), force conversion e. Tender offer= no call provision, buy in open market f. Call risk= investor lose stream of income i. Offer non-callable period= 5 to 10 years ii. Call protection= advantage given to investors during declining interest rates g. Reinvestment risk= investor wont be able to find similar interest rate h. Bonds continue to trade in market after call notice i. Once called can either return or sell in market at discount 3. 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 called a. New issued proceeds placed in escrow of government securities and used to pay off original b. High rating c. Defeasance= termination, not counted as debt d. During call protection period e. High marketability 5. Puttable bonds= lower interest rate for right to redeem at par whenever investor wants a. Muni bonds b. Protect against interest rate risk c. Wont trade much below par Bond Yields a. Yield= interest payments in relation to value i. Bonds quoted in yield and % of par b. Comparing yields i. Nominal/Coupon yield= fixed % of bonds par value 1. Annual income/current market price ii. Current yield= coupon payment relative to market price 1. Coupon payment/market price iii. Yield to maturity (YTM)= annualized return if bond held to maturity 1. Difference between price paid for a bond and par value a. Discount increases return b. 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 8

III.

iv. Yield to call= return takes early redemption and discount or premiums 1. Sooner bond called, sooner premium paid is lost 2. If called at par then less then nominal, CY, and YTM v. Ranking from lowest to highest at discount: nominal, CY, YTM, YTC 1. Premium is exact opposite c. Yield curve= difference between short term and long term rates i. X= years to maturity Y= yield 1. About 3 percentage points 2. Economic expansion ii. Short term rates= long term rates then flat 1. Economy is peaking iii. If short term rates are high then inverted a. Rates will decline iv. Can be used to compare spread between bonds 1. Wide gap between government and corporate bonds= recession a. Narrow gap= expansion d. Rate changes= inverse relationship between rate and price i. Long-term prices move more than short term prices ii. Two bonds have same maturity, bond with lower coupon will move more in price Corporate Bonds a. 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 collateral iii. Equipment trust certificates= issued serially so outstanding amount goes down with decreasing value of equipment 1. Amount borrowed less than full value of property b. Unsecured bond= no specific collateral i. Debentures= backed by general credit 1. Below secured and above subordinated debentures ii. Subordinated debentures= subordinated to other creditors thus offer higher yields or conversion factors iii. Liquidation hierarchy: unpaid wages, IRS, secured debt, unsecured debt, subordinated debt, preferred stock, common stock c. Guaranteed bonds= backed by company other than issuer (parent) d. Income/Adjustment bonds= pays interest only if enough income and does not pay missed payments i. Companies coming out of bankruptcy e. Zero-coupon bonds= no coupon payment, offer at deep discount of par and mature at par 9

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i. More volatile (longer YTM bigger volatility) 1. Price changes more than regular bond ii. Small investment iii. Price reflects interest rate climate iv. Issued by corporations, municipality, and US or may be created from other types of securities v. Advantages= small investment vi. Owe income tax each year on straight line basis 1. If held to maturity no capital gain 2. If sold before may be capital gain or loss vii. No reinvestment risk Trust Indenture a. Trust Indenture Act of 1939= issues > than 5 million dollars or sold interstate sold with indenture (issuers obligation, bondholders rights) b. Trustee= usually a bank to act on behalf of bondholders i. Federal and muni bonds exempt (some muni bonds do= marketability) c. Protective covenants protect bondholders i. Closed-end= senior claim to assets ii. Open-end= subsequent issues have equal liens Trading Corporate Bonds a. NYSE= provides central marketplace for trading bonds i. Bid and ask prices ii. Bond brokers= execute trades on client behalves b. Convertible bonds= bonds converted into stock, if not redeemed at face value i. 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 converted 1. Stated in price, not number of shares 2. Adjusted for stock splits and dividends a. Conversion price lowered iv. Conversion ratio/ rate= # of shares that will be converted into 1. Conversion Ratio= par/conversion price v. Parity= two securities have equal value 1. Market price bond/conversion ratio= parity price of stock 2. Market price stock* conversion ratio= parity price of bond vi. Rising market= convertible value rises vii. Declining market= price levels off with price of nonconvertible bonds viii.Anti-dilution covenant= requires adjustments for splits, dividends, and issuance of new shares ix. Forced conversion= issuer calls convertible bonds and it is in the best interest of the bondholders to convert to stock US Government and Agency Securities a. Marketable government securities= T-bills, T-notes, T-bonds 10

i. Treasury receipts= broker/dealer buys treasury securities, places them in trusts, and sells receipts 1. Securities used as collateral 2. Not backed by full faith and credit 3. Priced at discount= like zero-coupon bond ii. STRIPS= Separate Trading of Registered Interest and Principal Securities 1. Stripping interest into interest and principal components 2. Offered by banks and dealers iii. TIPS= Treasury Inflation Protected Securities 1. Fixed interest rate, principal adjusted semi-annually for inflation a. Adjusted due to CPI b. Interest payment adjust to new face value c. 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 Association 1. Buys mortgages (from FHA and VA) and auctions them to private lenders, thus pooling the mortgages a. Prepayment risk= homeowners pay off mortgages early i. Reinvestment risk b. Extended maturity risk= mortgages will remain outstanding c. Interest rate risk, thus move with interest rates 2. Guaranteed by federal government a. Still pay higher interest rates 3. Minimum denominations of $25,000 4. Pass-through= payments from mortgage holder to investor a. PC= mortgage participation certificates i. Principal and interest payments once a month ii. GNMA b. GMC= guaranteed mortgage certificates i. Interest payments twice a year, principal payments once a year 5. Taxed at all levels ii. FCS= Farm Credit System 1. Provides agricultural financing and credit a. Raises funds for loans by selling securities 2. Privately owned and government sponsored 3. Maturities are from one day to 30 years 4. Exempt from state and local tax iii. Freddie Mac (FHLMC)= Federal Home Mortgage Corporation 1. Public, stock trades on NYSE 2. Buys residential mortgages and packages them into mortgage backed securities a. Promotes secondary mortgages 3. Pass-through 4. Taxed at all levels iv. Fannie Mae (FNMA)= Federal National Mortgage Association 1. Publicly held 11

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2. Provides mortgage capital 3. 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 1m 5. Taxed at all levels v. Sallie Mae= Student Loan Marketing Association 1. Provide student loans 2. Publicly traded 3. Issues a. Short-term floating rates i. Six month maturities b. Discount notes 4. Taxed at federal level, exempt at most state levels c. Issuance of government securities i. Exempt from registration ii. Sold through action 1. Competitive bids= placed by dealers a. 20 banks and brokers designated as primary dealers i. Required to bid at auctions ii. Bids made in yield 2. Noncompetitive bids= placed by non primary dealers a. 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 yield i. 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 auction 4. Agencies issued through underwriters Accrued Interest Calculations a. 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 interest i. Zero-coupon, income bonds, bonds in default, and bonds that settle on interest payment day c. Corporate and muni bonds= 360 day method i. (Principal* interest rate* elapsed days)/360= accrued interest ii. Regular way settlement 1. Sell on April 15th, settle on April 17th d. Government bonds= 365 day method 12

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i. (Principal* interest rate* elapsed days)/365= accrued interest ii. Next business day Collateralized Mortgage Obligations (CMO) a. Mortgage backed securities that pool together mortgages i. Structure them into tranches ii. Relatively safe iii. Issues in 1k increments iv. Yields estimate of historical data from Public Securities Association (PSA) v. Issued privately, backed by government agencies vi. Interest rate risk 1. Prepayment risk= interest rates fall 2. Extension risk= interest rates rise vii. Maturity, interest, and principal received not guaranteed 1. Suitability statement= customer signs to acknowledge that rate of return will vary b. Pays principal and interest monthly i. Principal to only one tranche a month 1. Principal payments maid in 1K increments ii. 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 one d. Principal only CMO= sells at discount to par, rises as interest rate falls e. Interest only CMO= cash flows decline over time, value increases as interest rates rise i. Hedge interest rate risk f. Planned amortization class CMO (PAC)= targeted maturity dates, retired first thus reduced prepayment or extension risk g. Targeted amortization class CMO (TAC)= transfers prepayment risk to another tranche, but not extension risk i. Higher yield than PACs h. Zero-tranche CMO= no payment until all other tranches retired i. Most volatile Nonmarketable US Government Securities a. 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 value 1. 90% of average 5 year treasury yield ii. Reach face in 17 years, can hold to 30 years iii. 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 months i. Taxable at federal level when payments are received d. Series I bonds= sold at face value and interest added monthly paid when bond matures i. Real rate of return= grow with inflation 1. Variable= inflation rate 2. Fixed= interest rate ii. Up to 30 years 13

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iii. State and local exempt 1. Federal tax deferred a. Tax free if lower income and not used for college Money Market Securities a. Debt issues with maturities of one year or less b. 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 date a. Repo rate= difference between sale and repurchase price 2. Open repo= callable at any time 3. 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 days 2. Used to finance international trade a. Holder has lien on goods 3. Sold at discount, quoted in yield iv. Commercial paper/ promissory note= corporation issued, unsecured 1. Rates lower then bank rate loans 2. Excellent credit ratings 3. 1 to 270 days a. Most mature within 90 days 4. Sold at discount, matures at par, and quoted in yield a. Issued in book entry form v. Direct paper= commercial paper sold by finance company with out dealer vi. Dealer paper= commercial paper sold through dealers vii. CDs= fixed interest rate with minimum face value of 100k and can be traded in secondary market 1. Nonnegotiable CDs= not traded in secondary market, no money market securities 2. Negotiable CDs= time deposits with minimum face value of 100k a. Unsecured promissory note issued by bank 3. Brokered CDs= if redeemed before maturity than prepayment penalty a. Broker/dealer buys CD and then subdivides and resells to customer b. Maturity can be several years c. Higher yield d. Must be sold in secondary market Interest Rates a. Federal funds rate= rate banks over each other for overnight loans i. More than 1m ii. Most volatile iii. Barometer of short-term interest rates iv. Lowest rate b. Prime rate= interest rate banks charge most creditworthy corporate borrowers i. Highest rate 14

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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 rate d. Broker loan rate= interest rate broker/dealer charge on money lent to margin accounts i. Usually a percentage point above short term rate 1. Second highest rate ii. Callable with in 24 hours e. CD rate= offered on nonnegotiable CDs f. Commercial paper= rate set by finance companies Eurodollars and Foreign Currency Markets a. Eurodollars= US dollar deposited in banks outside US i. Time deposits= short term, overnight to 180 days ii. LIBOR= interest rate used iii. Pay in US dollars 1. Thus no currency risk b. 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 days d. Exchange rates= rate one currency converted into another i. Valuation= exchange rate changes or floats 1. Appreciating= currency rising in value 2. Depreciating= value of currency decreasing ii. Speculation is risky because banks may be unregulated and government policies could effect currency Tracking Debt Securities a. Description is 9s 2010= bond pays 9% and matures in 2010 b. N after the year indicates a treasury note, no letter indicates a bond

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Chapter 3- Municipal Securities I. Municipal Debt Characteristics a. Municipal Bonds= securities issued either by state or local governments, US territories, authorities, and special districts i. Loaning money for purpose of public works and construction projects ii. Second in safety 1. Lower interest rates then corporate bonds iii. Exempt for filing, but subject to antifraud requirements iv. Not taxed at federal level 1. Capital gains still taxed v. Tax exempt at state level if you live in state when bond is issued 1. More appropriate for high income investors 2. Not suitable for those in low tax brackets vi. Maturity= less than 1 year to 30 years vii. Term maturity= principal matures at single date 1. Some issuers establish sinking fund 2. Quoted in price, called dollar bonds viii.Serial maturity= bonds within issue mature on different dates 1. Quoted based on YTM 2. 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 maturity b. 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 taxes a. Backed by full faith and credit b. Property taxes= ad valorem 2. Statutory debt limits= amount of debt limited by taxpayers a. Voter approval= require vote b. Tax limits= limited by property taxes (expressed in mills, I mill= $.001 c. Limited tax GO= Go limited to one tax, thus more risk d. Overlapping debt= debt that tap same tax payer dollars (coterminous debt) i. State debt never overlaps e. Double-barreled bonds= characteristics of GO bonds, but paid from specific facilitys earnings i. Backed by taxing power of municipality ii. Rated and traded as GOs 3. If default, then bondholders can sue for more taxes to pay off bonds ii. 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 limits 2. Ensures adequacy of revenue to pay old and new debt 16

3. Feasibility study= engage various consultants to prepare report on feasibility of project 4. Sources: utilities, housing, transportation, education, health, industrial, sports a. Not backed by full faith and credit 5. Trust indenture/bond resolution= trustee to act on behalf of bondholders a. Municipality must abide by certain covenants i. Rate= maintains rates sufficient to pay expenses and debt ii. Maintenance= must maintain facilities iii. Insurance= facility insured iv. Additional bond test= determines whether bond is open or closed ended v. Sinking fund vi. Catastrophe clause= insurance to pay bonds if facility destroyed vii. Flow of funds= disburse revenue collected viii.Books and records covenant= outside audits ix. Call features b. Optional, but makes bonds more marketable 6. Types: a. Industrial development revenue bonds (IDRs/IDBs)= construct facilities which are then leased to corporations i. Money from leases to meet obligation ii. Bonds carry the companys debt rating iii. 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 obligations e. New housing authority bonds (NHAs/PHAs)= develop low income housing i. Backed by full faith and credit of US government 1. Most secure 2. Section 8 bonds f. Moral obligation bonds= if revenue collections are not sufficient, state backs them 7. If default, then only repaid through legislative appointment iii. Municipal notes= short term securities for municipality that expects revenues soon and repaid when revenues are received 1. Usually less than 12 months a. May be 3 months to 3 years 2. Categories: a. Tax anticipation notes (TANs) b. Revenue anticipation notes (RANs) c. Tax and revenue anticipation notes (TRANs) 17

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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 stable 4. State and Local Government Securities Series (SLGS)= proceeds from prefunding placed in escrow account a. Government securities issued for municipalities c. Municipal security documents i. Bond contract= with underwriters and prospective investors 1. Issuer must abide ii. Authorizing resolution= authorizes issue and sale of securities and contains description iii. 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 prospectus 1. 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 uncertainty 2. Unqualified= issued by bond council unconditionally a. Issuers desire 3. Ex-legal= no legal opinion and must be stated Issuing Municipal Securities a. Negotiated underwriting= appoints investment banker to underwrite offering and establish interest rate and offering price i. Revenue bonds b. Competitive bids= GO bonds awarded to underwriter through bid i. Bid with lowest interest rate to issuer wins ii. Official notice of sale= published in newspaper and includes information about the bonds to solicit bids c. Sources of muni bond information: i. The Bond Buyer= publishes information on bond issues 1. Friday edition a. 30-day visible supply= total dollar volume of muni offerings in next 30 days i. Large visible supply= interest rates will rise ii. Small visible supply= interest rates will fall b. Placement ratio= % of new issues sold vs. % new issues offered 18

c. Complies indexes: 40 Bond Index, 20 Bond Index, 11 Bond Index, Revdex 25 ii. Munifacts= subscription wire service of The Bond Buyer 1. 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 bid iii. Syndicate contract/agreement among underwriters= formalize relationship in negotiated underwriting iv. 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 portion a. Liability may continue after initial allocation i. Remaining unsold shares allocated between member v. Establishing syndicate bid= members meet to establish their bid 1. Writing the scale= establishing price for maturity a. Lists different maturities for issue 2. Firm commitment= submitted as competitive bids a. No profit guarantee b. Must bid for entire amount 3. Disclosure of fees= fees disclosed to members in advance 4. Awarding issue= issuer issues to syndicate with lowest net interest cost or true interest cost a. Net interest cost (NIC)= combines proceeds to issuer with total interest paid b. True interest cost (TIC)= same as NIC with time value of money c. Split rate bids= bids with more than one interest rate d. Cover= difference between winning bid and next best bid (cover bid) i. Expressed in basis points or dollars per bond 1. One bond point= $10 5. Syndicate account= keeps books and manages account a. Sales proceeds and expenses are paid out of b. Syndicate manage= manages account vi. Breakdown of spread= syndicates compensation (difference between price paid and reoffering price) 1. Production= total sales dollars earned 2. Management fee= price syndicate manager receives per bond 3. Total takedown= spread left after management fee a. Members buy bonds from manager at takedown b. Concession plus additional takedown vii. Selling concessions= discount selling group receives from syndicate member 1. Additional takedown= syndicate members keep remainder of total takedown 2. Reallowance= interested firms buy bonds from syndicate 19

III.

a. One half concession amount 3. Full spread= if manager is syndicate member e. Order Allocations= MSRB requires syndicates to establish priority allocation provisions i. Order period= time set by manager during which syndicate solicits customers ii. 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 priority 3. Designated order= priority after group net order, usually institutions 4. Member order/member related order= highest priority given to order that benefit most member f. Payment and delivery i. When issued basis= securities are authorized, but not yet issued ii. Order: 1. Awarding issue to syndicate 2. Bonds certificates are printed 3. Managing underwriter registers bonds with clearing agency 4. Syndicate manager gives notice of settlement date 5. 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 issue a. Interest begins to accrue Analysis of Municipal Securities a. GO bonds= backed by tax revenue, thus reflection of community wealth i. Includes: Property taxes, retail sales, bank deposits, industry base, population ii. Characteristics= quantitative (objective) and qualitative (subjective) iii. Debt limits= protect tax payers from excessive taxes and limits overall debt 1. Disclosed in official statement 2. Mature before project becomes obsolete iv. Income of municipality 1. State= income and sales tax 2. 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 county b. Backed by power to seize property 4. Analyzing official statement a. May need to issue more debt if: income cant meet payments, principal payments to close, inadequate sinking fund, pensions unfunded, make more capital improvements b. More debt= lower credit rating/higher interest payments c. 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 20

IV.

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 debt b. 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 facility 1. Flow of funds= issuer pledges to pay expenses in specific order 2. Net revenue pledge= operating and maintenance expenses 1st, issuer pays a. Receipts deposited into revenue fund and disbursed as follows: i. Operating and maintenance ii. Debt service account= pay interest and principal for this year iii. Debt service reserve= hold enough money to pay one year iv. Reserve maintenance fund= supplement v. Renewal/replacement fund= create reserve for replacing machine vi. Surplus fund= used for both b. Most common 3. Gross revenue pledge= issuer pays debt first i. User pays for maintenance c. Muni debt ratios= all with GOs i. Net debt assessed= 5% per assessed property value ii. Net debt estimated valuation= most analysts prefer over assessed iii. Taxes per person= citys tax income/population iv. Debt per capita= larger cities have larger debt because tax base is more diversified v. Debt trend= indicates if ratios are rising or falling 1. Anticipating long term debt vi. Collection ratio= taxes collected/taxes assessed vii. Coverage ratio/times interest earned ratio= how many times annual tax revenue will cover debt service 1. 2:1 is adequate 2. Used for revenue bonds d. Interest rate comparisons= fluctuate more than government and corporate bonds i. Thinner market e. Muni bond insurance= interest for interest and principal payments i. Insurance from: MBIA, AMBAC, FGIC f. Bond ratings= Moodys, S & P, Fitch i. Moodys= MIG 1 (the best) to MIG 4 (acceptable) to S6 (speculative) ii. S & P= SP1 to SP3 iii. Fitch= F-1 to F 3 Municipal Trading and Taxation a. Quotations= any bid or offer i. Trade OTC ii. YTM= basis quote 1. Serial maturities iii. Dollar bonds= quoted in percentage of par dollar 1. Term bonds= callable before maturity 21

iv. Types of quotations 1. Most common= bona fide and nominal a. Nominal/subject= dealers estimate of market value i. Informational purpose and must be marked as such 2. Bona fide/firm quotes= dealer must trade at specified price a. Quote must be b. Must reflect dealers best judgment i. Reasonable to fair market value c. May reflect firms inventory and expectations of market i. Not necessarily best price d. Dealer cant knowingly misquote e. If make quote with out bonds, dealer must know where to obtain them 3. Workable indication= bid price where dealers purchase from other dealers v. Holding a quote= may quote bond that is firm for certain time 1. Out-firm with recall=firm for hour with five-minute recall a. Dealer sells bonds that does not own because they know they can be bonds at fixed price for allotted time vi. Secondary market joint accounts= formed by group of investment bankers who purchase blocks from institutions and resell them 1. At resell can only give one quote for block b. Reports of sales= dealers must report trades to other dealers to MSRB i. Include firms names and accrued interest ii. Round lot= 100k par iii. Brokers broker= brokers trading only to institutional clients 1. Help other dealers sell unsold portions 2. Act as agents 3. Dont disclose customers c. Broker/dealer regulation i. Reciprocal dealings= dealer cant solicit securities from investment company in return for sales by the dealer of shares in the investment company 1. Ant reciprocal Rule ii. Customer recommendations= make suitable recommendations 1. Suitability test= find customers financial status a. With out information recommendation cant be made 2. Churning= increase commissions through excessive trades a. Illegal 3. Can not misuse securities held for another person 4. Can not guarantee against loss a. Or share in profits or lose i. Exception= joint account 5. Control relationship= if dealer is under control with issuer, additional written disclosure required d. Markups and commissions i. Agency transactions= executed for a commission 1. Commissions= dealer acts as agent and arranges trades 2. Consideration: availability, expenses, value of service, compensation received 22

V.

3. Best execution= make best effort to obtain at fair price 4. Disclosed on confirmation ii. Principal transactions= executed at net price, including markup/markdown 1. Markup= dealers acts as principal and sell securities 2. Markdown= when buy securities 3. Consideration: fair market value, expenses, profit, total dollar amount, direction of overall market iii. Confirmations= customers receive written confirmation when transaction entered 1. Disclosing yield= if bonds maturity known, yield shown as YTM a. 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, firms 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 media i. Dealer must approve all advertising 1. Never filed with MSRB f. The broker/dealer as financial advisor i. Financial advisor= muni dealer provides advisory or consulting services to issuer 1. Must be documented in writing ii. Conflict of interest= firm is financial advisor and underwriter 1. Competitive bid= issuer must consent in writing 2. Negotiated sale= in writing disclose to issuer and issuer acknowledges or if broker/dealer discloses source of amount and compensation received in writing 3. Help with OS= must make copy of official statement to underwriter before other syndicate members 4. Dealer can not use information about bondholders g. Taxation of municipal securities i. 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 securities a. Tax free benefit= tax free yield/(100%- investors tax rate) i. What corporate bond must yield ii. Muni yield always less than corporate yield 3. Expenses associated with purchasing or holding muni bonds are not deductible a. Except banks= max 10m, can deduct 80% of expenses Municipal Securities Rulemaking Board (MSRB) a. Established 1975 governs issue and trade of municipal securities i. Does not regulate issuers ii. No authority to enforce rules 23

1. NASD= dealer 2. Office of Currency= national banks 3. FRB= non-national banks that are FDIC members 4. FDIC= non-national banks that are not FDIC members b. Three categories of rules: legal definitions, administrative rules, general rules and regulations c. Regulations: i. G-1= bank has separate department for municipal securities ii. G-1 and 2= Must qualify by exam (Series 52 or 7) 1. Clerical workers exempt 2. If fail can not take for 30 days 3. 90 day apprenticeship= may not sell municipal securities a. May with dealers b. No commission but have salary c. Must pass with in 180 days iii. G-6= broker/dealer must maintain blanket of fidelity bonds 1. Dollar amount varies for firm size iv. G-7= dealer must keep file of information about associated person v. G-10= if complaint, must have complaint file and deliver MSRB brochure to customer vi. G-11= syndicate must establish priority of orders and conditions vii. G-12= uniform practices in settling transactions 1. Cash trade= trade day 2. Regular way= 3rd business day after trade 3. Subject to good delivery requirements a. If rejected seller must still sell b. Bearer bonds= 1k or 5k c. Registered= 1k with 100k max d. Mutilated certificates= not good delivery unless validated by issuer e. Partial call= not good delivery unless identified when called viii.G-13= dealers only publish bona fide bids or nominal if identified 1. 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 years xi. G-17= dealers must deal fairly with everyone xii. G-18= dealers must obtain reasonable prices xiii.G-19= municipal securities firm must obtain financial data about client for suitable recommendation 1. Can not recommend with out information xiv.G-20= dealers can not give gifts of greater than $100 xv. G-21= truthful advertising 1. Principal must approve advertising xvi.G-22= clients must be informed of conflicts of interest xvii.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 trades xix.G-25= may not misuse securities held for other people 24

VI.

1. May not guarantee against loss a. Put options/repurchase agreements not considered guarantee xx. G-27= firms must designate principal to supervise representatives 1. Principal must approve: new accounts, every transaction, customer complaints, correspondence 2. 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 rules xxiii.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/dealers record of sales in shares of investment company xxv.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 months xxvii.G-37= municipal firms may not engage in municipal securities business with an issuer for 2 years after political contribution is made 1. Only negotiated underwriting 2. Not apply to firms 3. $250 or less is acceptable xxviii.G-39= telemarketers may not call before 8am or after 9pm and must disclose name, firms name, firms #, and disclose face that it is a solicited phone call 1. Does not apply to established customer Tracking Municipal Securities a. Listed in financial publications i. The Bond Buyer and Wall Street Journal

25

Chapter 4- Options I. The Options Contract a. Option= right to buyer and obligation to seller i. Terms standardized by Office of the Comptroller of the Currency (OCC) ii. Types: call and put iii. Classes= all calls or puts of one issuer iv. Series= all options of one issuer, same class, exercise price and expiration month v. American style= exercise at any time before expiration date vi. European style= exercise on expiration date vii. Equity options contract contain 100 shares 1. Two parties: a. Buyer= long= holder= owner i. Rights to exercise b. Seller= short= writer i. Obligation at exercise viii.Three specifications: 1. Underlying instrument= anything fluctuating in value a. Derivative security= value derived from underlying instrument 2. Price= price at which exercising will occur 3. Expiration= expire on specified date a. Saturday following 3rd Friday of month b. 9 months c. Long-term equity anticipation security (LEAP)= 30 months ix. Bought or sold during life cycle b. Calls and Puts i. Calls 1. Buy= go long a. Buyer owns right to buy 2. Sell= go short a. Buyer has obligation to sell 3. In-the-money= market price > strike price a. Not necessarily breaking even 4. At-the-money= market price = strike price 5. Out-of-the money= market price < strike price 6. Intrinsic value= in the money amount a. Market price- strike price b. If out/at-the-money no intrinsic value 7. Parity= premium = intrinsic value 8. Breakeven point= strike price + premium ii. Puts 1. Buy= go long a. Buyer owns right to sell 2. Sell= go short a. Seller has obligation to buy 3. In-the-money= market price < strike price 26

II.

4. At-the-money= market price = strike price 5. Out-of-the-money= strike price > market price 6. Intrinsic value= in the money amount a. Strike price- market price b. If out/at-the-money no intrinsic value c. Buyers prefer, sellers do not 7. Breakeven point= strike price premium c. Options premiums= price of option contract i. Buyer= ask/offer ii. Seller= bid iii. Premium reflects: intrinsic value and time value 1. Time value= markets perceived worth of the time remaining to expiration 2. If option out of the money, price only reflects time value 3. Further expiration= greater time value a. Closer to expiration, option value decreases iv. Options quotes= per share basis 1. Total premium= quote*100 a. Contracts subject to stock splits and dividends i. May have more than 100 shares v. Factors affecting premium: volatility, intrinsic value, time until expiration, interest rates 1. Higher volatility= greater price movement vi. Cash paid out= debit (DR) vii. Cash received= credit (CR) Basic Options Transactions a. Buying calls= bullish, long i. Speculation= upward movement in stock price ii. Deferring a decision= lock in purchase price until option expires iii. Diversifying holdings= buys calls on variety of stocks and profit from any rise in the option premiums iv. Protection of a short stock position= insurance policy v. Maximum gain= unlimited vi. Maximum loss= premium paid b. Writing calls= bearish, short i. Speculation= downward movement in stock price ii. Increasing returns= additional income from writing call iii. 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 profit iv. Protection of a long stock= premium collected provides limited downside protection v. Maximum gain= premium vi. Maximum loss= unlimited c. Buying puts= bearish, long i. Speculation= downward movement of stock price ii. Deferring a decision= lock in sale price and protect its appreciation potential iii. Protection of long stock position= insurance iv. Maximum gain= strike price- premium v. Maximum loss= premium 27

III.

d. Writing puts= bullish, shirt i. Speculation= upward movement of stock price ii. Increasing returns= income from writing puts iii. Buying stock below its current price= premium received can offset cost of stock when put is exercised iv. Maximum gain= premium v. Maximum loss= strike price- premium e. Choices at expiration= owner of option has 3 choices i. Exercise the option 1. If in the money 2. Call= buy stock 3. Put= sell stock 4. Settle regular way 5. Option Can no longer be traded ii. Let option expire 1. If worthless a. At/out-of-money iii. 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 amount a. Long: i. Open= buy contract ii. Close= sell contract b. Short: i. Open= sell contract ii. Close= buy contact Using Options to Protect a Position a. Long stock position i. Offset by purchasing a put or writing a call 1. Full protection= best protection is buying put a. Eliminates downside and stock only reduced by price of call i. Breakeven= stock price + put ii. Maximum gain= unlimited iii. Maximum loss= (stock price exercise price) + premium 2. Partial protection= writing a call a. Generates income and reduces stocks upside b. Only protected amount of premium received i. Breakeven= stock price - premium ii. Maximum gain= (exercise price- stock price) + premium iii. Maximum loss= stock price premium b. Short stock position i. Offset by purchasing a call or writing a put 1. Full protection= best protection is buying call a. Eliminates risk i. Breakeven= short stock price premium 28

IV.

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 loss i. Breakeven= short stock price + put ii. Maximum gain= (stock price exercise price) + premium iii. Maximum loss= unlimited c. Collar= investor hedge downside risk on long position for no out-of-pocket class i. Buy a put and sell a call d. Ratio call writing= selling more calls than the long stock position covers i. Premium income, unlimited risk Multiple Option Transactions a. Spreads= purchase one option and sale of another in same class i. Call= long call and short call ii. Put= long put and short put iii. Price/vertical spread= different strike prices but same expiration date 1. Most common iv. Time/calendar/horizontal spread= different expiration date with same strike price 1. Little volatility v. Diagonal spread= options differ and both time and price vi. Debit spread= long position premium > short position premium vii. Credit spread= short position premium > long position premium viii.Debit call spread= reduce cost of long option position 1. Bullish 2. Breakeven= net premium to lower strike price 3. Maximum gain= difference between strike prices net credit 4. Maximum loss= net debit 5. Wants spread to widen a. Spread= difference between 2 premiums ix. Credit call spread= reduce risk of short option position 1. Bearish 2. Maximum gain= net credit 3. Maximum loss= (difference between strike prices) net debit 4. Breakeven point= between the two strike prices 5. Wants spread to narrow x. Debit put spreads= reduce cost of long put position 1. Bearish 2. Breakeven= Higher strike price net premium 3. Maximum gain= difference between strike prices net credit 4. Maximum loss= net debit xi. Credit put spreads= reduce risk of short put position 1. Bullish 2. Breakeven= between the two strike prices 3. Maximum gain= net credit 4. Maximum loss= (difference between strike prices) net debit 29

V.

xii. Market attitude= determined by the option that is more costly of the 2 1. Calls= lower strike price is higher premium 2. Put= higher strike price is higher premium b. Straddle= call and put (both must be long or short) with same strike price and expiration month i. Long straddle= expects volatile stock price but is uncertain of direction 1. Buy call and put 2. Breakeven= strike price -/+ combined price of premiums a. Two breakeven points 3. Maximum gain= unlimited 4. Maximum loss= combined price of premiums ii. Short straddle= expects price to not move 1. Sell call and put 2. Breakeven= strike price -/+ combined price of premiums a. Two breakeven points 3. Maximum gain= combined price of premiums 4. Maximum loss= unlimited iii. Combination= call and put with different strike prices or expiration months or both 1. Cheaper than long straddles if both options are out of the money 2. Breakeven= strike price -/+ combined price of premiums a. Two breakeven points 3. Long= makes money if stock outside breakeven points 4. Short= makes money if stock is inside breakeven points Nonequity Options a. Index options i. Broad based= movement of entire market ii. Barrow based= movement of market segment iii. Features: 1. Multiplier= of $100 a. Total premium= $100* option price b. Total dollar value of index= $100* strike price 2. Trading= stops at 4:15 3. Exercise= settles in cash next business day 4. Settlement price= based on closing value of index on day of exercise 5. Expiration dates= Saturday following third Friday iv. Strategy= speculates movement of market 1. Portfolio insurance= use of index puts as security a. Systematic/systemic risk= risk of decline in market v. Beta= volatility of stock relative to market 1. 1= stock has same volatility of market 2. Beta > 1= stock moves more than market 3. Beta < 1= stock moves less than market b. Interest rate options= based on yields of T-bills, T-notes, and T-bonds i. Quoted in points ii. European-style exercise c. Foreign currency options (FCOs)= performance of currencies relative to US dollars i. Features: 30

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1. Strike prices= quoted in US cents 2. Premiums= quoted in cents per unit a. Exception= Japanese yen, quoted in 100th of a cent 3. Contract size= large because for institutions 4. Trading= Philadelphia Stock Exchange (PHLX) 5. Expiration date= Friday preceding the third Wednesday 6. Settlement= next business day 7. American or European style 8. Strategies: a. Importers buy calls to hedge b. Exporters buy puts to hedge c. Options on US dollar not available i. Exporters should buy calls on won currency Option Market Functions a. Trade on major exchanges and OTC b. Listed options= exchange traded i. Standardized strike prices and expiration dates c. Features: i. Trading times= 9:30 to 4:02 ii. Expiration= expire Saturday following third Friday iii. Settlement= settle next business day 1. Stocks as a result of exercise settle regular way iv. Automatic exercise= in the money by at least $.25 1. Member firms= $.15 v. Position limits= 75,000 on the same side of the market 1. Apply to individuals and representatives d. 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 accounts iii. Floor brokers= firms representatives on floor iv. Order routing system= computerized order routing system used to route customer orders 1. OSS used on CBOE e. 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 premiums ii. Guarantee exercise 1. Assign exercise notice on random basis 2. 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 manager 2. 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 31

VII.

iv. Senior Registered Options Principal (SROP)= developing and enforcing programs provided for sales supervision of customer accounts v. Compliance Registered Options Principal (CROP)= reviewing firms compliance 1. Approves any advertising vi. Option contracts adjusted for stock splits, dividends, and rights offering 1. Not adjusted for cash dividends 2. Even splits= new contracts created a. Split ending in 1 3. Uneven split/fractional split= no new contract, just larger amount of shares a. Split not ending in 1 vii. Opening transaction= establishes position 1. If sale of option must indicate if covered or uncovered viii.Closing transaction= eliminates position ix. Open interest= number of contracts outstanding 1. Higher open interest= higher liquidity 2. 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 moving 4. Front running= taking an option position when a firm has received a block order but before block order is entered Tax Rules for Options a. Capital gains taxes apply i. LEAPs writers must report short-term capital gains at expiration b. Buy a call i. Option expires= capital loss ii. Option exercised= strike price + premium= cost basis iii. Position closed= capital gain or loss c. Sell a call i. Option expires= capital gain ii. Option exercised= strike price + premium= sale proceeds iii. Position closed= capital gain or loss d. Buy a put i. Option expires= capital loss ii. Option exercised= strike price - premium= sale proceeds iii. Position closed= capital gain or loss e. Sell a put i. Option expires= capital gain ii. Option exercised= strike price - premium= cost basis iii. 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 32

g. Married put= customer buys stock and put option as a hedge i. Cost basis added upward by premium paid 1. No capital loss on put

33

Chapter 5- Customer Accounts I. New Accounts a. 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 required 2. Required by NASD and NYSE a. Also require is more than 10% stockholder in public company b. 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 trade iv. NYSE Rule 405= know your customer 1. Can only give recommendations if it is suitable v. USA Patriot Act of 2001= verify identity of new customer and maintain records that verify identity and determine is person is on known terrorist list 1. 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 days 1. Include statement for corrections 2. Updating must occur every 36 months vii. Regulation S-P= firm must provide privacy notice to customer viii.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 child i. 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 customers name and shipped to them ii. Transfer and hold in safekeeping= securities registered in customers name and the broker/dealer holds them for safekeeping iii. Hold in street name= securities registered and held by broker/dealer, but customer is beneficial owner iv. Delivery vs. payment (DVP)= securities delivered to a bank (COD) broker/dealer verifies arrangement and customer notifies bank of any securities transactions c. 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: 34

II.

i. Cash/special= customer pays in full for securities 1. Must be opened as cash accounts: IRAs, Keoghs, tax sheltered annuities, corporate accounts, custodial accounts ii. 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 crash iii. Corporate= business must establish legal right to open account, identify limitations, and establish a who will represent the business in transactions 1. Firm must obtain corporate charter a. Proof firm exists iv. Fee based= charge single fee like a % of assets 1. Not wrap account a. Wrap account= firms provide services 2. Customer has moderate level of trading 3. Must have disclosure agreement e. Special account situations i. Numbered accounts= customer request account only identified by # 1. Sign form certifying he owns account 2. Celebrities/athletes ii. Multiple accounts= if both cash and margin then considered one account 1. 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/dealer 1. Firm has 3 days to validate instructions then 3 more days to complete transfer 2. Account frozen for 7 days (except options) after validation f. Opening accounts for other brokers employees i. NASD: 1. Margin= notification 2. Cash= notification 3. Duplicate confirm= upon request ii. NYSE: 1. Margin= prior permission 2. Cash= prior permission 3. Duplicate confirm= required iii. MSRB: 1. Margin= notification 2. Cash= notification 3. Duplicate confirm= required Types of Accounts a. Account registration= when account opened it is registered in one or more persons name i. Single= one beneficial owner who controls investments and requests distributions 1. Transfer on death (TOD)= transfer account to named beneficiary at death a. Taxes apply if applicable ii. Joint= 2 or more adults are named as co-owners, each with some control 35

III.

1. Joint account agreement must be signed a. Require signatures of all owners b. Distributions made payable and endorsed by all owners c. Mail to single address 2. Tenants in common (JTIC)= deceased tenants interest goes to estate a. 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 interest iii. Partnership= unincorporated association of 2 or more individuals 1. Must complete partnership agreement disclosing who can make transactions a. If margin account must disclose limitations iv. Fiduciary/custodial accounts= person other than owner initiates trades 1. Trust account= securities in trust for one person but managed by someone else a. Manager is fiduciary i. Fiduciary= any legal person appointed to represent another person ii. Has no legal control over them iii. Trades must be compatible with investment objectives iv. Prudent man rule= fiduciary must make safe decisions v. May not share in accounts profits 1. May charge a fee b. Securities must be registered to show custodial relationship is evident c. 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 decisions 2. Limited= some but not total control a. Buy or sell securities, no withdrawals b. Discretionary accounts= preapproved authority for representative to make transactions with out approval i. Discretion= what security, # of shares, and whether to buy or sell 1. Does not apply for investment timing a. Market held order ii. Discretionary authority= filing trading authorization 1. Limited power of attorney for broker/dealer iii. Regulation: 1. Discretionary orders must be identified 2. Partner must approve each order a. Not necessarily before 3. Must keep record 4. No churning 5. Must have supervisor Death of an Account Holder 36

IV.

a. Mark account deceased i. Freeze assets until instructions are received from executor of estate 1. Cancel open orders 2. Needed documents to release assets: death certificate, inheritance tax waiver, and letters testamentary 3. JTROW account not frozen a. Documents still required to transfer securities 4. In partnership member needs written authority from other partners before executing any orders ii. Discretionary authority ends Uniform Gifts to Minors Act (UGMA) Accounts a. Adult to act as custodian to minor b. Any kind of security or cash may be given c. Characteristics: i. Donor may not take back gifts and minor may not return gift 1. Indefensible title 2. When minor reaches age of majority property is transferred ii. Custodian= manages securities given to minors in account 1. Has right to: trade, liquidate, or hold securities and exercise rights 2. May use assets in account in any way deemed proper for minor support (i.e. education) 3. Account may only have 1 4. Minor may have more than 1 account 5. Custodian may be custodian for more than 1 account 6. Donor can be or appoint custodian 7. Parents have no control (unless custodian) iii. Opening UGMA account= contains custodians name, minors name & SS#, and state registered in iv. UGMA securities are registered in custodians name for benefit of minor v. 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 minors tax bracket 2. Parents responsibility vii. If beneficiary dies then securities go to the minors estate viii.If custodian dies donor or courts appoint new custodian ix. Transfer can be delayed until minor reaches 25 (21 in some states)

37

Chapter 6- Margin Accounts I. Types of Margin Accounts a. Long margin account= purchase securities on money borrowed and pay interest until loan is repaid b. Short margin account= stock is borrowed then sold short c. Advantages for customers: i. Purchase more securities ii. Greater leverage means greater rate of return d. Advantages for broker/dealers: i. Loans generate interest income ii. Trade larger positions because of increased trading capital generating higher commissions e. Margin agreement= three part agreement that customers must sign i. Credit agreement= terms of credit extended by broker/dealer 1. Includes interest computation and how rates may change a. 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 bank a. Brokers are limited to pledging more than 140% of customers debit balance b. Securities held in bank, bank loans money to broker/dealer c. Broker/dealer= nominal/named owner d. 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 customers consent iv. 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 deposit 3. Customers are not entitled to an extension 4. Firms can increase margin without notice f. Regulation T= customers must deposit 50% of market value of securities i. 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 requirement 2. Can not be used: options, rights, non-NASDAQ OTC stocks not approved by FRB, insurance a. If writing option the premium received reduce margin requirements b. 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 38

II.

a. Subject to firms requirements ii. 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 T ii. May not be less than 2k 1. If initial purchase < 2k then full amount of securities a. If short margin account then no exceptions h. Deposit must be made in cash or marginable securities if payment is late then file for extension i. If no extension firm must sell securities on 6th business day and freeze the account for 90 days Margin Accounting a. Must meet minimum requirements after marking to market b. Long margin accounting i. Long market value (LMV)= current market value of stock ii. Debit register (DR)= amount of money borrowed by customer 1. Never changes iii. Equity (EQ)= customers net worth in margin account iv. LMV-DR= EQ v. LMV DR = B/S EQ

1. If LMV changes then EQ changes by same amount vi. Maintenance requirement= 25% by NYSE/NASD 1. Always based on new market value a. Same with Regulation T 2. If below then maintenance margin call a. Customer must make deposit to bring account back to minimum b. If not made then securities are liquidated in order bring account back to minimum c. Value securities can fall before margin call i. Market value maintenance formula= DR/.75 3. 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 securities 2. 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 balance a. Retention requirement b. 50% of proceeds credited to SMA viii.Excess equity= amount of equity exceeding Regulation T ix. Special memorandum account (SMA)= line of credit customer can borrow from or purchase securities with 1. $1 increase in market value= $.50 increase SMA 39

2. Equal to the greater of excess equity or amount already in SMA a. Increase when market value increases b. 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 SMA a. Equal to half the amount of deposit b. 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 SMA 8. Can be used to used to withdraw cash by borrowing against SMA a. $1 SMA= $1 borrowed b. Reducing SMA and EQ and increasing the DR balance c. As long as it does not cause maintenance call 9. Can be used to meet initial margin requirements on new securities a. Gives investor buying power b. $1 of SMA= $2 of stock c. Reduces SMA and increasing the DR balance and LMV c. Pattern day trader= executes 4 or more trades in 5 days i. Minimum equity= 25k ii. Minimum maintenance= 25% iii. Buying power= 4 times maintenance margin excess 1. Maintenance margin excess= equity in account > minimum maintenance a. Regular buying power is 2 times SMA iv. Guaranteed accounts are prohibited 1. Cross guarantee= where customer uses money in his account to meet any margin calls v. Approval: provide risk disclosure and approve account for day trading strategy d. Short selling margin requirements= short selling always done through margin account i. Dividends paid to owner of stock ii. Short market value (SMV)= current market value of stock iii. Credit register (CR)= amount of money in customer account + margin deposit requirement 1. Security to broker/dealer so they will have cash if value of securities increases 2. Does not change iv. Equity (EQ)= customers net worth in margin account v. CR-SMV= EQ 40

vi. CR

SMV = B/S EQ

vii. Minimum maintenance requirement= greater of 30% or $5 per share 1. 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 T ix. Restricted= less than Regulation T but greater than minimum maintenance x. Maximum market value short sale position can increase before maintenance call 1. Short market value at maintenance= CR/1.3 xi. SMA is same as long margin accounting e. Combined account= has both long and short positions i. Margin requirements computed separately and added together

41

Chapter 7- Issuing Securities I. The Regulation of New Securities a. The Securities Act of 1933= regulates new issues of corporate securities and requires issuers to provide investors with enough information to make buying decisions i. Filed with SEC ii. Published prospectus 1. Ensure public informed iii. Protect public: 1. Require registration of new issues distributed interstate 2. Issuer provide fair and full disclosure 3. Make available all necessary material 4. Regulate underwriting and distribution 5. Provide criminal penalties for fraud iv. Prohibits any fraudulent activity involved in underwriting b. The Securities Exchange Act of 1934= addresses secondary trading of securities i. Created SEC ii. Amended by Maloney Act= self-regulatory bodies to police industry 1. National Securities Association of Securities Dealers (NASD)= regulates OTC Three Phases of an Underwriting a. Issue must file registration statement with SEC i. Discloses material information about issue 1. Includes prospectus 2. Must contain: description of business, names and addresses of officers, officers 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 process 1. Accuracy is still responsibility of issuer iii. Signed by CEO, CFO, CAO, and majority of BOD iv. All information becomes public once filed b. Cooling-off period= following the filing with the SEC period begins for 20 days i. Usually takes longer than 20 days ii. Deficiency letter= if registration needs revision 1. Cooling-off period resumes after corrected iii. Stop order= all underwriting activities cease iv. Preliminary prospectus/red herring= allows underwriters to gauge investor interest 1. Made to any investor who expresses interest between registration and approval 2. Sales, taking orders, and advertising are prohibited a. May publish tombstone advertisement i. Shows anticipated gross proceeds of issuer ii. Announces new issue iii. May be before or after effective date iv. Not required 3. Offering price and effective date are missing 4. Underwriters have due diligence meeting at the end of the cooling-off period 42

II.

III.

a. Examines: use of proceeds, financial analysis, determine companys stability, determine if risk is reasonable c. Effective date= date at which registration become effective i. Final prospectus= issuer amends preliminary prospectus to include offering price and spread 1. Orders may then be taken 2. Must be accompanied with all sales 3. 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 distribution a. Prospectus delivery requirement= final prospectus delivered to buyer in secondary market for specified time i. IPOs= 25 days if on exchange or NASDAQ 1. 90 days for pink sheets ii. Additional offerings= none for exchange or NASDAQ 1. 40 days for pink sheets The Underwriting Process a. Underwriter= broker/dealer specializes in investment banking and distribution of new securities i. Advise issuer based on market conditions and tax considerations ii. Underwriting syndicate= group of underwriters 1. It is the norm b. 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. Participants i. 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 issuers securities 1. Considerations: a. Stocks or bonds= determining cheapest price of capital b. Tax consequences= interest is tax deductible and dividends are after-tax payouts c. Money-market financing= short-term instruments d. Capital-market financing= long-term instruments 2. Required to be NASD member for nonexempt corporate securities d. 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 corporation 1. Any time or amount iv. Secondary offering= major stockholders selling portion of their stock 43

IV.

1. Underwriter proceeds to stockholder v. Split offering (combined distribution)= combines primary and secondary offering vi. Shelf offering (Rule 415)== issuer registers new securities without selling the entire issue at once 1. Sell portions over 2 year period 2. Both debt and equity securities e. Public offering= securities sold to public through one or more broker/dealers f. Private placement= securities sold to private investor i. Institutional investors ii. No solicitation to public iii. Exempt from registration requirements g. Underwriting sequence i. Forming syndicate 1. Competitive bid= syndicate assembled first and work together to arrive at bid a. Standard for municipal securities 2. Negotiated underwriting= syndicate formed after issuer and underwriting manager have negotiated the terms a. Terms include amount, price, fees b. Standard for corporate securities ii. Pricing the new issue= underwriter advises issuer on best price 1. Considerations: public interest, market conditions, price syndicate member will accept, P/E ratios of similar companies, dividend payment record, debt ratio 2. Determined by effective date iii. Stabilizing price= underwriter bids on securities where supply is higher than demand 1. Price may be at or below market price i. Pegging/fixing= bidding price higher than market value 1. Illegal 2. Not allowed after sold out a. Syndicate penalty bid= fine if syndicate members client turn in shares after sold out 3. If does not work, underwriter may pull public offering price (POP) and let market find price level Underwriting Syndicate a. Underwriter agreement (UA) contract that establishes relationship between issuer and underwriters i. Terms and conditions upon which issuer is required to sell b. Underwriting/syndicate manager= investment banker that negotiates with issuer 1. Directs underwriting process 2. May have more than 1 c. Syndicate members make financial commitment to bring securities to public i. 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 liability b. Designates syndicate manager and power he has ii. Financial liability 44

V.

VI.

d. Selling group= enlist other firms to help distribute securities i. Acts as agent with no commitment to buy 1. No financial liability ii. Syndicate managers responsibility to decide if to use one iii. 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 Types of Underwriting Commitment a. Firm commitment= underwriter contacts with issuer, selling investors, or both to buy securities at a price and date i. Letter of intent (LOI)= where terms outlined in ii. Most widely used iii. Losses prorated among members iv. Market-out clause= specifies conditions which offering may be cancelled 1. May abort if adverse event occurs a. i.e. death of CEO 2. May not abort if nonmaterial event occurs that does not affect investment quality a. 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 commitment ii. Issuer assured of selling all shares c. Best efforts= buy securities from issuer as agent, not principal i. No risk for underwriter ii. All or non (AON)= underwriter must sell all shares or cancel underwriting 1. Funds held in escrow until final disposition iii. Mini-max= underwriter must find enough buyers to support minimum but can expand to maximum once minimum is met 1. Funds held in escrow until final disposition d. Compensation i. Underwriter proceeds= price issuer receives ii. POP= price investors pay iii. Underwriter spread consists of: 1. Managers fee= for negotiating deal a. 10%-20% allocations of fees 2. Underwriting fee= for assuming risk a. 20%-30% allocations of fees 3. Selling concession= for placing securities with investors a. 50%-60% allocations of fees iv. Firm commitment earns larger spread than best efforts v. Higher marketability= lower spread vi. Stable stock has lower spread than volatile stock vii. Larger offer size= lower cost per-share Exemptions From the Securities Act of 1933 a. Either because of their credit worthiness or because another regulatory agency has jurisdiction 45

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 registered iii. 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 investors a. Cooling off period of 20 days between filing and effective date b. 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 > 1m ii. Annual income > 200K in each of the last 2 years and has reasonable expectation for that to continue b. Maximum of 35 investors 2. No limit on capital raised 3. Investor must sign letter stating it will hold stock for investment purposes only a. Lettered/legend stock= private placement stock i. Cant be transferred with out registration 4. Restricted iii. Rule 147 (Intrastate offerings)= offering that take place in 1 state exempt if: 1. Issuers principal office in that state 2. 80% of income, assets, and offering proceeds are in that state 3. Underwriter is resident of that state and has office there 4. All purchasers are residents of that state a. May not sell stock to resident outside of state for 9 months iv. 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 stock a. 10% counts immediate family members b. Insiders are not allowed to short stock or invest in speculative options i. May write calls c. 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 year i. 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 class 2. Average weekly trading volume of the last 4 weeks ii. After 2 years no restrictions for unaffiliated investors 46

VII.

1. Volume limits still apply for insiders iii. Buyers not subject to any restrictions 3. Form needs to be filed no later than sale of stock a. Good for 90 days b. Sales amounts < 10k or 500 shares no form needed 4. Current information must be made available v. Rule 144a= nonregistered foreign and domestic securities sold to institutional investors in US without holding period 1. Buyer must be qualified institutional investor (QIB) a. Minimum 1m in assets vi. Rule 145= reclassification of securities, merger/consolidation, and transfer of assets must be approved by stockholders 1. Excludes stock splits and dividends Antifraud Regulations of the Acts ff 1933 and 1934 a. No offering exempt from antifraud provisions b. NASD Rule 2790= protect integrity of public offering price i. Ensures: 1. Members make bona fide public offering of securities at public offering price 2. Members do not withhold securities for own benefit 3. Industry insiders do not take advantage of their information ii. Applies only to new issues iii. 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 firm 1. 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 issue 2. Held for 3 years

47

Chapter 8- Trading Securities I. The Regulation of Trading a. 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 Senate iii. Requires exchanges files registration statements with SEC and by doing so exchanges comply and help enforce rules 1. Exchange must tell SEC of rules change iv. Companies that list securities on exchanges on some OTC firms register with SEC Securities Markets and Broker Dealers a. Securities markets= bought and sold in secondary market i. Exchange/auction market= NYSE and other exchanges where listed securities are traded 1. Listed securities= listed on exchange ii. OTC/2nd market= where unlisted securities trade 1. Dealers connected by computers and telephones 2. All municipal and government securities 3. Divided into NASDAQ and non-NASDAQ (Pink Sheets) rd market/OTC listed/NASDAQ Intermarket= where exchange listed securities are iii. 3 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 transactions iv. 4th market= institutional investors trade large blocks of stock unassisted by broker/dealer 1. Listed and unlisted securities 2. Through electronic communications networks (ECN) a. Open 24 hours a day v. Trading hours 1. NYSE/AMEX/OTC= 9:30-4 a. Market makers remain open until 6:30 i. After hours less liquid 1. Wider spread and greater volatility b. Listed markets i. Have central location ii. Double-auction market= floor participants compete to execute bids iii. Specialists= dealers on stock exchanges 1. Prohibited from dealing directly with public 2. Stocks assigned to specialists c. OTC markets i. No central location 1. Trading over phone, computer, and trading rooms across country 2. Pricing system= market makers compete to post best bid and ask prices a. Negotiated market 48

II.

III.

ii. No stock assigned to a specialist 1. Competing market makers d. Quotes are in terms of bid and ask i. 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 21.55 e. Broker/dealer= firms engaging in buying and selling securities i. Brokers= agents that arrange trades and charge commissions 1. Not a market maker 2. 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 trading 2. May also buy from market maker and charge markup 3. Net price= stock price + markup 4. May make markets and take positions 5. Must disclose role to client and markup The New York Stock Exchange (NYSE) a. Handles 3/4s of all exchange transactions b. Does not influence prices c. Requirements= only companies of significant size i. At least 1.1m shares publicly held ii. 2,000 stock holders each holding 100 or more shares iii. NYSE reserves right to delist issuers if they fall below criteria 1. Or if they file bankruptcy, have low stock price or trading volume iv. If company wants to delist than must be approved by BOD d. Only NYSE member can trade on the floor i. Floor/commission house brokers (CHB)= execute orders for clients and for their firms accounts ii. Two-dollar broker= execute orders when CHB is busy and charge commission iii. Registered trader= trade from own accounts 1. If they accept public order than public order gets priority a. May not execute own trades if public order unfilled iv. Specialist= facilitate trading and maintain fair and orderly market 1. Act is broker and dealer 2. Acts as auctioneer e. Auction/double auction market= buyers and sellers call out best bids i. Best bid must be at least $.01 higher/lower than current best bid ii. Trades awarded in order: 1. Priority= first 2. Precedence= largest 3. Parity= random drawing f. Rules 80A and 80B protect against rapid drops in DJIA i. Program trading and index arbitrage curbed if DJIA increases or decreases by 2% in given day 49

IV.

V.

ii. 10% decline in 1 hour then 1 hour halt iii. 20% decline in 2 hours then 2 hour halt iv. 30% decline then halt for the day g. Arbitrage= profit from temporary price difference between markets i. Market arbitrage= security sells for 2 different prices in different markets ii. Convertible security arbitrage= convert bonds to stock and sell stock for profit iii. Risk arbitrage= for mergers, buy stock in company being acquired and short stock in the acquiring company The Specialist a. Role is to minimize price disparities by buying or selling stock from own inventory i. Specialist is a market maker 1. May not buy stock for own account if it would compete with current market price ii. 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 post 1. Trading post= horseshoe shaped and surrounded by computer towers 2. 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 market 2. Only for benefit of public order v. Crossing orders= using 1 order to fill another 1. 2 market orders for same stock, 1 buy and 1 sell for same amount of shares 2. Must make sure there is not a higher bid first Types of Orders a. Market= executed immediately without restrictions and has priority i. At current market price ii. Buy= executed at lowest market price iii. Sell= executed at highest bid price iv. Guarantees execution b. Limit orders= limits the amount paid or received for securities i. Executed at specified price or better ii. May risk missing trade if market moves away from price iii. Stock ahead= arranged in order received 1. If not filled, earlier order took precedent iv. Firms holding limit orders not trade ahead of these 1. Firm can not act as principal without filling that order c. Stop/stop loss orders= protect profit if stock begins to move in wrong directions i. Stop price= becomes market order once stock trades at price ii. Left with and executed by specialist 1. Orders not immediately executed put in specialists book a. Only round lots iii. No guarantee that it will be executed at price iv. Trigger= at or through stock price v. Execution= stop order becomes market order and is executed at the next price 50

VI.

VII.

1. Price after stop order is triggered vi. Buy stop order= protect profit in short position 1. Price above market price 2. Placed over resistance level 3. Establish long position vii. Sell stop order= protects profit in long position 1. Below market price 2. Placed below resistance level 3. Establish short position d. Stop limit order= stop order that when triggered becomes limit order i. i.e. Sell stock if it falls below 30 but dont want less than 29.90 1. Stop= 30 2. Limit=29.95 3. Market could leapfrog between stop and limit e. Orders can be reduced on ex-dividend date i. Buy limits/sell stops/sell stop limits lowered by dividend amount ii. DNR order= not reduced by cash dividend iii. All orders adjusted for stock splits or dividends iv. Reverse splits on open orders care cancelled f. Time sensitive orders i. Day= open order valid only till close of trading that day ii. Good-till-cancelled (GTC)= valid until cancelled or executed iii. At-the-open= executions at open iv. Market-on-close=executed near or possible closing price 1. Entered before 3:40 v. Not held (NH)= floor broker not held to particular time and decides on best time to execute trade 1. Not placed with specialist 2. Day orders unless marked GTC vi. Fill-or-kill (FOK)= fill entire order at limit price or better, if not then cancel 1. No longer permitted on NYSE vii. Immediate-or-cancel (IOC)= like FOK except can fill partial orders viii.All-or-none (AON)= executed in their entirety and do not have to be filled immediately 1. No longer permitted on NYSE ix. Alternative Orders (OCO)= 2 orders, one cancels the other Exchange Short Sale Rules a. Up tick rule= must be listed as plus tick or zero-plus tick i. Plus tick= price higher than last different price ii. 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 short d. Muni bonds market is too thin too short e. Regulation SHO= pilot program to suspend tick rule for certain securities Other Domestic and Regional Markets a. AMEX= private, not-for-profit 51

VIII.

IX.

X.

XI.

i. 1/5 of all stocks traded there ii. Also known as the curb b. Regional= serve the financial communities in different regions i. Boston, Chicago, Philadelphia, Cincinnati Computerized Order Routing a. SuperDot= processes 75% of NYSE orders i. Sent directly to specialist ii. Receives preopening orders b. SuperMontage= quotation and execution system for NASDAQ Consolidated Tape a. Consolidated tape system open from 9 to 6:30 i. Delivers real-time reports ii. Network A= NYSE transactions 1. Includes regional exchanges, 3rd market, and ECN iii. Network B= AMEX iv. Prints prices and volumes 1. In round lots of 100 2. Multiples are followed by s a. 10 share units followed by ss 3. Consecutive trades separated with dot (.) v. Message appear when market is too active making the tape inaccurate or out of sequence 1. DIGITS & VOL DELETED= when message appears when both first digit of price and volume will be dropped 2. REPEAT PRICES OMMITED= tape will only show transactions that differ in price 3. SLD= exchange did not report on time 4. OPD= initial transaction has been delayed 5. HALT= trading for that security has been halted OTC a. Market where broker/dealers negotiate with each other i. Largest securities market ii. Regulated by both SEC and NASD b. No centralized market c. 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 these ii. Negotiated market= bargain during trade d. OTC market makers are broker/dealers trading from their own inventory i. No specialist ii. Must register with SEC and NASD Quotations a. 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 bonds 1. Firm quote always good for 1 round lot ii. All quotes 52

XII.

XIII.

iii. Counter offer/bid= negotiate better price with market maker 1. Only way to guarantee trade is at firm quote iv. Away from quote is violation of NASD trading rules b. Recognized quote= any public bid/offer for one or more round lots i. Bidder must buy any round lots at bid price c. Subject quote= price is tentative and is subject to reconfirmation by market maker d. Qualified quotes= conditions that allow broker dealer to back away i. Workout quote= approximate figure ii. Nominal quote= assessment of where stock might trade 1. Informational only and labeled as such e. Spread i. Influences: issues size, issuers financial conditions, amount of activity, market conditions ii. Wide spread indicates thin trading market f. Pink sheets/OTCBB use tree-quote rule i. Must contact 3 dealers before determining price NASD 5% Markup Policy a. Guideline only and not a firm rule for non-listed (OTC) securities i. May charge more if reasonable ii. Municipal and government securities are exempt b. Markup based on representative market prices if sold from inventory i. Price at which dealer acquired has no bearing c. Applies to markups, markdowns, and commissions i. 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. Considerations i. Type of security= more risk, higher markups ii. Inactivity= thinner/volatile market, higher markups iii. Selling price= higher stock price, lower commissions iv. Dollar amount= small dollar amount, higher commissions v. Nature of broker/dealer business= higher costs, higher commissions vi. Pattern of markups= if established patterns, single excessive markup is unfair NASD Automated Quotation System a. Three levels: i. Level 1= registered representatives 1. Displays bid and ask 2. Can not guarantee price to client ii. Level 2= NASD=approved subscribers only 1. Current quote and size 2. To list must guarantee quote is firm for at least 1 round lot iii. Level 3= 1+2 and allows market makers to input quotes b. Market makers must report trades with in 90 seconds of execution i. Include: symbol, # of shares, price, and buy/sell/cross c. Market makers must make daily reports of total volume d. Inside market= best bid/ask in interdealer market 53

i. Lead markets

54

Chapter 9- Brokerage Support Services I. O P M C Processing an Order a. A client places an order and is routed as follows: i. Order department/wire room/order room= transmits orders to markets ii. Purchases and sales department (P & S)= records all transactions from trade tickets iii. Margin/credit department= handles margin accounts and computes days when clients must deposit money and for what amount iv. Cashiering department/cage= receives securities and delivers money 1. Delivers money only if instructed to do so by margin department b. National Securities Clearing Corporation (NSCC)= simplifies process by providing specialized comparison clearance and settlement services c. Other departments: i. Reorganization department= handles changes in securities outstanding ii. Dividend department= credits customers with dividends and interest iii. Proxy department= sends out statements to clients whose securities are held in firms name iv. 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 clients 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 manager 1. All changes must be kept in writing for 3 years iii. Must be approved by principal after execution iv. Representative must check report with order ticket 1. Report received after execution 2. Report execution to customer 3. If error than contact principal v. If order executed outside of instructions then trade is not binding f. Trade confirmation= document that confirms trade i. Send confirmation to client on settlement date ii. 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. Dont know (DK)= if one side does not recognize other in interdealer trade 1. Or if wire room does not recognize account # g. Firms must send clients quarterly statements i. 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-discriminatory i. Reasonable fee= not excessive when compared top other broker/dealers 55

II.

III.

IV.

Transaction Settlement Date a. Settlement date= date at which ownership changes i. Uniform Practice Code (UPC) standardizes dates for settlement ii. Regular way/T+3= third business day following trade date 1. i.e. trade on TU settles on FRI 2. T-bonds, T-notes, T-bills, and options settle next day (T+1) a. Government agency issues settle regular way 3. Interdealer trades that deliver before settlement date can be refused a. Government securities settle in federal funds b. Other securities settle in clearing house b. If customer buys stock before ex-date customer is entitled to dividend i. 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 day i. No later than 2:30 d. Sellers 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+4 e. When-issued confirmation= received if purchased muni-bond before issued i. Must include: description, yield, trade date ii. Does not include: settlement date, accrued interest, total dollar amount f. Regulation T payment= date customers are required to pay for transactions i. 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 for i. Client must deposit full purchase price or account will remain frozen for 90 days Proxy Department a. Proxy= stockholders vote absentee ballot i. Revoked if stockholder attends meeting b. SEC requires company to give stockholders information about items if votes solicited c. Anyone who participates in proxy contest must register with SEC d. Firms must alert customers and forward them proxy notices i. Firms reimbursed by issuers for cost e. 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 fit Rules ff Good Delivery a. Physical condition must be good i. In interdealer transaction must be accompanied with uniform delivery ticket ii. If mutilated then authentication must be obtained b. 1st rule of good delivery= if proper number of shares is met i. Interdealer partial delivery must be accepted if remainder constitutes a round lot 1. 100-share uniform units= round lots are cleared separately a. 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 56

c. Each stock certificate must be endorsed by owner whose name is registered on face of security i. Once endorsed than negotiable 1. If lost, same as losing a check 2. Assignment of stock power= separate piece of paper that when put together with actual certificate is treated as endorsed ii. Alteration must be signed with explanation iii. Must be guaranteed by party acceptable to transfer agent 1. Corporations need fiduciary d. If failed to deliver then seller will not receive payment i. May charge seller for any loss caused ii. Firm representing seller must by securities in 10 days

57

Chapter 10- Investment Company Products I. Investment Company Purpose a. Investment company= pools investor money and invest in securities on their behalf i. More efficient than individual investors ii. Raise capital by selling shares iii. 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 future 1. Issuer is face amount certificate company 2. Very few today because of tax law changes ii. Unit investment trusts (UITs)= organized under trust indenture 1. Do not trade or manage securities 2. Not traded in secondary market a. Redeemed by trust 3. Purchase shares in other investment companies then issue redeemable shares/ units/beneficial interest a. Undivided interest in portfolio b. When shares liquidated proceeds to shareholders 4. Fixed= purchase portfolio of bonds and terminates when bonds are sold 5. 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 stocks 2. Closed-end investment company= raise capital through common stock offering a. Initial offering of fixed # of shares i. Anyone can buy or sell shares on secondary market ii. Supply and demand determine price iii. 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 shares a. Continuous offerings b. No bonds or preferred stock c. Sold and redeemed by fund only d. Priced by NAV + sales charge e. Ex-date set by BOD 4. Diversified investment company= 75-5-10 test a. 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 issuers outstanding stock 5. Nondiversified= fails 75-5-10 test a. Specializes in single industry 58

II.

III.

i. Specialized/sector funds ii. May still be diversified if passes test Investment Company Registration a. Company must register with SEC as investment company if: i. In the business of investing/trading securities ii. 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 assets ii. 100 investors iii. Clearly defined investment objectives 1. Changes only by majority vote c. Open-end companies must have minimum asset-to-debt ratio of 300% i. May borrow money if meets the 300% minimum d. 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 statement 1. Part 1/N1-A/summary prospectus= prospectus a. Furnished to whoever it offers securities to b. 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 investor b. Expanded history, policy, and financial statements ii. Both for open and closed ended 1. Closed end only at IPO e. Mutual funds can not be purchased on margin i. 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 registration i. 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 Management Investment Companies a. BOD= Majority must be noninterested people i. Tasks: defines type of fund, funds objectives, approves transfer agent, custodian, investment advisor, and underwriter b. Investment advisor= outside of fund contracted by BOD i. Tasks: invest cash, implement strategy, identify tax status, manage day to day trading ii. May not have been convicted of a securities related felony iii. May not be loaned money by fund iv. May not transfer responsibility v. Must be registered vi. 2 year contract and subject to shareholder approval 59

IV.

V.

VI.

vii. Earns fee 1. % of portfolio value and incentive bonus c. Custodian= who securities placed with i. Tasks: keep assets segregated, restrict assets ii. Handles clerical functions iii. Receives fee iv. 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 shares e. Underwriter/sponsor/distributor= sells and markets shares to public i. Prohibited from maintaining inventory in open-ended fund ii. Fund may not act as own underwriter 1. Exceptions are no-load and 12b1 funds Information Distributed to Investors a. Prospectus= before or during solicitation of sale b. 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 purchased c. Additional disclosures= factors materially affecting performance, line graphs comparing performance with index, people responsible for day-to-day management 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 distributions c. Money is constantly moving d. Most funds offer minimum investment of $500 and additional purchases of $25 e. Automatically reinvest capital gains f. Liquidate portion without disturbing diversification g. No preemptive rights h. Ex-dividend day after record date i. Reduced sales charges by offering break points i. Larger deposits, LOI, rights of accumulation j. Each year fund distributes 1099 form k. Various withdrawal plans i. May reinvest withdrawn funds within 30 days with one cost Investment Objectives a. Must match objective stated in prospectus b. 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 companies iv. Specialized/sector funds= specialize in economic sector 60

VII.

1. High risk, high appreciation v. Special situation funds= buy companies that benefit from change within or economy (takeover or turnarounds) vi. Index funds= mirror index 1. Low turnover vii. Foreign stock funds= invest in companies with principal business outside US 1. Long-term capital appreciation c. Balanced funds= stocks for appreciation and bonds for income d. Asset allocation funds= split investments between stocks for growth, bonds for growth, and money market for cash i. Switch allocation according to performance e. Bond funds= income is main objective i. 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 separately i. Investors seeking income purchase income shares and receive all interest and dividends ii. Investors seeking capital gains purchase gains shares and receive all the gains g. Money market funds= temporary holding tanks for investors concerned with liquidity i. No-load and open ended ii. Interest rates are not fixed 1. Computed daily iii. NAV= $1 per share iv. Restrictions: may not be guaranteed by government, no assurance of stable NAV, maturities < 13 months, average maturity < 90 days v. T-bills, commercial paper, bankers acceptance Comparing Mutual Funds a. Performance= funds must disclose annual performance for 1,5, and 10 years i. Must reflect loads with no discounts b. 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 withdraw 4. 12b-1= ongoing fees a. Charged quarterly and approved annually ii. 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 securities 1. 100% holds securities for less than 1 year a. All gains are subject to maximum tax rate b. More aggressive funds 2. 25% holds securities for 4 years iv. Services offered 61

VIII.

Mutual Fund Marketing and Pricing a. Public offering price (POP)= price fund is sold to customer at i. Customer= anyone not an NASD member ii. Only nonmembers may purchase shares at discount iii. POP= NAV + sales charge 1. Customer sells back at NAV iv. Sales charge %= sales charge/POP v. POP= NAV/(100%-sales charge %) b. Marketing mutual fund shares i. Fund to underwriter to dealer to investor 1. Investor gives order for fund to dealer 2. Dealer places order with underwriter 3. Fund sells shares to underwriter at NAV 4. Underwriter sells shares to dealer at NAV + concession 5. Dealer sells shares to in investor at POP ii. Fund to underwriter to investor 1. Underwriter acts as dealer 2. Investor give order to underwriter 3. Fund sells to underwriter at NAV 4. Underwriter sells shares to investor at POP iii. Fund to investor 1. Open-end fun distributes directly to public a. No-load= no sales charges i. 12b-1 fees of less than .25% are considered no-load iv. Fund to underwriter to plan company to investor 1. Plan companies= organizations that sell plans of periodic payments of funds c. NAV calculated once per business day i. Redeemed shares the next day NAV 1. Forward pricing ii. Uses funds total assets iii. Increases when securities increase or when income payment 1. Does not change when shares are redeemed d. NASD prohibits members from charging more than 8.5% sales charge i. Funds typically less ii. Includes redemption fees iii. 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 fund ii. Extra shares held in escrow iii. Dividends are not counted toward breakpoints iv. May backdate for up to 90 days 62

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 shares b. 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 breakpoints 1. Long term investor ii. B= backload, reduced over time 1. Can not have breakpoints iii. C= 12b-1 charged quarterly 1. Can not have breakpoints iv. Closed-end= no sales charge but brokerage commission or markup v. Open-end= all sales commissions and expenses paid from charges 1. Front-end load= charges included in POP a. Charges added to NAV b. Most common 2. Back-end/contingent deferred load= charges at redemption a. 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 disturber i. Permitted to collect fees for promoting and selling ii. Fees represent what would have gone to underwriter b. Maximum is .75% c. Fee must reflect anticipated distribution services d. Restrictions: i. Must be approved initially and annually ii. May be terminated by BOD iii. If more than .25% may not be described as no-load e. Fund must redeem shares with in 7 days of redemption request i. Customers signature must be guaranteed ii. May be suspended if NYSE is close or restricted or if SEC ordered suspension of redemption 63

IX.

X.

iii. Shares cancelled and never reissued iv. If redemptions fees, they go to underwriter Mutual Fund Distributions and Taxation a. Conduit theory= funds may avoid taxation on net investment income if distributions go to shareholders i. Net investment income= income + dividends expenses ii. Investors taxed at 15% iii. Subchapter M qualifications= regulated investment companies 1. Distribute 90% of net investment income 2. 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 year ii. Taxed at 15% iii. Short-term gains taxed at ordinary income rates c. Cost base= amount of money invested i. At liquidation is return on capital 1. Not taxed again ii. Includes cost, distributions, sales charges iii. 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 gain a. Adverse tax consequences in rising market b. IRS assigns unless told otherwise 2. Share identification 3. 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 quarter iii. 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 illegal g. Form 1099= sent to shareholders and discloses income and capital transactions Mutual Fund Purchase and Withdrawal Plans a. Voluntary accumulation plan = periodic, regular investment program i. May have minimum purchase ii. Not penalized for missed payments iii. Dollar cost averaging= investing identical amounts 1. Purchase more share when price is low 2. Average cost per shares is lower then average price per share b. Lump sum withdrawal= sell all shares at once c. Systematic withdrawal= sell shares over time 64

XI.

Free service Fixed dollar amount= liquidates enough to send that sum Fixed %/share Fixed time= liquidate holdings over time 1. Require minimum worth 2. Discouraged for continued investment v. Representative must: not guarantee gain, stress possibility of over exhausting account (especially in down market), never use charts Tracking Investment Company Securities a. Newspapers carry NAV (bid) and POP (ask) i. The difference between the 2 is the load b. Standard & Poors Depository Receipts (SPDRs, Spiders)= index funds that track the performance of investments in portfolio i. Traded on AMEX ii. Quarterly cash dividend after expenses iii. Trade like a stock and create additional shares 1. Open and Closed iv. Uses: asset allocation, following industry trends, portfolio balancing, speculative trading, hedging v. Different from mutual funds: trade during day, can be bought on margin, can be sold short vi. Low turnover and expenses c. Qs= performance of NASDAQ 100

i. ii. iii. iv.

65

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 trust 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 eligible ii. Risky because company may fold 1. May forfeit benefits if leave before retirement c. Payroll deduction plans= deduct payment from paycheck and placed into retirement plan 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 50 ii. Earned income= income from work (includes alimony) 1. May contribute until 70 iii. 6% contribution penalty if exceeds 4k iv. Made by April 15th b. Spousal IRA= If nonworking spouse then 8k contribution i. Must file joint tax return c. Distributions with out penalty after 59.5 i. Must begin by April 1st the year after 70.5 1. If not then 50% insufficient distribution penalty ii. 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 plan a. May still make contribution e. Not acceptable: collectible, life assurance, aggressive option strategies, and short sales, margin accounts i. Covered calls and annuities are permitted ii. Muni bonds are inappropriate given tax-exempt status f. IRA rollovers= move funds from one qualified plan to another i. Must be completed with ion 60 calendar days ii. Payor of qualified employee plan must withhold 20% tax iii. Owner may not take procession of funds g. Roth IRA= after-tax contribution of 4k i. Earnings not taxed at distributions 66

II.

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IV.

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VI.

1. Money must have been in account for 5 taxable years ii. No minimum distribution after 70 iii. Penalty rules before 59.5 apply iv. 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 43k ii. Employer can take income tax reduction iii. Contributions for employees are also tax deductible Education Savings Accounts a. Coverdell (Education IRA)= after-tax contributions of up to 2k per student younger than 18 i. Limits reduced for high income taxpayers ii. 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 IRA b. 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 education a. More popular 2. College savings plan ii. Lump sum or periodic payments iii. Contributions are made with after tax dollars and considered tax free 1. Earnings accumulate tax deferred 2. 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 expenses v. Assets remain under donors control vi. Balances may be transferred vii. No income limitations Keogh (HR-10) Plans a. Qualified plans for self-employed persons and owner employees of an unincorporated business i. Tax deductible contributions of 43k until 70.5 ii. Employer must make contributions of eligible employees 1. Eligible: 1,000 hours a year, one or more years of employment, at least 21 2. i.e. if max amount contributed into owners Keogh then 25% to eligible employees Keogh 3. Tax deductible for owner a. Income from employees is not deductible iii. 10% penalty for excess contributions Tax-sheltered Annuities [403(b) Plans]= available for public educational institutions, tax exempt organizations, and religious organizations a. Employees have completed one year and are at least 21 b. Earnings tax-deductible and grow tax-free until distribution c. 10% penalty if distributed before 59.5 67

VII.

VIII.

Corporate Retirement Plans a. All administrators have fiduciary responsibility where risk is main concern b. Defined benefit plan= specific benefit at retirement i. Used to favor old, key employees ii. Pension liability= legal obligation to pay benefits iii. Unfunded pension liability= adequate reserves have not been set aside to meet obligations iv. Actuary calculates contribution to me requirements c. Defined contribution plan= employees contribute specific amount to plan i. Profit-sharing plan= allow contributions to be skipped in low profit years ii. Savings incentive match plans for employees (SIMPLEs)= employees make pre-tax contribution of up to limit (6k) and employer matches 1. Less than 100 employees iii. 401 (k)/thrift plans= employee contributes % of pre-tax salary and employers are permitted to match 1. Accumulate tax free 2. Hardship withdrawals are allowed 3. Self-employed 401(k)= business with no full-time employees a. Higher contribution and greater flexibility b. Make take out loan from 4. Roth 401(k)= like Roth IRA a. Except: no income limitations, no 5 year of tax-free withdrawals, must begin withdrawals by 70.5 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 service ii. Funding= funds segregated from other corporate assets iii. Vesting= employees get entire benefit after certain amount of years iv. Communication= plan document in writing with annual statement 1. Explains formula to determine contributions v. Nondiscrimination= all eligible employees treated impartially vi. Beneficiaries= must be named to receive employees benefits at death

68

Chapter 12- Variable Annuities I. Types of Annuity Contracts a. 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 funds b. 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 vote 3. Separate account= objective of achieving growth that will match or exceed inflation a. Separated from general funds b. If responsibility of management is passed to another party then must be registered as UIT 4. Death benefit provision= if annuit dies then beneficiary receives payments directly a. 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 59.5 a. 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 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 postponed c. Immediate= lump sum with payments starting in 60 days d. 2 phases: i. Accumulation phase= growth phase ii. Annuity phase= payout phase 1. Annuitization= take income from account 69

II.

III.

IV.

e. Accumulation/annuity units= owners interest in separate account during accumulation i. Once annuitized # of units received is fixed 1. Total annuitization value= units* unit value Receiving Distributions From Annuities a. Can withdraw randomly or in lump sum b. 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 income b. Separate account performance = AIR; same monthly income c. Separate account performance < AIR; less monthly income 2. 1st AIR comparison is what is used for the rest of the payments c. Payout options: i. Life income= payment for life, when annuit dies no more payments 1. 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 years a. Still guaranteed for life iii. Joint life with last survivorship= payments guaranteed over 2 lives 1. Smallest monthly payout of payment options Taxation of Annuities a. All contributions are after tax unless part of a qualified plan i. Assume it is nonqualified b. Contributions are tax basis i. Cost basis not taxed when withdrawn ii. 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

70

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 credits b. 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 management 2. Easiest to avoid= continuity of life a. Freely transferable interests c. Advantages: investment managed by others, limited liability, flow through of income i. Biggest disadvantage is lack of liquidity d. Master LPs= listed on OTC e. Report income and losses to IRS and then partners are responsible for reporting their share i. Double taxation avoided ii. Passive income 1. Can not use losses on ordinary income iii. 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 LP i. Potential for returns from cash distribution and capital gains ii. 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 people 1. Must be sold to accredited investors with substantial investment experience ii. In public offering LPs are sold with prospectus to a larger # of investors iii. Sydicator= oversee selling and promotion iv. 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 days 2. Subscription agreement= investors interested in becoming LPs must complete a. Appoint GP to act on behalf of LPs i. Includes: investors net worth/annual income, statement that investor knows risks, power of attorney appointing GP ii. Effective only in GP signs it b. Recourse loan= subscribers assume portion of the loan 71

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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 lenders 2. Creditors 3. LPs a. Claims to profit b. Claims to capital 4. GP a. Claims for fees b. Claims for share of profits c. 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. GPs 1. 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 compensation 3. 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. LPs 1. Features: limited liability, no management responsibility, can recover damages from GP 2. Can do: vote on changes, receive cash distributions, inspect books 3. Can not do: act on behalf of partnership, knowingly sign certificate with false information, have names as part of partnership name 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 potential b. Downside: no income distributions or tax deductions c. Tax features: not a tax shelter d. Degree of risk: most speculative 2. New construction= build new property for appreciation value a. Plus side: appreciation potential, low maintenance costs b. Downside: cost overruns, no track record, hard to find permanent financing, cant 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 72

c. Tax features: mortgage interest and depreciation d. Degree of risk: low 4. Government-assisted housing= develop low-income and retirement housing a. Plus side: tax credits and rent subsidies b. Downside: low appreciation, changing government programs, high maintenance c. Tax features: tax credits and losses d. Degree of risk: low 5. Historic rehabilitation= develop historical sites for commercial use a. Plus side: tax credits b. Downside: cost overruns, no track record, hard to find financing, cant deduct current expenses c. Tax features: tax credit, deductions d. 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 year 2. 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 money ii. Types: 1. Exploratory (wildcatting)= locate undiscovered reserves a. Plus side: high rewards b. Down side: few new wells produce c. Tax features: high IDCs (immediate) d. Degree of risk: high 2. Developmental= drill near existing fields a. Plus side: less risky than wildcatting b. Down side: few new wells produce c. Tax features: medium IDCs (immediate) d. Degree of risk: medium to high 3. Income= immediate income from selling oil a. Plus side: immediate cash flow b. Down side: oil prices, well stops c. Tax features: depletion allowances d. Degree of risk: low 4. Combination= allocates money between income and exploratory iii. 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 73

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3. Net operation profits interest= GP bears non of the costs but gets % of profits a. LP bears all costs b. Only through private placement 4. Disproportionate sharing= GP has small % of costs but high % of revenues 5. Carried interest= GP shares in TDCs but receives no IDCs a. LP= immediate deductions b. GP= depreciation deductions 6. Functional allocation= revenues are shared a. LP= IDCs b. GP= TDCs c. Most common c. Equipment leasing programs= purchase equipment and lease to other businesses i. Income from lease payments ii. Write-offs from operating, interest, and depreciation expenses iii. Primary objective is tax sheltered income Analysis of Limited Partnerships a. Measuring economic viability i. Cash flow analysis ii. IRR= PV of future cash flows b. Tax features i. Deductions ii. Depreciation write-offs (cant be land)= straight line or accelerated 1. Accelerated= depreciation reduced in later years a. 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 reductions i. Biggest tax benefit ii. Cross-over point= point where program begins to generate taxable income instead of losses iii. LPs must keep track of basis 1. Basis= liability assumed by LP a. Can not lose more than b. 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 year 4. Can not deduct lower then their basis a. Losses carried forward i. May be added to basis at sale 5. Gain/loss= sale - basis d. Other: management ability, blind pool (less than 75% of assets are specified for use), time frame, lack of liquidity, revenue projections, start up costs

74

Chapter 14- Economics and Analysis I. Economics a. Study of supply and demand b. Business cycles: i. Expansion= increased business activity thought economy until it reaches upper limit 1. Characteristics: increased demand, increased production, rising stock prices, increased GDP 2. Always starts with ii. Peak= upper limit of expansion iii. Contraction= business activity declines from peak 1. Characteristics :rising bankruptcies, higher debt, falling stock prices, rising inventories, decreasing GDP a. Recession= short-term contraction i. Six month decline in GDP b. Depression= long-term contraction i. 18 month declining of GDP iv. Trough= business activity stops declining c. 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 month i. Constant dollars= adjustments in GDP to account for changes in prices 1. Inflation= increase in prices a. Mid inflation encourages economic growth i. Always in growing economy b. High inflation reduces buying power c. Drives up inflation rates d. Barometer for price levels 2. Deflation= decline in prices a. Sever recession when unemployment is on the rise e. Economic indicators= serve as barometers for business cycle i. 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 cycle 1. Number of hours worked, employment levels, nonagricultural employment, personal income, industrial production, sales, GDP iii. 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 health g. Monetarist theory= quantity of money determines price levels and is controlled by FRB 75

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III.

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 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 agreements iii. M3= M1+ M2+ time deposits of more than 100K and repurchase agreements of greater than 1 day b. 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 common c. Buys securities to increase/expand/loosen money supply i. Increase in reserves allows banks to make more loans ii. Lowers inertest rates iii. Used to stimulate slow growth iv. Vice versa for decreasing/contracting/ tightening money supply 2. Discount rate= interest rate Fed charges to member banks for short-term loans a. Federal funds rate= rate banks charge each other i. Fluctuates daily, thus more volatile and move quicker 1. Long-term bond prices move more than short term bond prices ii. Not set by FRB b. Determined by supply and demand for money c. Lowering rates indicates deposits are growing i. Increases demand for loans 1. Money supply increases ii. Used to stimulate slow growth iii. Vice versa for declining rates 3. Reserve requirement= banks certain % of depositors money with the Fed a. Most drastic because of multiplier affect b. Raising requirements= less money for banks to lend i. Used to stimulate slow growth ii. Vice versa for lowering requirements Fiscal Policy a. Actions of Congress and the President b. Governmental budget decisions i. Government can control unemployment by adjusting overall demand for goods 1. Changes in: federal spending, money raised through taxes, budget surplus/deficit 2. Takes time thus inefficient for short term problems 76

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ii. Lower taxes are bullish for stock market 1. 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 countries 1. Surplus or deficit 2. Balance of trade= largest component 3. Debits: imports, spending/investments/loans abroad, foreign aid 4. Credits: exports, foreign spending/investments in US 5. Weak dollar= exports increase 6. Strong dollar= imports increase Technical Analysis a. Predicts direction of prices based on historic models i. Market timers= technical analysts b. Market averages i. Stock prices move together 1. Rise in bull 2. 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 day 1. Bull= advances > declines 2. Bear= declines > advances c. Charting stocks i. Trendlines= over time stock price moves in one direction and thus connects lows in an up trend with highs in a down trend 1. Hard to reverse 2. Bull= upward 3. Bear= downward 4. Consolidating= stock prices moves in narrow range and trendline is horizontal a. Reversal= stock price moves in opposite direction of trend line i. Between 2 trend lines consolidation occurs and stock price levels off ii. Saucer= reversal of down trend iii. Inverted saucer= reversal of uptrend iv. 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 indicator 1. Reversal of head and shoulder bottom pattern ii. Support and resistance levels= move with in narrow range 1. Support= bottom level 77

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a. When stock declines to it attracts buyer b. Bearish breakouts= decline i. Signal of new trend 2. Resistance= top level a. When stock rises to it attracts sellers b. Bullish breakout= rise i. Signal of new trend d. Overbought= indexes are rising, but # of declining stocks relative to # of advancing stocks is rising e. Oversold= market is declining, but # of advancing stocks relative to # of declining stocks is rising f. Technical market theories i. Dow= confirm end of market trend 1. Three types of changes a. Primary= 1 or more years b. Secondary= 3-12 weeks c. 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 trend b. 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 lower b. 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 shorted 1. Reflects mandatory demand because stocks must be repurchased a. Bearish= high short interest b. Bullish= low short interest iv. Modern portfolio theory (MPT)= relationship of all investments in portfolio 1. Select mix of investments weighted to emphasize economic trends v. Random walk theory= direction of market is unpredictable 1. Efficient market theory= stock market is perfectly efficient g. Indexes i. Dow Jones Industrial Average= 30 stocks 1. Oldest and most widely used ii. Dow Jones Composite= 30 industrial, 20 transportation, and 15 utility stocks iii. Value Line Index= 1,700 NYSE, AMEX, and OTC stocks iv. Wilshire 5000= all NYSE, AMEX, and NASDAQ stocks 1. Most broad v. S & P 500= 500 most widely held companies with respect to market size, liquidity, and industrial sector Fundamental Analysis 78

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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 analysis i. 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 trends 1. Durable goods (machinery, cars, etc) 2. Counter cyclical= rise when economy is down iii. Growth= grow faster then economy as a whole iv. Special situation stocks= unusual profit potential because of non-recurring circumstances Corporate Analysis a. Balance sheet (B/S)= snapshot of companies position i. Assets-liabilities= net worth/equity 1. 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 expenses b. 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 firms reputation adds to book value 2. Liabilities= what firm owes in order of liquidity a. 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 year i. Includes: mortgages, promissory notes, bonds ii. Funded debt= debt of greater than 5 years 3. Stockholders equity/net worth= stockholders claim to assets after creditors are paid a. Includes: i. Capital stock at par= arbitrary value assigned to stock ii. Capital in excess of pair/additional paid in capital/paid in surplus= amount over par company received from selling stock iii. Retained earning/earnings surplus= total earning paid out total dividends- total losses ii. Capitalization= debt + equity iii. Liquidity= measure of working capital 1. Working capital= cash company has available a. Current assets- current liabilities iv. Changes that effect B/S 79

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1. Double entry book keeping= offsetting changes in books 2. Depreciation= declines value of asset over time a. Affect B/S: i. Accumulated= reduced value of assets ii. Deduction= reduces income b. Accelerated= depreciates more in early years i. 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 earnings 1. FIFO= first in, first out a. During inflation sales are inflated and fair inventory values i. Reduces cost of goods 2. LIFO= last in first out a. During inflation sales are fair and inventory is understated i. Raises cost of goods ii. Issuing securities= equity and cash increase iii. Bond redemption= liabilities reduced and cash is reduced iv. Dividends= when declared lowers retained earnings and increases liabilities 1. Once paid lowers cash and liabilities v. Stock dividends/splits= have no effect on equity 1. Only effect is on par value per share and shares outstanding vi. Financial leverage= use long term debt to increase return on equity 1. Highly levered= high long-term debt to stock a. More aggressive b. High returns but high risk i. Increase EPS ii. Default risk iii. Affected by change in interest rates 2. Industrial companies are highly levered c. 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 bondholders 1. Not considered operating expense 2. Reduce taxable income 3. Pretax income= operating income- interest expense iii. Net income after taxes 1. Dividends paid out from this iv. Earnings per share (EPS)= earnings available to common/ # of outstanding shares 1. Earnings available to common= what remains after interest, taxes, and preferred dividends v. Retained earnings= earning available to common- dividends 1. Earnings surplus= what is not paid out in dividends Financial Ratios a. Capitalization ratios= asses bankruptcy risk by studying leverage in its overall capitalization 80

i. Debt-to-equity= long-term debt/ equity 1. Most common measure of leverage ii. Bond/debt= long-term debt/ capitalization iii. Common stock= equity/ total capitalization iv. Preferred stock= preferred stock/ capitalization b. Liquidity ratios= firms ability to meet current financial obligations i. Current= current assets/ current liabilities ii. Quick assets= current assets- unsold inventory iii. Acid test/quick= quick assets/ current liabilities 1. Most stringent measure of liquidity iv. Cash assets= cash and equivalents/ current liabilities v. Debt service= EBIT/ (annual interest + principal payment) 1. Ability to meet payments on bonds vi. Book value per share= (assets- liabilities-intangibles- par value of preferred stock)/ # of shares outstanding 1. Book value= theoretical liquation value a. Tangible dollar amount per share if company liquidated c. Valuation ratio= compare company with industry i. EPS/primary earnings per share/basic earnings per share 1. 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 outstanding iv. Current/dividend yield= dividends per share/ market value per share v. Dividend payout = dividends per share/ EPS 1. Older companies (utilities) have high ratio vi. Price/earnings (PE)= market price per share/ EPS 1. Growth companies= high PE 2. Companies subject to cyclical fluctuations= low PE 3. Be aware of extremely high and low PEs a. Speculative stocks Chapter 15- Ethics, Recommendations, and Taxation I. Ethical Business Practices a. Rules that guide relationship between members of securities industry and others are set by SEC, NYSE, NASD, and others i. Practices that provide unfair advantage are prohibited ii. All broker/dealers are required to maintain written supervisory procedures iii. A principal is responsible for enforcing rules of broker/dealer iv. Broker/dealer may have more stringent rules 1. But never less v. NASD conduct rules deal with treatment of customer b. Prohibited business practices i. Manipulative and fraudulent devices to induce security sale 1. Statue of limitations of 3 years of incident and within 1 year of discovering it 81

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ii. Outside business activity= associated person cant work for any other business without employer knowledge iii. Private securities transactions/selling away= sale of securities outside of regular business 1. Does not include passive investments 2. May enter if: provide written notice, describe transaction/, role in transaction/ compensation a. With compensation= enter transaction on own books i. Employer may disapprove b. Without compensation= employer must acknowledge written notification and require person to certain conditions i. Excludes immediate family members iv. Recommendations= must consist of customer needs and be explained c. Conduct rules= require broker/dealer to inquire customers situation i. Violations= recommending unsuitable investments, short-term mutual fund trades, fictitious accounts, unauthorized transactions, recommending purchases that customer cant afford, fraudulent acts (i.e. forgery), guaranteeing against loss ii. Excessive trading/churning= generate commissions instead of achieving customers financial need 1. Safeguard= principal must review all trades iii. Broker/dealers may not distribute compensation to employees of other member firms 1. Exceptions: compensation not conditional on sale, employing members 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 themselves a. Covering: qualifications, education, experience, nature of services offered, fees v. 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/losses a. Not proportionate for family members vii. Advisor must establish policies to prevent use of nonpublic information viii.Information regarding customer securities are treated with confidentiality d. Unethical trading practices i. Painting the tape= sell a stock to another party with understanding that stock will be repurchased on later date for same price 1. Looks like more activity ii. Marketing the close= falsely reporting trades iii. Influencing market price by paying for favorable reviews iv. Promoting false information v. May not place order if they have information of impending block order Investment Considerations and Suitability 82

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a. NYSE Rule 405= know your customer i. Nonfinancial considerations: age, marital status, dependents, employment status of customer/family members, current and future financial needs ii. Risk tolerance/investment goals: risk, liquidity, tax considerations, long or short term investments, investment experience, investments currently held b. Customer investment outlook i. Preservation of capital 1. For many most important ii. Current income 1. Fixed-income securities iii. Capital growth iv. Tax advantages= reduce or defer taxes 1. i.e. using IRAs, muni bonds v. Diversification vi. Liquidity= sell it quickly 1. Liquid= stocks, bonds, mutual funds 2. Illiquid= DPPs, annuities CDs, real estate vii. Speculation= higher returns for higher risk Suitability: Analyzing Financial Risks and Rewards a. Unsolicited statement= customer wants investment that representative feels us unsuitable i. Not required ii. Explain why trade is unsuitable b. Investment risks= investment will not earn expected rate of return i. Inflation/purchasing power= effect of rising prices on investment 1. Bond yield < inflation rate purchasing power diminishes ii. Capital= investor will lose some or all of their money iii. Timing= risk that investor will buy/sell at wrong time iv. Interest rate= sensitivity of investment to rate changes v. Reinvestment= difficult to invest proceeds from redemption at same level without raising risk 1. Declining interest rates a. Mortgage-backed securities because of refinancing b. Bonds 2. Not subject: zero-coupon bonds vi. Call= bond may be called before maturity and will be unable to reinvest at comparable rate 1. Call protection period= period when bond cant be called vii. Market/systematic= investors lose capital because of price volatility in market 1. Cant be diversified away a. Nonsystematic/selection risk can be minimized 2. It can be hedged by purchasing market puts viii.Liquidity/marketability= client may not be able to sell investment quickly 1. Muni bonds are less marketable ix. Legislative/political= legal changes will affect investment c. Risk measurements i. Beta= stocks volatility relative to market 83

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1. How stock moves: a. 1= moves with market b. >1= moves more than market i. More volatile, thus greater loss in declining markets ii. Aggressive 1. Includes technology and cars c. <1= moves less than market i. Less volatile, thus less loss in declining markets ii. Conservative 1. Includes utilities and drug 2. Measures market risk 3. Treynor measure= portfolios benefit to risk ration a. Average return in excess of risk-free rate/ beta ii. Correlation= securities move in same direction 1. Correlation coefficient is from 1 to -1 a. 1= perfectly correlated b. 0= unrelated c. -1= perfectly uncorrelated iii. Standard deviation= volatility of stocks potential returns 1. 5.5= stock may differ 5.5% above or below predicted return 2. Larger standard deviation= larger returns are expected from average return 3. Lower standard deviation= lower risk 4. Sharpe measure= portfolios benefit to risk ratio a. Average return in excess of risk-free rate/ standard deviation iv. Duration= time in years it takes a bond to repay itself 1. % change price= +/- duration* change in interest rate a. (-)= increase in interest rates b. (+)= decrease in interest rates Portfolio Management a. Portfolio= combined investment holdings i. Aggressive strategy= maximize returns with higher risk 1. Includes: selecting volatile stocks, buying on margin, option strategies ii. Defensive strategy= safety is top priority 1. Includes: blue chip stocks, AAA bonds b. Modern portfolio theory= determining the relationship between risk and reward i. Quantify and control risk ii. Derived from Capital Asset Pricing Model (CAPM) 1. Pricing of stock take into account systematic and unsystematic risk iii. 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 price v. Constant ratio plan= buy/sell securities to keep portfolio balanced between equity and debt 84

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vi. Constant dollar plan= buy/sell securities to keep set dollar amount invested at all times c. Measuring volatility i. Speed and degree which stocks price will change 1. 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. Beta d. Asset allocation= balancing different asset classes to get mix of assets i. Strategic= proportions of investments that should compromise long-term portfolio 1. i.e. 100-age= % of portfolio should be invested in stocks ii. Tactical= short-term portfolio adjustments in consideration of market conditions 1. i.e. market is up allocate more assets to stocks e. Active management= relies on managers stock picking and timing f. Passive management= no management style will outperform market i. i.e. construct portfolio of index funds g. Growth portfolio= focus on stocks whose earning grow faster than other stocks i. Buy stocks at 52-week high h. Value= concentrate on undervalued securities i. Buy stocks at 52-week low Federal and State Taxation a. Regressive taxes= levied equally regardless of income i. i.e. sakes, payroll, property, etc b. Progressive tax= increases tax rate as income increase i. i.e. estate, income, etc c. Types of income i. Earned= from salary, bonuses, or active participation in business ii. 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 gains iii. Portfolio income= derived from securities 1. Taxed in year it was received 2. Capital losses can only offset capital gains d. Taxation on portfolio income i. Interest: 1. Corporate bonds= taxable at all levels 2. US government securities= taxable at federal level only 3. Agency issues= taxable at federal level only a. Mortgage-backed government issues= taxable at all levels i. i.e. Freddie Mac and Fannie Mae 4. Accrued interest= included as income when investor receives a bond between payment dates a. Taxable to seller b. Deduction for buyer 5. Municipal securities= exempt at all levels a. If purchased in state/municipality where investor is resident 85

i. Always tax free at federal level b. 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 free b. Corporate bond funds= taxable as ordinary income c. 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 citizen a. If foreign tax is withheld on distribution then investor gets tax credit e. Taxable upon receipt= taxable in year they are received f. Cost basis= price at which securities were bought at + commission i. Adjusted for stock splits and dividends ii. Capital gain= security sold for higher price than basis iii. Capital loss= security sold for less than basis iv. Net capital gain/loss= long-term capital gains/losses + short term capital gains/losses 1. Losses are deductible for maximum of 3k a. May be carried over v. Which shares to sell: 1. FIFO= used by IRS 2. Average basis= average price of share 3. Share identification a. Most flexible vi. 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 sales 2. Muni tax swaps= investors sell depreciated bonds to generate loss and buy new bonds with higher rates a. To avoid wash rule investor must change 2 of the following: issuer, coupon, maturity 3. Applies if investor sells a loss then writes puts g. Adjusting cost basis on muni bonds= only will have tax effect if capital gain i. Bought at premium= must amortize the premium over life of the bond using straight line 1. Reduces cost basis 2. Reduces reported income ii. Bought at discount= must be accreted by adjusting the basis back up to par 1. Increases cost basis 2. Increases interest income a. If bought in secondary market [not original issue discount (OID)] then accretion taxed as ordinary income 86

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m.

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i. After-tax yield= between stated YTM and coupon 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 loss 2. If customer amortizes then no capital loss but lower interest income Donations i. To charity 1. Donors deduction= market value a. No taxes due on appreciation unless security was held short term 2. Recipients cost base= higher current market value ii. To others 1. Donors deduction= none 2. Recipients cost base= original value of securities iii. Inherited 1. Recipients cost base= fair market value up death Estate and gift taxes are progressive taxes i. Tax is due on estate when person dies 1. Payable by estate 2. 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 tax 3. 11k per year to any # if individuals without tax 4. Interspousal are not subject to tax Margin interest in tax-deductible i. Except on muni bonds 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 owns 1. 5% margin requirement 2. Cant be used to stretch short-term gain into long-term gain AMT= high income taxpayers dont escape paying taxes i. Adds items back into taxable income: accelerated depreciation on property (after 1986), some costs with DDPs, local tax and interest on investments that dont generate income, tax-exempt interest on private purpose (after 1986), stock options exceeding fair market value ii. Taxpayers required to add ATM to regular tax 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 Legislation a. The Securities Act of 1933= first legislative response to crash of 1929 that requires issuers to full and fair disclosure of nonexempt issues i. 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 exempt 1. Non is exempt from anti-fraud provision iii. Tender offer= company makes cash offer for another company 1. Shareholders of target company may tender their shares only to extent of their net long position a. 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 OTC a. 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 companies i. Requires them to: register with SEC, state investment objectives, net worth of 100k before offering shares, owned by at least 100 shareholders, comply with standards ii. 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 registration f. 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 88

g. h.

i.

j.

1. Valuation date is day proceeding start/day trustee was appointed ii. Street name securities distributed on pro rata basis iii. SPIC fund are distribute to meet remaining claims iv. 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 account b. Individual, joint and custodial accounts are counted separately c. Does not cover futures or commodities 5. SPIC must be used in broker/dealer advertising, but not overstated 6. Blanket fidelity bond= protects against employee theft a. Members must have and review once a year b. Minimum coverage is 25k The Securities Acts Amendments of 1975= established MSRB Insider Trading and Securities Fraud Enforcement Act of 1988 amends provisions and penalties for insider trading i. Insider= anyone who has access to nonpublic information ii. 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 used iii. Broker/dealers must establish written procedures prohibiting the misuse of inside information and must restrict flow on inside information between departments 1. Chinese Wall/firewall/informational barrier= restricts information between departments iv. 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 informers v. Contemporaneous trader= enters securities trade at same time as insider 1. May sue if insiders violate regulations for up to 5 years Penny stock cold calling rules prevent abusive sales of high risk/speculative securities i. Stocks that are less than $5 ii. Representative must first determine suitability and then customer must sign suitability statement 1. Representative must disclose: name of stock, # of shares, current quote, amount of commission 2. If account holds penny stocks, monthly statement must be sent 3. Established customers are exempt from suitability statement a. Held account for at least one year b. Made at least 3 penny stock purchases of different issuer on different date 4. Provisions only apply to solicited transactions Bank Secrecy Act established the Treasury as the lead agency for developing regulation in connection with anti-money laundering programs 89

II.

i. Requires broker/dealers to detect abuses 1. Regulations require a. Deposits of 10k or more must be reported to IRS b. 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 going iii. 3 money laundering stages: 1. Placement= assets moved into system a. Easiest to detect 2. Layering= conceal source of funds 3. Integration= illegal money mixed with legal money to appear legit State Securities Regulations a. Blue-sky laws= state laws pertaining to the trading and issuance of securities b. 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 IPOs 2. Filing (notification)= issuer met criteria and filed in previous state it may notify state of intentions a. If no response registration effective 5th business day 3. Qualification= issuer must respond to qualifications a. 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 state 2. 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/Dealers a. 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 employees a. Exceptions: not involved in securities sales, do not handle cash, do not supervise b. 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 NYSE iii. MSRB= regulates underwriting and trading of municipal securities iv. Chicago Board of Options (CBOE)= regulates trading of options 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. Characteristics i. Districts= divided into 11 each with own commissioner ii. Dues, assessments, and other charges 1. NASD funded by annual membership fees a. 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 member c. NASD Manual= describes 4 rules i. Conduct Rules= set fair trading practices that member firm follow ii. Uniform Practice Code (UPC)= establishes uniform trade practices iii. Code of Procedure= how NASD handles member violations iv. Code of Arbitration Procedure= governs resolution of disagreements d. National Adjudicatory Council (NAC)= establishes rules and membership i. Broker/dealers registered with SEC, people affecting trades, and muni bond firms may apply for membership with NASD or 1. 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 firm a. Must certify that investigation and credentials are in order e. Postregistration rules i. Registered persons are required to attend education programs 91

II.

III.

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 plan ii. 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 action iv. 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 examinations i. Registered representatives= persons engaged in investment banking and securities business 1. Includes: officers that are not principals, supervisors, solicitors, trainers, anyone involved in securities business 2. Series 7 allows representatives to sell securities a. Need Series 3 to sell commodities ii. License become void if person is unaffiliated for 2 years iii. Registered principal= anyone who manages members 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 Investigation: Code of Procedure and Code of Arbitration a. 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 complaint 1. If complaint is filed against representative then supervisor is usually mentioned as well ii. 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 appeal 2. Contested offer= offer is contested and submitted to hearing officer who may order a settlement conference a. 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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IV.

V.

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 2.5k iii. 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 decisions v. 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 court 2. 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 versa 1. All new accounts contain a predispute arbitration clause ii. Class action claims are not subject to arbitration iii. Statement of claims= party describes dispute in detail dispute 1. Initiates proceedings a. Includes check for claiming fee b. May seek injunction 2. Respondent has 45 days to respond and specify defenses iv. Mediator will preside over discussions before hearing 1. May not serve on arbitration panel v. Nonpublic arbitrator= associated with broker/dealer 1. If customer involved then will be public vi. 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 years 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 1,366 i. Seats are thus negotiated ii. Only individuals may own seats c. Allied member= holders of more than 5% of members voting stock i. Not allowed to trade on exchange floor d. Salespersons of NYSE member firms must be registered through there firms i. 120-day training programs e. Representatives must have firms permission before taking a second job f. Representative may be paid in salary or commission Communication with the Public: Advertising and Sales Literature 93

a. Advertising has no control over audience i. Generic advertising= promotes securities as investment medium but does not refer to specific security 1. 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 representative ii. Recruitment advertisements do not have to disclose firms name 1. May not emphasize salary of top-paid salespeople b. Sales literature has target audience i. Correspondence does is not require principal approval 1. Includes group emails to customers ii. Public appearances require principal approval iii. Must identify firms name, person that prepared material, and the date it was first used iv. Proposals that include recommendations must have basis 1. If stock then provide current stocks price, a. References must reveal: price range, markets 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 interest 2. If mutual fund then: use charts, reveal source, separate dividends from capital gains, not state that mutual fund is safer, reveal highest sales charge a. Periodic payments then: profit is not assured, dont proved protection against losses, plans involve continuous investment, consider their financial ability b. Advertisements that feature total return must explain how it is calculated 3. If written recommendation then requires principal approval a. Not needed for individual recommendation c. 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 use iii. Investment company must file 10 days after use iv. Options/CMOs filed 10 days before use and must be accompanies with OCC document v. DPPs must file 10 days after use vi. Prospectuses are excluded from filing e. Spot checks= submit all advertising material to NASD upon request i. Except for those relating to muni bonds and investment companies f. Opinions passed off as guarantees are prohibited g. 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 kind i. Ambiguous references to NASD must not be made j. Use of members names must: clearly state firms name, describe relationship with NASD, not use degree in misleading manner 94

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VII.

i. Fictional name is permitted if filed with NASD ii. Generic/umbrella name may be used: displayed with NASD member name, relationship is clear, no implication umbrella is broker/dealer iii. May designate portion of its business (i.e. division) 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 issuers i. 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 issues c. 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 persons i. 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 Telephone Communications a. Telephone Consumer Protection Act of 1991 (TCPA) was enacted by FCC to protect consumers from unwanted solicitation i. 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 dont want to be called, cold calls inform firms 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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