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The Guide to Financial Industry

The Guide to Financial Industry

Prepared by Frederic Goblet 01/13/98 page 1


The Guide to Financial Industry

The Guide to Financial Industry

Table of Content

THE GUIDE TO FINANCIAL INDUSTRY....................................................................................2

INTRODUCTION.........................................................................................................................6

WHAT IS AN INVESTMENT ? ....................................................................................................7


The Investment Process......................................................................................................7
THE MARKET AND THE INSTITUTIONS ..................................................................................9
THE INVESTMENT BANKS ............................................................................................................9
The Investment Bank ..........................................................................................................9
THE INSTITUTIONAL INVESTORS.................................................................................................10
THE CUSTODIAN ......................................................................................................................10
What is Custody ?.............................................................................................................10
The Custodian...................................................................................................................10
THE SUBCUSTODIAN ................................................................................................................12
Role of the Subcustodian ..................................................................................................12
TRUSTEE ................................................................................................................................13
THE BROKER ..........................................................................................................................14
THE SECURITY EXCHANGES ......................................................................................................14
The New York Stock Exchange.........................................................................................15
The American Stock Exchange .........................................................................................16
Regional Stock Exchanges................................................................................................16
NASDAQ ..........................................................................................................................16
The Chicago Board Options Exchange..............................................................................17
Country Specific Exchanges (National Exchanges)............................................................17
THE MARKET INDEXES .............................................................................................................18
W HAT IS A TRADE, HOW DOES IT WORK ? ...................................................................................19
Securities Settlement ........................................................................................................22
Delivery vs. Payment ........................................................................................................23
Clearing House Funds vs. Same Day Funds .....................................................................23
Free Delivery.....................................................................................................................23
Book Entry vs. Physical.....................................................................................................23
Trade Date........................................................................................................................24
Contractual Settlement Date .............................................................................................24
Actual Settlement Date......................................................................................................24
Failed Trades ....................................................................................................................24
DK (Don't Know) ...............................................................................................................25
Market Conventions ..........................................................................................................25
THE INVESTMENT MANAGERS ...................................................................................................27
THE DEPOSITORIES AND CLEARANCE SYSTEMS ..........................................................................28
Book Entry ........................................................................................................................28
Immobilization ...................................................................................................................29

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Dematerialization...............................................................................................................29
Depository Trust Company (DTC) .....................................................................................29
Participant Trust Company (PTC)......................................................................................30
Federal Reserve Bank (+ see Regulators).........................................................................30
EUROCLEAR....................................................................................................................30
Cedel ................................................................................................................................31
PRIMARY MARKET....................................................................................................................31
SECONDARY MARKET...............................................................................................................31
THE OVER-THE- COUNTER MARKET ..........................................................................................31
THE REGULATORS ...................................................................................................................32
THE CENTRAL BANK OF THE U.S.A. : THE FEDERAL RESERVE SYSTEM .........................................32
How the Fed works ...........................................................................................................33
Member Banks..................................................................................................................33
The Federal Reserve’s many Roles...................................................................................33
THE G30 , THE GROUP OF THIRTY ............................................................................................34
S.W.I.F.T. SOCIETY FOR W ORLDWIDE INTERBANK FINANCIAL TELECOMMUNICATIONS ...................35
TYPES OF INVESTMENT ........................................................................................................37

INVESTMENT STRATEGIES ...................................................................................................38


RISK-RETURN TRADE-OFF ............................................................................................38
DIVERSIFICATION ...........................................................................................................38
ASSET ALLOCATION.......................................................................................................39
β ,…) AND RETURN .......................................................................42
THE CONCEPT OF RISK (β
What is Risk ?...................................................................................................................42
The Types of Risk .............................................................................................................42
How to measure risk ? ......................................................................................................43
Measuring Systematic Risk ...............................................................................................44
The Required Rate of Return.............................................................................................45
THE BALANCE SHEET AND THE INCOME STATEMENT......................................................46
THE BALANCE SHEET ................................................................................................................46
Assets...............................................................................................................................46
Liabilities ...........................................................................................................................46
Owner's equity ..................................................................................................................47
THE INCOME STATEMENT ..........................................................................................................47
THE TIME VALUE OF MONEY ................................................................................................49
THE NET PRESENT VALUE ........................................................................................................49
REQUIRED RATE OF RETURN ....................................................................................................49
EXPECTED RATE OF RETURN ....................................................................................................49
PRESENT VALUE FORMULA .......................................................................................................50
FUTURE VALUE FORMULA .........................................................................................................50
THE STOCK MARKET .............................................................................................................51
GOING PUBLIC ........................................................................................................................51
THE PRICE ..............................................................................................................................52
The Price ..........................................................................................................................52
The Spread .......................................................................................................................52
The Ticker.........................................................................................................................53
Reading the Newspaper ....................................................................................................53
THE SUPPLY AND DEMAND........................................................................................................54
HOW TO VALUE A STOCK ?........................................................................................................58
EARNINGS PER SHARES (EPS).................................................................................................58

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PRICE/EARNINGS RATIO ...........................................................................................................58


THE STOCK PRICE ...................................................................................................................58
DIVIDENDS ..............................................................................................................................59
The Dividend Yield ............................................................................................................59
STOCK SPLIT ..........................................................................................................................60
VALUABLE STOCK MARKET TERMS ............................................................................................60
Common Stock .................................................................................................................60
Preferred stock..................................................................................................................60
The Right to Vote ..............................................................................................................61
Book Value .......................................................................................................................61
Debt /Equity Ratio .............................................................................................................62
Tender Offer .....................................................................................................................62
Insider Trading ..................................................................................................................62
Warrant.............................................................................................................................62
Program Trading ...............................................................................................................62
Rule of 72 .........................................................................................................................63
Capitalization.....................................................................................................................63
Arbitrage ...........................................................................................................................63
Blue Chips ........................................................................................................................64
Bull Market Vs Bear Market...............................................................................................64
SHORT SELLING ......................................................................................................................64
BUYING W ARRANTS .................................................................................................................65
BUYING ON MARGIN .................................................................................................................65
THE FIXED INCOME SECURITIES THE MONEY MARKET VS THE CAPITAL MARKET ......67

MONEY MARKETS ..................................................................................................................68


Money Market Vs Capital Market.......................................................................................68
TREASURY BILL OR T-BILL ........................................................................................................69
COMMERCIAL PAPER ................................................................................................................69
BANKER’S ACCEPTANCE ...........................................................................................................70
CERTIFICATES OF DEPOSIT .......................................................................................................71
THE EURODOLLAR MARKET ......................................................................................................72
THE BOND MARKET ...............................................................................................................73
Creditor Vs Owner ...........................................................................................................73
Registration.......................................................................................................................73
Figuring a Bond’s Worth....................................................................................................74
VALUE..............................................................................................................................74
Analyzing Bond Yield.........................................................................................................75
BUYING AND TRADING BONDS ...................................................................................................77
How Trading Works ?........................................................................................................77
VALUABLE BOND MARKET TERMS ..............................................................................................77
CALL.................................................................................................................................77
DEFAULT .........................................................................................................................77
COLLATERAL...................................................................................................................78
High-Yield (Junk ) Bonds...................................................................................................78
U.S. GOVERNMENT SECURITIES ..........................................................................................79
TREASURY SECURITIES.............................................................................................................79
Treasury Bills ....................................................................................................................79
Treasury Notes .................................................................................................................79
Treasury Bonds.................................................................................................................79
Trading .............................................................................................................................80
AGENCY SECURITIES ...............................................................................................................80

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Ginnie Maes (GNMA)........................................................................................................80


Fannie Maes (FNMA)........................................................................................................81
Freddie Macs (FHLMC).....................................................................................................81
Sallie Maes .......................................................................................................................81
Tennessee Valley Authority...............................................................................................81
MUTUAL FUNDS......................................................................................................................82
Paying out the profits ........................................................................................................83
MUTUAL FUND CHECKLIST .........................................................................................................84
Objective...........................................................................................................................84
Performance .....................................................................................................................84
Loads and fees .................................................................................................................84
The Net Asset Value .........................................................................................................85
PENSION FUNDS.....................................................................................................................86
DEFINED BENEFIT PLANS..........................................................................................................86
DEFINED CONTRIBUTION PLANS ................................................................................................86
MARKETS FOR DERIVATIVE SECURITIES............................................................................88
THE LANGUAGE OF OPTIONS .....................................................................................................88
FUTURES ................................................................................................................................90
SOURCES AND BIBLIOGRAPHY ..........................................................................................109

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Introduction

This guide aims at two public targets, the beginners and the professionals
who need some memory refreshment.

It is mainly a compilation of existing publications mentioned at the end than


a new guide containing new information.

This publication is not commercial and is published thanks to the many


people who helped on the compilation of the information contained.

I want this guide to be helpful, to be informative, self-explaining that will link


the theory to the real world.

Frederic Goblet

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What is an Investment?

To invest is to acquire an asset with the expectation of growing value in the


future. It is linked to the concept of ownership.

The Investment Process

The investment process can be split in three steps: THE PRE-TRADE, THE
TRADE AND THE POST-TRADE.

The pre-trade concerns the decision on what to buy in what quantity.

The trade process is the actual agreement between the seller and the
buyer regarding the price and the quantity. At this moment, the asset
changes ownership.

The post-trade concerns everything after the trade itself: the management
of the trade.

Pre -Trade Trade Post - Trade

Market Data Order Routing Transaction Confirmation


News Trade Management Custody
Portfolio Management Trade Execution Performance & Analytics
Analytics Cash Management Portfolio Accounting
Currency Management
Securities Lending

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The Market and The Institutions

"MARKET" in a very general way, refers to the availability of,


and inter-relationships between, potential buyers and sellers of
goods or services. The term "market" can be used in a variety
of ways to refer to different physical locations or environments
in the investment system for the purchase and sale of
securities, commodities or currencies.

THE INVESTMENT BANKS

The Investment Bank

The INVESTMENT BANK is a financial specialist who acts as an intermediary


in the selling of securities.

Three basic functions are provided by the investment banker:

1. He assumes the risk of selling a new security issue at a satisfactory


(profitable) price. This is called underwriting. Typically, the investment
banking house, along with the underwriting syndicate, actually buys the new
issue from the corporation that is raising funds. The syndicate (group of
investment banking firms) then sells the issue to the investing public at a
higher (hopefully) price than it paid for it.

2. He or she provides for the distribution of the securities to the investing public.

3. He or she advises firms our governments on different matters like merge and
acquisitions, economic health, …

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THE INSTITUTIONAL INVESTORS

An INSTITUTIONAL INVESTOR is an organization that invests its own assets or


those it holds in trust for others. Typical institutional investors are
investment companies (including mutual funds), pension systems,
insurance companies, universities and banks.

THE CUSTODIAN

What is Custody ?

CUSTODY means “safekeeping of assets”. This refers to “keep” the assets in


a “safe” place. They are two main reasons why banks are originally
responsible for custody:

First, you need a vault in order to immobilize the assets if physical, and
secondly because it implies the exchange between cash and securities.

Custody function involves to:

n capture the trade

n protect the investment, to gain ownership : settlement date

n record the position

n Keep track of the rights (income, corporate action, taxes,…)

The Custodian

A CUSTODIAN is an agent, usually a bank, which receives delivers, and


safekeeps cash and securities for its clients. The custodian is also
responsible for the maintenance of the securities while they are under
custody.

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RECEIPTS AND DELIVERIES

Receipts and deliveries of securities and cash are done only upon
instruction or authorization of the client or the client's authorized
investment manager. These transactions usually involve a trade, that is, a
purchase or sale of securities or cash. When a security is purchased, the
security is received in and cash is delivered out. When the security is sold,
the security is delivered out and cash is received in. Cash itself can be
purchased and sold as an investment in the context of foreign exchange.

SAFEKEEPING

Securities under custody must be protected in a secure environment


regardless of whether they are held physically or electronically. Securities
held physically are generally kept in a vault at the custodian bank or in a
SUBCUSTODIAN bank hired by the primary custodian. Securities held in
Book Entry are recorded on the books of the DEPOSITORY as being in the
account of the custodian. Once securities have been purchased and
received into safekeeping, the custodian is responsible for the
maintenance of these assets as it pertains to registration, income
collection, and corporate actions.

INCOME

One major custodial responsibility is the timely crediting of income


payments due to the client from investments held in the client's portfolio.

Custodians need to be aware of any income event affecting securities


under their care. This is often accomplished by contracting for the services
of various Information agents, who provide, among other things,
information regarding the terms of a securities issue, income schedule, or
dividend announcements.

CORPORATE ACTIONS

A corporate action on a security can have a significant impact on the value


of that security, and therefore on the value of the client's portfolio.
Monitoring and accurately processing corporate actions on securities held
under custody is one of the important responsibilities of a custodian. The
custodian must be aware of any pending action, which could affect any
security being held on behalf of any client; monitoring for corporate actions
thus becomes a significant element of custodial functions. Most custodians
have contracted with a variety of news services or information agents in

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order to receive daily information regarding corporate events. Further


information might be obtained from depositories, subcustodians, or even
issuers.

ACCOUNTING SERVICES

The custodian may also provide accounting services to the client, although
this service is not necessarily part of every custodial contract. This
accounting can include pricing of securities in the portfolio on a daily,
weekly, or monthly basis, keeping track of expense accruals and payments,
capital purchases or contributions and disbursements, and calculating the
NET ASSET VALUE of the portfolio (also known as fund pricing.)

THE SUBCUSTODIAN

Rule: The securities stay in the local market. They remain in the country
where they are issued.

A SUBCUSTODIAN can be a bank located in any country, hired by a primary


custodian that performs custodial functions in the local market in which it
has expertise. The success of the custodian in servicing its clients
depends greatly on the subcustodian's ability to function for the custodian
in that particular market; therefore, a consistently high level of service
quality must be provided.

Role of the Subcustodian

The role of the subcustodian generally includes:

1. Settling and vaulting securities,

2. Collecting income,

3. Sending information to the custodian regarding cash and security


movements, cash balances, month-end securities positions, notification
of corporate actions and upcoming income events, and reporting
changes in the market environment and tax regulations.

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TRUSTEE

A TRUSTEE is a person or entity who is legally responsible for another


person or entity's investment, property or other assets. There are two
types of Trustees in the financial industry, Trustees for Master Trust
Accounts and those for Corporate Trust Accounts.

Trustees for Master Trust Accounts

A MASTER TRUST is a pool of trusts or a pool of assets involved in one trust


agreement. A trustee for a master trust manages and oversees all assets
for a trust client according to a trust agreement or plan document. Most
often a trustee is hired to service PENSION PLANS.

Many of the responsibilities of a trustee and a Custodian are similar,


however, a trustee has more responsibilities and greater legal burden on
behalf of the plan or trust. A trustee has a FIDUCIARY RESPONSIBILITY to act
with discretion and diligence in the best interest of the client. These
fiduciary responsibilities in general apply to a trustee who has the power to
act on behalf of the client, to manage a plan, or who provides investment
advice regarding the plan assets or administers a plan.

In most cases, the trustee is liable for a loss which occurs as a result of its
actions, unless the mistake was created by a third party or unless the
contract includes a provision to indemnify the trustee from any loss or
expense.

Because agreements between the client and the trustee may vary, the
responsibilities of the trustee can be different from one client to another.
Some of the basic responsibilities of a trustee are recordkeeping, income
collection, corporate action processing, and pricing, although there can be
additional responsibilities according to the terms of the agreement.

Trustees are also responsible for collecting Income and monitoring


corporate actions on securities held in client portfolios. When a corporate
action is announced, the trustee must notify the Investment Manager who
will decide the suitable course of action on behalf of the client. This final
decision is passed back to the trustee who will act accordingly.

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CORPORATE TRUSTEE

A company issuing bonds in an amount greater than $5 million must hire a


bank or trust company to administer its securities. The CORPORATE
TRUSTEE acts as intermediary between the company issuing the bonds and
the investors buying the bonds.

THE BROKER

An INVESTMENT BROKER can be anyone who earns commissions or fees for


executing investment transactions that transfer ownership from one party to
another.

All brokerage firms and all brokers acting as individuals must be a member
of the exchange through which they trade, and must pay an annual
membership fee to the exchange. Exchanges have strict codes of conduct,
and can bar individuals or firms from membership due to fraudulent or
unethical activity. Brokers can hold MEMBERSHIP in more than one
exchange. Some brokers specialize in a particular security type or
commodity, and would therefore be a member of that specialized
exchange.

Some of their functions include: transition management, directed


brokerage, soft dollars agreements, commission recapture programs,
electronic trading, …

THE SECURITY EXCHANGES

A STOCK EXCHANGE is a private association that provides a physical


location and clerical support for its members. Trading occurs AUCTION-
STYLE with investors exchanging bids and offers on the exchange’s listed
securities.

Organized security exchanges are tangible entities whose activities are


governed by a set of bylaws. Security exchanges physically occupy space
and financial instruments are traded on such premises.

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Exchanges do not buy or sell securities, nor do they set prices. TRADING is
conducted on the exchange “FLOOR” where each SPECIALIST presides over
the auctioning of shares for one or more of the listed companies. Sellers
willing to take the lowest prices and buyers willing to pay the highest prices
are given priority trade instructions.

When a company first goes public (INITIAL PUBLIC OFFERING), the


management decides how its shares will be traded among investors, either
on a stock exchange, an auction market, or OVER-THE-COUNTER, a
negotiated market.

Major stock exchanges must comply with a strict set of reporting


requirements established by the SECURITIES AND EXCHANGE COMMISSION
(SEC). These exchanges are said to be registered.

Organized security exchanges provide several benefits to both


corporations and investors. They (l) provide a continuous market, (2)
establish and publicize fair security prices, and (3) help businesses raise
new financial capital.

A corporation must take steps to have its securities listed on an exchange


in order to directly receive the benefits noted above. Listing criteria differ
from exchange to exchange.

Three of the most well known United States exchanges are the NEW YORK
STOCK EXCHANGE (NYSE), THE AMERICAN STOCK EXCHANGE (AMEX), AND
THE NATIONAL ASSOCIATION OF SECURITIES DEALERS AUTOMATED QUOTATION
SYSTEM (NASDAQ). Other national exchanges specialize in commodity
and security options and futures trading. These include the CHICAGO
BOARD OF TRADE, CHICAGO BOARD OF OPTIONS EXCHANGE, MID-AMERICA
COMMODITY EXCHANGE, NEW YORK COFFEE, SUGAR AND COCOA EXCHANGE,
NEW YORK COTTON EXCHANGE, NEW YORK FUTURES EXCHANGE, PACIFIC
STOCK EXCHANGE AND THE PHILADELPHIA EXCHANGE.

The New York Stock Exchange

The NEW YORK STOCK EXCHANGE (NYSE), sometimes referred to as the


"Exchange" or the "Big Board", was established in 1792 and is the oldest
and largest securities exchange in the United States. Usually only large
firms can meet the stringent eligibility requirements of the NYSE. These
require that a firm have a minimum of one million publicly held shares, a

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market value of publicly held shares of at least $10 million, total market
value of $16 million, annual net income of over $2.5 million before federal
income taxes, and 2,000 holders of 100 shares or more.

The American Stock Exchange

The AMERICAN STOCK EXCHANGE (AMEX) was originated in 1921.The


AMEX could be considered a proving ground for the NYSE, as it trades
securities from mainly small and medium size companies. A large number
of companies that were once listed on the AMEX have moved to the NYSE.
Another difference between these two exchanges is that the AMEX has an
options market where the NYSE does not.

Regional Stock Exchanges

Regional stock exchanges are organized securities exchanges located


outside of New York City and registered with the SEC. They do not
exclusively list only regional or local securities, but list many issues that
are also on the New York exchanges. NYSE and AMEX listings often also
list on a regional exchange to receive broader market exposure. This dual
listing practice of a security on one or more exchanges increases
competition for the issue and boosts trading availability due to different
time zones. Regional exchanges in the United States include the BOSTON,
CINCINNATI, MIDWEST, PACIFIC, PHILADELPHIA STOCK EXCHANGES.

NASDAQ

NATIONAL ASSOCIATION OF SECURITIES DEALERS AUTOMATED QUOTATION


SYSTEM (NASDAQ) is a computerized communication system that serves
the dual function of providing security information to its members, and
acting as an exchange for stocks. Ranking third in trading volume behind
the New York Stock Exchange and the Tokyo Exchange, it features
efficiency in trading, as it can locate the most up-to-date quotes regardless
of where the market is in the U.S.

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The Chicago Board Options Exchange

The CHICAGO BOARD OPTIONS EXCHANGE (CBOE) revolutionized options


trading by creating standardized, listed options in 1973. Before 1973,
options were individually tailored and traded "over-the-counter" by a few
put/call dealers. CBOE established a secondary market where options
could be traded. The growth in the use of options propelled CBOE to
become the world's largest options exchange, and the second largest
securities exchange in the U.S. Today, CBOE captures the largest share of
the U.S. options market by trading 700,000 option contracts daily
accounting for over 47 percent of trading in equity options, over 95 percent
of index options trading and over 65 percent of all options trading.

Today, options are traded on five U.S. exchanges: the Chicago Board
Options Exchange, the American Stock Exchange, the New York Stock
Exchange, the Pacific Stock Exchange and the Philadelphia Stock
Exchange. Although there are five U.S. exchanges that trade standardized
options, options have become a global contagion trading on over 50
exchanges worldwide.

Country Specific Exchanges (National Exchanges)

Various countries throughout the world have national exchanges that


provide trading arenas for that specific country. Some of these countries
include:

AUSTRALIA: Australia Stock Exchange (ASX) is the nation-wide


exchange.

AUSTRIA: Vienna Stock Exchange is the national exchange;


Telefonhandel is the OTC exchange.

BELGIUM: Brussels is the main exchange, with branches in


Antwerp and Liege.

CANADA: Toronto and Montreal exchanges are linked together,


with branches in Vancouver and Alberta.

DENMARK: Copenhagen Stock Exchange.

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FRANCE: Paris is the center of all equity trading in France.

GERMANY: Frankfurt is the main exchange.

ITALY: Milan is the main exchange, and there are several


regional exchanges.

JAPAN: Tokyo and Osaka are the main exchanges.

MEXICO: Mexico City is the national exchange.

NETHERLANDS: Amsterdam Stock Exchange is the national exchange.

NORWAY: Oslo Stock Exchange (OSE) is the national


exchange, with branches in Bergen and Trondheim.

SPAIN: Madrid is the main exchange, with branches in


Bilbao, Barcelona and Valencia.

SWEDEN: Stockholm is the national exchange.

SWITZERLAND: Zurich is the main exchange, with branches in


Geneva and Basle.

UNITED KINGDOM: London Stock Exchange (LSE) is the main exchange


for equity trading in the U.K. and the Republic of
Ireland. Branches are in Manchester,Birmingham,
Glasgow, Leeds and Belfast in the U.K., and Dublin in
Ireland.

THE MARKET INDEXES

A BENCHMARK is a standard; a set of information used for comparisons.


Indexes are often used as benchmarks.

A MARKET INDEX is a weighted average of the specific security prices,


industrial production components, or market factors that make up the index.

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The DOW JONES INDUSTRIAL AVERAGE is composed of 30 stocks. The Dow


accurately measures what it claims to measure : the performance of 30 key
companies which are worth about 25% of the total value of all stocks listed
on the NYSE. To the extent that those companies represent key sectors of
the economy, their performance indicates how the economy is doing.
However, other sectors of the economy perform differently.

The NYSE COMPOSITE INDEX includes all stocks traded on the New York
Stock Exchange . The NYSE also reports the activity in four sectors -
industrial, utility, transportation and financial - in separate indexes.

The STANDARD & POOR’S 500 INDEX incorporates a broad base of 500 of
some of the largest U.S. public corporations: 400 industrial, 40 utility, 40
financial and 20 transportation companies.

The NASDAQ COMPOSITE INDEX was created to track the progress of more
than 4000 stocks listed on the National Association of Securities Dealers
Quotation System.

The AMEX MARKET VALUE INDEX monitors the performance of over 800
companies listed on the American Stock Exchange.

The RUSSELL 2000 represents the smallest two-thirds of the 3,000 largest
U.S. companies, including a great many of the initial public offerings of the
last few years.

The WILSHIRE 5000, the broadest index, includes all stocks traded OTC and
on exchanges, including the S&P 500.

WHAT IS A TRADE, HOW DOES IT WORK ?

Stocks are generally traded in 100-share increments called ROUND LOTS.


Any number of share fewer than 100 is an ODD LOT.

When you buy or sell a security, the brokerage firm enters your order into
its computer system for transmittal to its traders at the designated
exchange or the firm’ OTC trading desk. For an exchange-listed security,
the order is sent to the BROKERAGE FIRM’S FLOOR BROKER on the exchange

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or directly to a SPECIALIST in that particular stock, who maintains a post on


the exchange floor, to be matched with an offsetting order.

THE SPECIALISTS

Brokers called "SPECIALISTS" play a critical role because they serve as the
contact point between brokers with buy and sell orders in the NYSE's two-
way auction market.

Each stock listed on the NYSE is allocated to a specialist, a broker who


trades only in specific stocks at a designated location. All buying and
selling of a stock occurs at that location, called a trading post. Buyers and
sellers - represented by the floor brokers - meet openly at the trading post
to find the best price for a security. The people who gather around the
specialist's post are referred to as the trading crowd. Bids to buy and offers
to sell are made by open outcry to provide interested parties with an
opportunity to participate, enhancing the competitive determination of
prices. When the highest bid meets the lowest offer, a trade is executed.

To a large degree the specialist is responsible for maintaining the market's


fairness, competitiveness and efficiency. Specifically, the specialist
performs four vital functions.

One of the specialist's jobs is to execute orders for floor brokers in their
assigned stocks. A floor broker may get an order from a customer who only
wants to buy a stock at a price lower than the current market price - or sell
it at a price higher than the current market price. In such cases, the broker
may ask the specialist to hold the order and execute it if and when the price
of the stock reaches the level specified by the customer. In this role the
specialist acts as an agent for the broker.

In a sense, specialists act as auctioneers for their assigned stocks. At the


start of each trading day, the specialists establish a fair market price for
each of their stocks. The specialists base that price on the supply and
demand for the stock. Then, during the day, the specialists quote the
current bids and offers in their stocks to other brokers. Investors may direct
brokers to place stock orders contingent on a variety of conditions. The
most common are : MARKET ORDER and LIMIT ORDER.

MARKET ORDERS are executed immediately. A LIMIT ORDER is an open order


to buy or sell at a specified price or better.

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When your trade is executed, the brokerage firm sends you a confirm, a
written confirmation that reports the trade date (date the order takes effect,
you are the legal owner), the quantity, the description, and the price.

When securities are purchased, payment must be made on or before the


SETTLEMENT DATE. Settlement for stock generally occurs on the third
business day following the trade date.

Commissions and Markups. Transaction costs for buying and selling stock
are based on the share price and number of shares traded during a single
market session. Stock commissions are typically a fraction of 1 percent to 3
percent. The higher the stock price and the greater the number of shares
traded, the lower the commission.

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The Customer
The Brokerage Firm
Places orders to buy and
sell

Initiates transaction
Pass the order to a Floor
Broker on the Stock
Exchange

The Stock
Exchange
The Floor Broker

When the order reaches The Specialist


the floor of the exchange,
the floor broker takes it to
a specialist in that
particular stock
The Order will be
confronted with others
and the specialist will
match them

Buy = priority for the


highest bid
Sell = priority for the
lowest offer

Securities Settlement

SECURITIES SETTLEMENT is the final point in the trading process at which


securities are delivered and money is exchanged.

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Delivery vs. Payment

DELIVERY VS. PAYMENT involves any settlement where securities are


delivered and cash is received concurrently. DVP describes the seller's
perspective.

Clearing House Funds vs. Same Day Funds

Depending upon how payment is made to settle a trade in the United


States, use of clearing house funds or same day funds will determine the
availability of cash associated with a trade. CLEARING HOUSE FUNDS are
available to spend one day after actual settlement date. Almost all DTC
trades settle in clearing house funds, the exception being commercial
paper which settles in same day funds. SAME DAY FUNDS are available to
spend on the same day as actual settlement date. Same day funds are
sometimes referred to as Fed funds.

Free Delivery

FREE DELIVERY or Delivery Free of Payment involves security transfers


where there is no corresponding cash movement. Securities transferred
from a previous custodian or trustee to a newly hired custodian or trustee
are examples of free delivery settlements.

Book Entry vs. Physical

BOOK ENTRY is an electronic system that records transfers of securities


and/or cash between a buyer and a seller. Most DEPOSITORIES operate in a
book entry environment. For securities that settle through book entry,
physical certificates may or may not exist. If physical certificates do exist,
however, a major advantage to book entry is that these certificates do not
have to physically move in order to settle the trade. Another major
advantage to book entry is that registration in the name of the new owner is
usually effective immediately upon settlement. In the United States, book
entry settlement locations include DTC, the Fed, and PTC.

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In contrast, PHYSICAL SETTLEMENT requires that paper certificates change


hands. Disadvantages to physical settlement include the increased risk
that certificates could become lost, the time delay associated with re-
registration because new certificates must be issued, and the time required
to make physical delivery itself. Physical certificates are generally held in a
vault by the appropriate bank or broker.

Trade Date

TRADE DATE refers to the date upon which a buyer and seller agree to the
terms of a security purchase or sale, including the price, the amount of
shares, and the date, location, and method of exchanging the cash and the
securities. By agreeing to the trade, both buyer and seller have entered
into a mutually binding contract regarding the exchange of securities and
cash.

Contractual Settlement Date

CONTRACTUAL SETTLEMENT DATE is the date upon which a trade is expected


to settle, according to the terms of the trade agreement.

Actual Settlement Date

ACTUAL SETTLEMENT DATE refers to the date upon which the trade actually
settles. Actual settlement can occur on or after contractual settlement
date. Although the contractual settlement date is agreed to on trade date,
a trade may not settle until sometime later, due to an error or problem with
delivery of the security.

Failed Trades

A FAILED TRADE occurs when a trade does not settle on contractual


settlement date due to either inaccurate delivery or non-delivery of the
security by the seller. Trades which are open after contractual settlement
date are said to be "failing", as they have "failed to settle" on time. Failed
trades can cause subsequent problems with income collection and
corporate actions, as the new owner is unable to register the security until

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settlement has occurred. A failed buy can also cause problems if the
purchaser wishes to sell the security but is unable to make delivery on the
sell since the purchase has not yet settled.

DK (Don't Know)

In some cases, the receiving party does not accept an attempted delivery
of securities for settlement. This may occur when there is a mismatch in
the information connected with the delivery, such as the name of the
security, the amount of shares or par, the price, the contractual settlement
date, the broker, etc. It may also occur if the receiving party has no
instructions regarding the trade whatsoever. The receiving party refuses to
accept delivery, saying that they "DON'T KNOW" this trade as delivered.
The expression "DK" is short for "don't know", thus, the receiver is said to
"DK" the trade. Errors which could cause a mismatch in information may
have occurred in either the buyer's or seller's instructions to their
respective agents. Both parties usually reconfirm their information and
changes are made as necessary in order to effect good delivery.

Market Conventions

Depending upon the type of security traded and the market in which the
trade occurs, the period between Trade Date and Contractual Settlement
Date will vary. The scheduled contractual settlement date is usually
denoted as TRADE DATE + (number of days), or TD + (number of days),
or T + (number of days). The following describes examples of settlement
variations within different markets as of this writing.

United States

In the United States, LONG TERM DEBT and EQUITY SECURITIES are
scheduled for Trade Date + 5 settlement.

Settlement dates for COMMERCIAL SHORT TERM DEBT (MONEY


MARKET INSTRUMENTS) can be negotiated at the time of the trade, but
due to the nature of these investments, most are traded to settle either on
Trade Date or Trade Date + 1.

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SHORT TERM TREASURY securities on the secondary market are


generally traded for settlement on T + 1. Some trades can be negotiated
for same day settlement, however the interest rate agreed to may be lower
than if the trade is made for next day settlement. Treasury securities
bought at Monday Treasury auctions (primary market purchases) usually
settle on T + 3.

Canada

The Canadian Depository for Securities (CDS) settles trades executed on


the Toronto and Montreal Exchanges through their Securities Settlement
Service (SSS). Although owned by the depository, SSS is used to settle
both depository and non-depository trades. SSS operates both a book
entry system and a physical settlement system. Depository eligible
securities settle by book entry through the Book Based System (BBS).
Depository ineligible securities with valid CUSIP numbers are settled
physically through the Certificate Based System (CBS). Ineligible securities
without valid CUSIP numbers cannot be settled through SSS, and must
settle physically, at the office of the buyer's broker or custodian.

Denmark

All settlements in Denmark occur on T + 3.

Italy

Formal settlement practices in Italy apply only to trades executed on one of


the official stock exchanges. Whether a trade is contracted to settle on the
forward or cash market determines how quickly it will settle. Trades
executed on the FORWARD MARKET have a settlement period of up to T
+ 45. Trades made during the last two weeks of a month and the first two
weeks of the following month settle during the last half of that second
month. Trades executed on the CASH MARKET settle T + 3. The
transaction costs for cash market trades are slightly higher, as the costs
reflect the settlement of those trades within a shorter period of time.

Korea

In Korea, equities and convertible bonds settle on T + 2. Trading and


settlement activity take place on Saturdays, since Saturday is a working
day in Korea.

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Sri Lanka

All settlements in Sri Lanka occur on T + 7.

United Kingdom

In the United Kingdom, trades are processed for settlement every fourteen
days. The fourteen day schedule is maintained unless the scheduled
settlement date falls on a holiday, then the whole cycle is moved forward to
be begun again on the next open business day. Thus, settlements may
occur on Mondays for a while, then be pushed forward to Tuesdays, etc.
An attempt is made to settle failed trades within the next few days. Trades
are always settled through physical delivery.

THE INVESTMENT MANAGERS

An INVESTMENT MANAGER, (also known as an Investment Advisor), is an


individual or agency designated to make investment decisions for a Client
Company or entity that has beneficial ownership of assets. Clients may be
pension funds, mutual funds, or other types of investment funds.

Often, the investment manager is an outside agent or agency hired by the


client company. Companies may also use internal investment managers.

Investment managers operate in accordance with the client's investment


strategy. In many instances, investment managers specialize in managing
a specific investment type, such as equities or fixed income securities.

Responsibilities include making trade decisions, executing trades with


brokers, and providing trade details to the custodian or trustee bank.
Investment managers are also responsible for making decisions on
voluntary corporate actions and managing cash, both as an investment
asset and to ensure that sufficient cash is available to cover pending
purchases. An investment manager has power to purchase and sell any
plan asset, and has FIDUCIARY responsibility to act with discretion and
diligence in the best interest of the client.

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THE DEPOSITORIES AND CLEARANCE SYSTEMS

Today, many debt securities are in electronic book-entry form. Ownership


is transferred via computer rather than via actual transfer of paper
certificates, reducing the possibility of loss, theft, or mutilation of the
certificates. In the future, more and more securities certificates will be in
this electronic form.

A DEPOSITORY is an institution that provides central VAULTING of certificates,


and where security ownership is transferred and recorded. A security must
be accepted by a given depository as "depository eligible" before the
depository will begin to service it; once this has occurred however, an
attempt is usually made to keep all physical certificates underlying that
security centrally vaulted in the depository, regardless of ownership.

Today there are numerous depositories around the world and in addition to
the standard service of maintaining ownership records, each performs
services unique to their requirements and technology. Many depositories
collect income, maintain a linkage between cash and security movements,
provide recordkeeping of securities held, and provide reporting to all
participants in the depository to facilitate income and corporate action
information flow. Depositories act as TRANSFER AGENT and PAYING AGENT,
as well.

The term "clearance system" is often used interchangeably with the term
"depository", as both generally provide some form of recordkeeping service
that facilitates the accuracy of trade information.

Book Entry

The transfer of ownership records at a central location without physical re-


registration taking place is known as BOOK ENTRY. Almost all depositories
use book entry systems. Reports are generated reflecting current
ownership and transfer activity for each security held.

Book entry systems can be used whether or not certificates physically exist
to represent the underlying securities.

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Immobilization

When securities are represented by physical certificates, the depository


provides a central vaulting location where the certificates are held
regardless of changes in ownership. This is known as IMMOBILIZATION
since the certificates do not move upon trading. Advantages of
immobilization include decreased risk of error, decreased risk of loss, and
decreased cost, since certificates do not have to be handled physically to
effect the delivery and re-registration process. Usually, certificates held in
a depository are registered in the name of that depository.

Dematerialization

In some cases, security certificates may not exist physically. A depository


simply records changes in ownership of the security. This certificate-free
environment is called DEMATERIALIZATION, also referred to as "scripless".

Depository Trust Company (DTC)

DTC, located in New York City, is a member owned depository and not a
profit driven company. With a main purpose of providing timely and
accurate securities settlements, fees are kept to a minimum and any profits
generated are distributed to participants in DTC. Established in 1968, DTC
is the largest safekeeper of corporate stocks and bonds in the U.S. Not all
securities are "DTC eligible", or can be traded using DTC as the
depository, however, most U.S. equities and corporate bonds are eligible.
A security which is DTC eligible does not have to be traded or held in DTC.
An owner has the option of withdrawing the certificates from DTC and
holding them physically.

To participate in DTC, an institution applies for DTC membership, and


upon approval, is assigned a participant number. Payments on trades in
DTC are usually in "same day funds", meaning that cash movement occurs
on the day of actual settlement.

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Participant Trust Company (PTC)

PTC purchased the Mortgaged-Backed Securities Clearing Corporation


(MBSCC), a depository for Government National Mortgage Association
(GNMA) securities, in 1989. This depository, renamed the Participant Trust
Company (PTC), is chartered by the state of New York and is registered
with the Securities and Exchange Commission as a clearing agency. PTC
is a central depository where mortgaged-backed securities are exchanged
and vaulted. PTC is member owned. In PTC, cash payment is in same
day funds.

Federal Reserve Bank (+ see Regulators)

The FEDERAL RESERVE BANK provides a book entry system for settlements
of securities issued by the United States Treasury, including Treasury Bills,
Notes and Bonds, along with the related re-purchase agreements and
certain mortgage and loan issues. Only members of the Federal Reserve
Bank, which are generally commercial banks, may be direct participants in
this depository. Since brokers, therefore, cannot be participants, a broker
must affiliate with a member bank in order to settle transactions. Cash for
delivery or receipt of settled trades is in same day funds.

EUROCLEAR

International depositories were developed in order to deal with the growing


number of trades that crossed country borders and were not being
adequately handled.

EUROCLEAR is a major international depository, located in Brussels, formed


to provide exchange and clearance services for internationally traded
securities. Euroclear was initiated in principle in 1965 and formally created
in 1968 with Morgan Guarantee Trust as founder. Euroclear is owned by
the Euroclear Clearance System Public Limited Company, whose
shareholders are over one hundred banks, brokers and investment
institutions worldwide. As of this writing, Euroclear handles securities
issued from over 121 countries worldwide.

Euroclear has an "electronic bridge", a direct link, to the Cedel depository


to facilitate settlements between the two.

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Cedel

CEDEL (CENTRALE DE LIVRAISON DE VALEURS MOBILIERES) is the second


major depository, along with Euroclear, for international trading. Located in
Luxembourg, Cedel was created in 1971 and is owned by various banks.
Cedel works with Euroclear to facilitate transaction flows. An example of
the cooperation between these two depositories which results in efficiency
for participants, is that Cedel performs pre-matching of trades with
Euroclear daily to ensure timely delivery and receipt. Benefits of Cedel's
working relationship with Euroclear include fewer physical settlements that
result in lower fees charged to participants and same day cash proceeds.

PRIMARY MARKET

Securities are first offered for sale in a primary market. For example, the
sale of a new bond issue, preferred stock issue, or common stock issue
takes place in the PRIMARY MARKET. These transactions increase the total
stock of financial assets in existence in the economy.

SECONDARY MARKET

Trading in currently existing securities takes place in the SECONDARY


MARKET. The total stock of financial assets is unaffected by such
transactions.

THE OVER-THE- COUNTER MARKET

OVER-THE-COUNTER MARKETS include all security markets except the


organized exchanges. The money market is a prominent example. Most
corporate bonds are traded over-the-counter.

Most Stocks and Bonds are not traded on exchanges but in the over-the-
counter market. The OTC market is not a place but rather a method of
negotiated trading which, unlike exchanges, has no central location. It is
composed of numerous dealers called market makers. Acting as

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wholesalers and principals, these dealers “make a market” in the shares of


one or more companies as they trade for their customers and their own
accounts.

THE REGULATORS

The various securities markets, procedures of issuance, marketing, and


subsequent trading of securities, must adhere to certain rules and
standards in order to proceed in a reasonable and orderly fashion.

In the U.S., the main regulatory agencies include the Securities and
Exchange Commission (SEC), and the Federal Reserve Board (Fed).

The SECURITIES AND EXCHANGE COMMISSION (SEC) regulates all organized


securities exchanges to protect investors from unfair practices and to
maintain orderly markets.

SEC regulations include three major Acts governing the trading of


securities on organized exchanges. The SECURITIES ACT OF 1933 pertains
to newly issued securities, the SECURITIES EXCHANGE ACT OF 1934 deals
with trading in securities markets, and the SECURITIES ACT AMENDMENT OF
1975 centers on the national securities markets. In fact, the SEC
established many of the regulations cited in the U.S. Regulations and Acts
module.

There are also specific regulators for specific markets, such as the
COMMODITIES FUTURES TRADING COMMISSION which regulates activities in
commodities futures markets.

THE CENTRAL BANK OF THE U.S.A.: THE FEDERAL RESERVE SYSTEM

THE FEDERAL RESERVE SYSTEM is the guardian of the nation’s money -


banker, regulator, controller, and watchdog all rolled into one.

Like other countries, the U.S. has a national bank. However, the Federal
Reserve (the Fed) is not one bank; it’s twelve separate ones governed by a

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seven- member Board of Governors. Congress established it in 1913 to


stabilize the country’s chaotic financial system.

How the Fed works

Technically a corporation owned by banks, the Fed works more like a


government agency than a business. Under the direction of its Chairman, it
sets economic policy, supervises banking operations, and has become a
major factor in shaping the economy.

The Fed has several tools by which it influences, indirectly and to a greater
or lesser extent, the amount of money in the economy and the general level
of interest rates. These tools are reserve requirements, open market
operations, open market repurchase agreements and the discount rate.
These instruments represent the key ways that the Fed interacts with
commercials banks in the process of creating money.

Member Banks

About half of all the banks in the country are members of the Federal
Reserve System. All national Banks must belong, and state-chartered
banks are eligible if they meet the financial standards the Fed has
established.

The Federal Reserve’s many Roles

The Fed plays many roles as part of its responsibility to keep the economy
healthy. The Fed handles the day-to-day banking business of the U.S.
government. It gets deposits of corporate taxes for unemployment,
withholding and income, and also of federal excise taxes on liquor,
tobacco, gasoline and regulated services like phone systems. It also
authorizes payment of government bills like Social Security and Medicare
as well as interest payments on Treasury bills, notes and bonds.

Moreover, the Fed manages the currencies replacement, the gold matters
and is also a clearing house for checks.

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THE FED AS A REGULATOR

By buying and selling government securities, the Fed tries to balance the
money in circulation. When the economy is stable, the demand for goods
and services is constant, and so are prices. Achieving that stability
supports the Fed’s goals of keeping the economy healthy and maintaining
the value of the dollar.

THE FED AS A LENDER

If a bank needs to borrow money, it can turn to a Federal Reserve Bank.


The interest the Fed charges banks is called the DISCOUNT RATE. Bankers
do not like to borrow from the Fed since it may suggest they have
problems. In addition, they can borrow more cheaply from other banks.

THE FED AS AN AUDITOR

The Fed monitors the business affairs and audits the records of all the
banks in its system. Its particular concerns are compliance with banking
rules and the quality of loans.

THE G30, THE GROUP OF THIRTY

The GROUP OF THIRTY (commonly known as G30) is a private, international


group of top economists and bankers who meet for the purposes of
exploring and discussing issues of international finance and global
economics. Although the group has no legislative power, it is highly
respected, and its recommendations are taken into serious consideration
when relevant national or market policies and practices throughout the
world are being revised or formulated.

In 1989, the G30 issued a set of NINE RECOMMENDATIONS for improving


international securities settlements, corporate actions processing, and
income processing. The purpose was to reduce risk and improve efficiency
in national and world markets.

The nine G30 recommendations, as published in 1989, are:

1) By 1990, all comparisons of trades between direct market participants should


be accomplished by T+1.

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2) Indirect market participants should, by 1992, be members of a trade


comparison system that achieves positive affirmation of trade details.

3) Each country should have a fully developed central securities depository


organized to encourage the broadest possible industry participation by 1992.

4) Each country should determine whether a trade netting system would help
reduce risk and improve efficiency. If a netting system is appropriate, it
should be in place by 1992.

5) Delivery vs. Payment (DVP) should be used for settling all securities
transactions. A DVP system should be in place by 1992.

6) Payments associated with the settlement of securities transactions should be


consistent across all instruments and markets by adopting the same day
funds convention.

7) All markets should adopt a "rolling settlement" system. Final settlement


should occur on T+3 by 1992. As an interim target, final settlement should
occur by T+5 by 1990, except where it hinders the achievement of T+3 by
1992.

8) Securities lending and borrowing should be encouraged as a way to expedite


the settlement of securities transactions. Regulatory barriers to securities
lending should be removed by 1990.

9) Each country should adopt the ISO standard for securities messages and the
ISIN numbering system by 1992.

S.W.I.F.T. SOCIETY FOR WORLDWIDE INTERBANK FINANCIAL


TELECOMMUNICATIONS

S.W.I.F.T. is an acronym for SOCIETY FOR WORLDWIDE INTERBANK


FINANCIAL TELECOMMUNICATIONS. S.W.I.F.T. is not a payment
system, rather it is a system of electronic communication. S.W.I.F.T. is a
nonprofit organization that facilitates the exchange of payment instructions
or advises of payment between financial institutions around the world.
S.W.I.F.T. messages can be sent both internationally and domestically. A

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S.W.I.F.T. message can also be used to convey trading and settlement


messages, corporate action notices, and general messages, among others.

S.W.I.F.T. was organized in 1973 to provide a more efficient


communications method than telegraph wire (also known as TELEX) or
mail. Participants to the S.W.I.F.T. network include broker-dealers,
securities firms, Investment Management Institutions, recognized
exchanges, central depositories and clearing institutions, registrars and
transfer agents, and custodian banks.

The advantages of S.W.I.F.T. in a global environment are that it provides


common rules, standards and communication methods across a variety of
users. S.W.I.F.T. is considered one of the most secure and efficient
networks for the delivery of funds transfer instructions. S.W.I.F.T. protects
against unauthorized access, loss or incorrect delivery of messages,
transmission errors, loss of confidentiality and fraudulent changes to
messages.

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Types of Investment

There are four basic types of investments:

1. LAND (real estate)

2. COMMODITIES

3. SECURITIES (debt/equity)

4. CASH (“fake asset”)

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Investment Strategies

Various INVESTMENT STRATEGIES allow all types of investors the opportunity


to maximize returns on their investments according to their individual
needs.

Before developing an investment strategy, investors must consider the


objectives and constraints influencing their investment choices.

Objectives are what the investor wishes to accomplish by investing. For


example, objectives can be to generate a steady and secure income flow,
to maintain liquidity, to have a specified amount of money available at a
particular time in the future, to increase the initial capital by a substantial
amount, etc… Not all objectives are mutually exclusive, but different
objectives require different types of investments and strategies.

Constraints provide the framework of limitations within which the stated


objectives will be pursued. Constraints can be liquidity requirements, tax
considerations, legal and regulatory requirements, or circumstances of the
investor.

RISK-RETURN TRADE-OFF

The RISK-RETURN TRADE-OFF is a subjective principle of investment


strategy. Before a strategy can be developed, the amount of risk an
investor is willing to take must be considered.

Generally, the highest risk investments will offer the highest potential
returns, as well as the highest potential for losses.

DIVERSIFICATION

DIVERSIFICATION reduces an investor's exposure to risk by spreading a


variety of investment choices among different asset categories.
Diversification works on the theory of "not putting all of your eggs in one
basket"; by choosing investments in different markets or industries, or

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mixing equity and debt, the investor is protected from a negative impact in
one category. For diversification to be effective, the chosen investments
should not fluctuate in a similar fashion, such that external market
conditions would cause the investments to rise or fall in value at the same
time. Diversification implies that if one asset or investment category
performs poorly, the entire portfolio will not be affected.

ASSET ALLOCATION

Everyone invests for the same basic reason: to make their assets work as
hard as they can to meet a set of financial objectives. But those objectives
are different for each of us, and they define how we invest.

The relationship between your needs, resources, goals and tolerance for
risk will pinpoint the asset allocation strategy--the method by which you
divide your assets among stocks, bonds and cash--that's best for you. The
different strategies are based on several factors, and differ in how they
balance risk and reward. In general, higher growth means a greater
emphasis on stocks--and a higher level of risk.

Identifying your investment objectives will help you decide which


investment strategy is right for you.

ASSET ALLOCATION is related to diversification, and refers to the question of


what percentage of a portfolio should be invested in any asset category in
order to maximize returns within the risk parameters desired. Determining
an optimal asset mix of any combination of investments, including short
term debt, stocks, bonds, real estate, options, futures, venture capital and
derivatives, enhances the investor's ability to achieve desired returns.

• You need a CAPITAL PRESERVATION strategy.

This strategy is based on the following asset allocation:

Stocks: 10%

Bonds: 55%

Cash: 35%

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This division of assets is designed to maintain capital. Most of your money


will be in bonds and cash, with a small portion seeking equity growth to
offset the effects of inflation. Overall returns may be lower than normal in
order to minimize the risk of principal loss.

• You need a CURRENT INCOME strategy.

This strategy is based on the following asset allocation:

Stocks: 30%

Bonds: 60%

Cash: 10%

While moderate risk is assumed from fluctuating interest rates, this strategy
provides the greatest level of income.

• You need an INCOME AND GROWTH strategy.

This strategy is based on the following asset allocation:

Stocks: 40%

Bonds: 50%

Cash: 10%

This strategy seeks a balance between bonds for income and stocks for
growth of principal and dividends. Dividends and interest income comprise
a large part of the invested assets' total return. Some risk is assumed in
order to achieve growth.

• You need a LONG-TERM GROWTH strategy.

This strategy is based on the following asset allocation:

Stocks: 70%

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Bonds: 25%

Cash: 5%

In order to accumulate wealth over a 3-5 year period, this strategy places
greater emphasis on stocks. An investor would need to be willing to accept
some price volatility to achieve growth. Equities are dominant, particularly
leading companies in strategically favored industries. There is limited
turnover, and dividend reinvestment and dollar cost averaging are stressed
to achieve the growth objective.

• You need an AGGRESSIVE GROWTH strategy.

This strategy is based on the following asset allocation:

Stocks: 80%

Bonds: 10%

Cash: 10%

The primary investment objective of this strategy is to achieve above-


average capital growth over a 3 - 5 year period. Income is of no concern.
The investor is willing to make few changes in this larger-than-normal
commitment to stocks in strategically favored industries.

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β ,…) and Return


The Concept of Risk (β

What is Risk ?

RISK can be defined as the possible variation in cash flow about an


expected cash flow.

Conventionally, we measure the EXPECTED CASH FLOW as follows:

EX = X1 P1 + X2 P2 + . . . + X n Pn

where Xi is the cash flow in the ith state of the economy and Pi is the
probability of the ith state of the economy.

Similarly, the EXPECTED RATE OF RETURN is given by:

Σ R i Pi
n
ER =
i=1

where Ri is the rate of return in the ith state of the economy and pi is the
probability of ith state of the economy.

The Types of Risk

MARKET RISK An asset may lose market value because of economic


and other swings in the overall market or conditions
affecting the asset itself.

CREDIT RISK The borrower may fail to repay principal

INFLATION RISK The currency in which an asset is based may lose


purchasing power

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LIQUIDITY RISK An asset may lose market value because it is difficult


to sell.

INTEREST-RATE RISK The market value of a fixed-income investment moves


opposite to market interest rates.

REINVESTMENT RISK When reinvesting a bond’s principal and interest


proceeds, you might not get as high a rate because
market interest rates have declined.

CURRENCY RISK An asset denominated in foreign currency may lose


value when the home base strengthens.

How to measure risk ?

Market risk refers to the fluctuation of an investment’s price volatility or


potential loss in market value at the time you need to liquidate. Wall Street
has found a way to actually measure the risk of certain investments in
terms of price volatility.

ALPHA. With this measure, you can gauge how much better an investment
or portfolio performs, given its risk. Alpha is the return over and above the
market average, as measured by the S&P 500 Index. An Alpha of ‘0’ means
you are being adequately compensated for risk taken; a higher number
reflects better than expected performance.

BETA. With this measure, you can gauge a security’s price volatility
relative to the overall market. Theoretically, a portfolio or security with a
beta of 1.00 moves in line with S&P 500 index. A Beta higher than 1.00
denotes greater price volatility than the overall market.

Statistically, risk may be measured by the standard deviation of the random


cash flow.

The STANDARD DEVIATION is denoted by σ and is calculated as follows:

n
σ= Σ
i =1
R i – ER 2 Pi

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where n is the number of states of the economy, Ri is the return in the ith
state and Pi is the probability of the ith state of the economy.

The attractiveness of a security cannot be determined by standard


deviation alone. The risk and return of a security has to be compared with
the alternatives available for investment.

Total Risk or variability of returns can be divided into:

The variability of returns unique to the security :

Commonly referred to as Firm Specific Risk or Unique Risk or Diversifiable


Risk or Unsystematic Risk.

The risk related to market movements : Also referred to as MARKET RISK or


Non-diversifiable Risk or Systematic Risk.

By diversifying, the investor can eliminate the “unique” security risk. The
systematic risk, however, cannot be diversified.

Measuring Systematic Risk

SYSTEMATIC RISK affects all securities. To measure systematic risk, we


measure the tendency of a stock to move relative to the market.

The plot of firm excess returns versus market excess returns is called the
CHARACTERISTIC LINE, i.e.,

ER - Rf = β (ERm - Rf)

The measure of a stock’s systematic risk or market risk is commonly called


BETA. BETA is also the slope of the Characteristic line.

The BETA of stock A is calculated as follows:

Cov (Ra , Rm )
βa =
Var R m

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where Ra is the return on stock A and Rm is the return on the market


portfolio and where

n
Var Rm = Σ Rmi – ERm 2 p i
i= 1

n
Cov R a, Rm = Σ Rai – ERa Rmi – ERm pi
i =1

The beta of a portfolio is the weighted average of the individual securities


betas. The beta of the market is one.

The Required Rate of Return

The required rate of return equals the risk free rate plus a return to
compensate for the additional risk.

The REQUIRED RATE OF RETURN can be expressed as :

R = Rf + RP,

where R is the investor’s required rate of return, Rf is the risk-free rate,


and RP is the risk premium.

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The Balance Sheet and the Income Statement

THE BALANCE SHEET

The BALANCE SHEET represents a statement of the financial position of the


firm on a given date, its asset holdings, liabilities, and owner supplied
equity. This statement is considered the most important financial statement
for judging the economic well being of the firm. The balance sheet consists
of two basic components: (1) assets and (2) liabilities plus owner's equity.

Assets

On the ASSET side of the balance sheet, we usually find two categories.

a) CURRENT ASSETS are those assets that are expected to be realized in


cash, sold, or consumed either in 1 year or within the operating cycle of
the firm, whichever is longer.

b) FIXED OR NONCURRENT ASSETS contain all those resources that are not
expected to be converted into cash within the operating cycle of the
firm. Security investments, plant, equipment, and land are the most
common fixed assets.

Liabilities

LIABILITIES represent the outstanding claims held against a firm's assets


and are reported at their stated or face value. There are two basic
categories of liabilities.

a) CURRENT LIABILITIES represent obligations that are reasonably expected


to be liquidated within 1 year.

b) LONG-TERM OR NONCURRENT LIABILITIES include permanent obligations of


the firm that are not reasonably expected to be liquidated within the

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normal operating cycle of the firms but are payable at some later date.
Noncurrent liabilities are often referred to as long-term liabilities.

Owner's equity

OWNER'S EQUITY represents the book value of the owner's interest in the
assets of the firm. Owner's equity is comprised of capital stock (par value
of common stock plus paid in capital) and retained earnings (undistributed
earnings).

THE INCOME STATEMENT

The INCOME STATEMENT represents an attempt to measure the net results of


a firm's operations over a specified time interval. Some of the more
important components of the income statement are discussed below:

1. SALES represent the total sales of products or services net of returns


and allowances attributable to the period.

2. COST OF GOODS SOLD is simply the cost of the product sold or service
provided. There are two widely used methods for computing cost of
goods sold. The First In First Out (FIFO) method assigns to cost of
goods sold the prices the firms paid on the oldest item in inventory.
The Last In First Out (LIFO) method assigns cost to items sold based
on the cost of the most recently purchased inventory item. The method
selected can have an important effect on net earnings for a period in
which prices have risen or fallen significantly.

3. GROSS PROFIT represents the amount by which sales exceed cost of


goods sold.

4. SELLING EXPENSE includes all those expenses incurred in the process of


making the period's sales.

5. GENERAL AND ADMINISTRATIVE EXPENSES include all those operating


expenses not directly attributed to the cost of merchandise sold or
selling expenses. These expenses usually include administrative

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salaries, utilities, non-income-related taxes, insurance, and


depreciation.

Depreciation is not a cash expense; it represents an attempt to allocate


the cost of the firm's plant and equipment against the periods in which
those assets are being used. The purpose of depreciation is to allow
firms to help defray the cost of asset allocation by deducting the cost for
tax purposes.

6. NET OPERATING INCOME reflects the net results of a firm's operations


before considering financing costs and income taxes.

7. NET INCOME AFTER TAXES represents net earning for the period after
income taxes.

8. RETAINED EARNINGS for the period represent any earnings that remain
after all dividends have been paid to stockholders. This amount is often
added to the existing retained earnings figure on the balance sheet.

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The Time Value of Money

THE NET PRESENT VALUE

NPV = Present value of expected future cash flows - Cost

NPV measures the value created by a financial decision.

Positive NPV increases wealth.

A zero NPV decision earns the “fair” rate of return.

A positive NPV decision earns more than the fair rate of return.

REQUIRED RATE OF RETURN

The REQUIRED RATE OF RETURN is the return that exactly reflects the risk of
the expected future cash flows.

A person requires the return from an investment before she/he is willing to


make the investment.

EXPECTED RATE OF RETURN

It is the return that an investor expects to earn from the investment.

If it is equal to the required rate of return, the investment has a zero NPV.

If it is greater than the required rate of return, the investment has a positive
NPV.

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If it is less than the required rate of return, the investment has a negative
NPV.

PRESENT VALUE FORMULA

Let PV = Present Value

FVn = Future Value at time n

r = interest rate (or discount rate) per period.

 1 
PV = FVn  
 (1 + r ) 
n

FUTURE VALUE FORMULA

Let PV = Present Value

FVn = Future Value at time n

r = interest rate (or discount rate) per period.

FVn = PV (1 + r )
n

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The Stock Market

EQUITY SECURITIES represent the ownership of a corporation. For example,


if an investor purchased 50 shares out of 1000 outstanding XYZ shares,
this investor owns 50/1000 of the XYZ Corporation.

A privately owned company goes public by selling all or parts of its


ownership to investors to raise capital. By purchasing common stock, you
actually own a part of the company’s assets and stand to participate in its
profitability.

SHAREHOLDERS or STOCKHOLDERS have the right to vote for the Board of


Directors and on corporate matters.

Over the years, studies have shown that successful stock investing is a
matter of time rather than a matter of timing. That's because stock prices
can move up and down dramatically on a day-to-day basis but, over the
long-term, build wealth better than any other investment vehicle.

From the investment point of view, there are two main reasons why
investors are interested in investing in equity securities: dividend payments
and the growth of the stock's market value.

A DIVIDEND represents that portion of the net earnings of the corporation,


which is distributed to stockholders.

A combination of the current earnings and financial status of the company


plus potential investors' perceptions of the company's future earnings and
financial status determine the Market Value of a company's shares. Thus,
as a company grows and becomes more successful, the value of the
shares increases.

GOING PUBLIC

The first time companies issue stock, is called GOING PUBLIC. After that,
they can raise additional money, or capital, by selling additional stock.

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To take a company public, which means making it possible for investors to


buy the stock, the management makes an INITIAL PUBLIC OFFERING (IPO).

The company goes to INVESTMENT BANKERS who agree to UNDERWRITE the


stock offering - that is, to buy all the public shares at a set price and resell
them to the general public, hopefully at a profit.

The company has to prepare a PROSPECTUS, a legal document containing a


detailed analysis of the company’s financial history, its products, its
management’s background and experience.

THE PRICE

The Price

Whether a company’s stock is listed on a stock exchange or traded over-


the-counter, two prices are always quoted the bid and the offer.

If selling shares, you are interested in the bid, the highest price offered by
a buyer. If buying shares, you want to know the offer, the lowest price at
which one or more shareholders have agreed to sell.

Prices are still quoted in points and fractional points (1/8, ¼, 3/8, ½, 5/8,…)

The Spread

The difference between the bid price and the offer is the SPREAD. The
spread varies usually between 1/8 and $1. A larger spread may indicate
greater risk to market makers or low trading activity.

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The Ticker

Every public company has a TICKER SYMBOL or a stock symbol by which it is


easily identified.

Reading the Newspaper

52-weeks

Hi Lo Stock Sym Div Yld% PE Vol 100s Hi Lo Close Net Chg


677/8 501/2 Disney DIS $.44 .6 26 32001 691/8 673/4 685/8 +7/8

52 Weeks Hi/Lo The highest and lowest prices paid for Disney's stock
during the past year. The numbers are expressed in
points, but represent dollar amounts. In this case, 677/8
is the same as $67.875. Knowing the highs and lows for
the past 52 weeks can help an investor evaluate a
stock's current price.

Stock The name of the company.

Sym The stock's trading symbol. To avoid confusion and to


simplify the order process, every stock that is traded on
an exchange or in the OTC market is assigned a
symbol. Some newspapers do not provide the stock's
trading symbol, but instead provide an abbreviation of
the company's name.

Div Short for dividend. For each share of stock owned, a


Disney shareholder should receive 44 cents from the
company's annual profits. Payment is usually made on a
quarterly basis. Not all companies pay dividends all the
time. The company's Board of Directors decides
whether a dividend will be paid and its amount.

Yld% The yield, or rate of return, on a stockholder's


investment. It is figured by dividing the annual dividend
by the current price of the stock. Disney stockholders
earn .6 percent of today's stock price from dividends.

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Investors who want income from their stock look for a


high yield.

PE Short for price/earnings ratio. The price of a share of


stock divided by the company's earnings per share for
the last year. Investors use the P/E ratio to decide if a
stock is over or under priced.

Vol 100s The total amount of stock traded during the previous
day. On that day, 3,200,100 shares of Disney stock
changed hands. The number does not include odd lots
or sales of less than 100 shares.

Hi and Lo The highest price paid for Disney stock during the
previous day was $69.125 (or 691/8). The lowest was
$67.75 (or 673/4).

Close The last price paid for Disney at the end of the previous
day was $68.625 (or 685/8).

Net Chg The last price on the previous day, $68.625 (or 685/8),
was 87.5 cents (or 7/8 of a dollar) more than the last
price on the preceding day. Brokers call this "closing up
7/8
."

THE SUPPLY AND DEMAND

There is an old saying on Wall Street that a stock is worth what somebody
is willing to pay for it. Moreover, that is true - the price of a stock is
determined by buyers. As they gain new information, investors decide
whether they are willing to pay more for a stock or less. Their changing
perceptions continually push stock prices up or down.

Simply put, the price of a stock - or for any product or service, for that
matter - is determined by supply and demand. The supply of stocks is
based on the number of shares a company has issued, or sold to the
public. People wanting to buy those shares from the people who already
own them create the demand for stocks. If people think they will make
money on a stock, they will want to buy it.

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But here's the catch: supply is limited, and not everyone who wants to own
a company's stock can. The more people desire to own a stock, the more
they will be willing to pay for it. High demand for a stock pushes up its
price. Similarly, as the value of a stock increases, owners are more
reluctant to sell it.

The rise continues until prospective buyers decide the price has gone too
high. Then, fewer people are willing to buy the stock at the high price.
Stockowners who are anxious to sell must lower the price at which they are
willing to sell. The stock's price falls until investors believe the stock is
again worth the price at which owners are willing to sell.

THE COMPANY FINANCIAL HEALTH

The laws of supply and demand explain why stock prices fluctuate. How do
investors and analysts arrive at their decisions as to whether a stock is
worth buying or selling at a given price? Above all, they examine the
financial health of the company offering the stock. Investors are not likely to
put a high value on stock in a company that is going to lose money. They
look for a business with a history of making strong profits and consistently
paying healthy dividends.

While history is important, investors also analyze a company's future


prospects. A company with a poor profit history might have a promising
future, and one with a good history might be on the way down. Therefore,
careful investors also review how a company fares against its competition
and whether it's being run by experienced, responsible people who keep
up with current trends. If a company is viewed by potential investors as
increasing efficiency or producing new, innovative products, its stock is
likely to rise in price.

Alternatively, trouble on the horizon - damaging lawsuits, threats of a strike,


more intense competition, or more stringent regulation - can depress the
value of a company's stock. When a major oil company announced that it
was filing for bankruptcy, for instance, the value of its stock dropped 11
percent.

A report that someone or some company is trying to buy a certain business


usually pumps up that business's stock prices. That is because the
purchaser has to buy a majority of the stock to gain control of the company.
To do so, the suitor must persuade stockholders to sell their stock by
offering an attractive price or their shares.

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Sentiment may also count. For example, when the owners of the Boston
Celtics basketball team offered shares of stock in 1986, analysts suggested
that the stock was overvalued. But investors - most of them Celtic fans -
had a high regard for the team and were willing to pay the price to be
associated with it.

AN INDUSTRY’S FINANCIAL HEALTH

Another important factor to consider is the health of a company's whole


industry.

A company's stock prices may go up or down depending on whether


investors think its industry is about to expand (grow bigger) or contract
(grow smaller). For example, a company may be doing well financially, but
if its industry is declining, investors might question the company's ability to
keep growing. In that case, the company's stock price may fall.

Many industries expand and contract in cycles. For example, home building
declines when interest rates rise.

ECONOMIC TREND

In addition to events surrounding a specific industry or company, analysts


carefully watch what they call economic indicators - general trends that
signal changes in the economy.

An essential indicator is the change in the rate of economic growth as


measured by the Gross National Product (GNP). GNP measures the total
production of goods and services in our economy. If it is rising, then short-
term business prospects are improving. Another important indicator is the
inflation rate. Inflation occurs when prices are rising rapidly. During an
inflationary period, a company's costs may rise faster than it can increase
its prices; so its profits shrink.

In addition, the inflation rate has a major influence on another important


indicator, interest rates. Rising interest rates mean that the government,
businesses and consumers must pay more to borrow money. Therefore,
the government's budget deficit increases, businesses may delay their
plans for new projects, and consumers don't spend as much. That can set
the stage for a recession - a period of slow economic growth.

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Analysts also monitor the U.S. budget deficit - the gap between the money
the Federal Government takes in and the money it spends. When the
deficit grows, the Government has to increase its borrowing of money that
would otherwise be available to businesses to expand and consumers to
spend.

Many other indicators signal changes in the economy. Among them are
stock prices, unemployment rates (the percentage of U.S. workers who
cannot find jobs), and changes in the value of the dollar (the amount of
foreign currencies that can be purchased for each U.S. dollar).

These indicators are more than just numbers. They point to changes in the
way ordinary people spend their money - and, in turn, how the economy is
likely to perform. If unemployment rates are falling, or if people are getting
good values for their money, they are probably going to feel optimistic
about the economy. They are more likely to spend money, benefiting
companies and stock prices.

WORLD AND NATIONAL EVENTS

Nothing alters people's attitudes toward saving and investing more than
their perceptions of a major news event. For example, when a nation has
declared war, stock prices may go up. That's because a country at war
needs armaments, supplies for troops, spare parts, and huge amounts of
fuel. Therefore, companies gear up to produce and sell more goods.

News of other events can push stock prices down. If fighting between Iran
and Iraq, for example, flares up in the Persian Gulf, U.S. stock prices may
drop. That's because fighting may decrease the supply of oil coming from
that region. Consequently, oil may become more expensive and the cost of
all U.S. goods that rely on oil or petroleum products may increase.

People are reluctant to invest unless they feel confident about the future of
the economy. If investors are not sure how a major event will affect the
nation's economy, they are likely to hesitate about investing in securities.
For example, if investors are uncertain of a new president's attitude toward
business, stock prices may drop while investors await developments.

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HOW TO VALUE A STOCK?

The price of a stock is not by itself any indication of value by itself. Stocks
are analyzed based on a multitude of criteria, including Price/Earnings ratio
and dividends.

EARNINGS PER SHARES (EPS)

The portion of a company’s profit paid on each share of common stock. It is


calculated after paying taxes and preferred shareholders and bondholders

PRICE/EARNINGS RATIO

A company’s stock price is greatly influenced by its earnings growth. The


P/E is calculated by dividing the stock price by the company’s annual
earnings per share.

SHARE PRICE ÷ EARNINGS PER SHARE = P/E

Company earnings are anticipated and estimated, therefore you can see
how a stock’s P/E reflects investors’ feelings about the company’s future
prospects.

The higher the P/E, the more earnings growth investors are expecting.
Stocks with a higher P/E, usually over 20, are considered riskier than
stocks with lower growth.

THE STOCK PRICE

PRICE = EPS (ANNUAL) X P/E

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DIVIDENDS

The total return of a stock investment includes dividends paid by the


company in addition to share-price gains. Newer companies generally
reinvest profits, but as they mature, nearly all large public companies pay
cash dividends to share-holders out of their earnings. A company’s Board
of Directors decides if a dividend is to be paid and how much.

Dividends generally increase in line with company profits.

The percentage of a company’s retained earnings paid as dividends is the


PAYOUT RATIO. The typical payout ratio is 25 to 50 percent of company
earnings. Dividends are paid quarterly to shareholders, designated owners
of record. To qualify, shares must have been purchased before the ex-
dividend date, approximately three weeks before the dividend is paid.

Dividends may also be paid in shares of stock when its Board of Directors
feel that the money can be best used to expand the business or develop
new products.

As you might expect, when many corporations increase their dividends, it is


considered positive for the stock market. Indeed, dividend yields are an
indicator of corporate growth and profitability as well as investment value.

Stocks that pay dividends regularly are known as INCOME STOCK, while
those that pay little or no dividend while reinvesting their profit are known
as GROWTH STOCKS.

The Dividend Yield

The Dividend Yield is the percentage of purchase price you get back
through dividends each year.

For example, if you buy a stock for $100 a share and receive $4 per share,
the stock has a dividend yield of 4%. However, if you get $4 per share on
stock you buy for $50 a share, your yield would be 8%.

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STOCK SPLIT

If a company determines that it stock price is too high to interest investors,


it may split the shares to lower the price. Although a split changes the
number of outstanding shares, it has no effect on shareholder equity, and
dividends are adjusted accordingly. Sometimes the announcement of a
split increases the stock’s market value, but often is has no effect at all.

A STOCK SPLIT may be a distribution of any whole or fractional number of


shares for each share held.

A reverse split decreases the number of outstanding shares. A company


may reverse split its stock when the price is too low for its stock to be used
as collateral for borrowing money or is too costly to trade.

VALUABLE STOCK MARKET TERMS

Common Stock

Most often corporations offer equity ownership in the form of COMMON


STOCK. Many corporations issue just one class of common stock to raise
capital; however, there can be different classes of common stock issued by
the same corporation in the market, such as Class A and Class B stocks.
Terms of each class issued by the corporation are detailed in the
prospectus.

Each common stockholder is entitled to dividend payments, and the right to


vote their shares at annual meetings. In some cases, shareholders have
the opportunity to purchase newly issued shares at below market price
before they are offered to the public.

Preferred stock

PREFERRED STOCK is sometimes called a hybrid security because it has


some characteristics of both equity and debt securities. It is like common
stock in that it earns dividends, and has no maturity date. It is as if debt in

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that the amount of each dividend paid to the preferred stockholders is


predetermined. This is different from the dividend payments on common
stock for which the dividend rate may fluctuate depending on the
performance of the corporation. For example, an investor owns 1000
preferred shares of XYZ Corporation and the company declares a 10%
dividend rate annually. This investor will receive a dividend of $100
annually, or $25 quarterly. This income calculation is very similar to debt
instruments, where investors are paid according to a stated interest rate.
One other difference between preferred and common stock is that the
preferred stockholder has little or no voice in the management of the
corporation.

They reduce the investor’s risk but limit reward.

There are five distinct types of preferred stock. These are cumulative
preferred, participating preferred, convertible preferred, prior preferred, and
callable preferred stocks.

In case of liquidation of the corporation, the debt holders and preferred


stockholders are ranked ahead of common stockholders for claims on both
the assets and income of the corporation.

The Right to Vote

Owning a stock gives you the right to vote on important company issues
and policies.

Most shareholders vote by PROXY, an absentee ballot they receive before


the annual meeting. On the other hand, they have the option of attending
the meeting and voting in person.

Book Value

Theoretical historical value (not market value) of a company’s assets after


all debts are paid.

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Debt /Equity Ratio

A measure of a company’s financial solvency. Debt is the total cash a


company owes creditors; equity is the dollar value assigned to shareholder
ownership. The relationship between the two is an indicator of a company’s
financial condition.

Tender Offer

Offer from a company or group to purchase several of a company’s shares.


The bidding entity sends a document to the shareholders outlining the
terms of the offer. Shareholders are not obliged to tender (sell) their
shares, but generally it is in their interest to do so, since the offered price
might be the highest price at which the stock will trade in the near future or
perhaps ever again.

Insider Trading

Illegal trading in securities based on confidential information to which only


insiders (such as a company’s accountants, lawyers, and employees) are
privy. Industry computers detect heightened trading activity in certain
stocks, which allows suspicious trades to be traced and investigated for
insider-trading abuse.

Warrant

The right to purchase a certain number of a company’s shares at a fixed


price prior to a specified future date. Companies that plan to issue stock or
raise cash by selling shares held in reserve issue warrants.

Program Trading

Some of the big investors speed up the process of buying and selling
stocks by using program trading techniques that involve placing large

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orders by computer. The programs are sometimes triggered automatically,


when prices hit predetermined levels.

Such sudden buying or selling can cause abrupt price changes or even
dramatic shifts in the entire market. The stock market crash of 1987
occurred, at least in part, because of program trading triggered by falling
prices. To prevent potentially catastrophic program trades, trading now
shuts down in a major sell-off to let things cool down.

Rule of 72

Quick calculation to determine how long it takes to double an investment at


a given interest rate. Divide 72 by the rate of interest earned to get the
number of years it takes money to double.

For example, if an investment earns 8% annually, it takes 9 years to


double.

Capitalization

In order to fully appreciate market price in a comparative sense, one must


take into account the capitalization of the companies in question. This is
defined as the amount derived by multiplying the current market price by
the number of outstanding shares.

CAPITALIZATION = MARKET PRICE PER SHARE X SHARES OUTSTANDING

Arbitrage

ARBITRAGE is the method whereby investors buy a security in one market


and simultaneously sells it in another market, when legally able to do so.
Arbitrage techniques differ from market to market but traditionally they have
been confined to two or more markets which happen to trade the same
security, for instance the NYSE and Pacific Stock Exchanges. The process
is very rapid and is based upon even the smallest of price differentials.

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Blue Chips

Blue Chips is a term borrowed from poker, where the blue chips are the
most valuable, and refers to the stocks of the largest, most consistently
profitable corporations.

Bull Market Vs Bear Market

A bull market is a period during which stock prices are generally rising. A
bear market is a period which stock prices are generally falling. Each of
these is fueled by investors' perceptions of where the economy and the
market are going.

If investors believe they are in the midst of a bull market, or one seems
likely, they will feel confident that prices are going up. Their own
confidence helps to keep stock prices rising. During a bear market
investors believe stock prices will fall. They hesitate to invest in stocks, and
their own concerns help keep stock prices down. A bull or bear market can
last anywhere from several months to several years.

SHORT SELLING

The most common form of stock investing is buying long. When you are
“LONG A STOCK”(meaning you owe the stock), the most you can lose is the
amount of cash you invested. However, if an investor believes that the
price of a company’s shares will decline, he may speculate by selling the

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stocks short. SELLING A STOCK SHORT involves selling borrowed shares with
the expectation that the price will fall, providing the opportunity to buy them
back cheaper - sell high, buy low - The short seller’s profit is the difference
between the buy and sell prices, less commissions.

You borrow shares from your broker, sell them and get the money. Then
you wait, expecting the price of the stock to drop. If it does, you buy the
shares at the lower price and repay the broker to settle the loan (plus some
interest and commission). Buying shares back is called COVERING THE
SHORT POSITION.

BUYING WARRANTS

Warrants are a way to wager on future prices. Warrants guarantee, for a


small fee, the opportunity to buy stock at a fixed price during a specific
period. Investors buy them if they think a stock’s price is going up.

For example, you might pay $1 a share for the right to buy XCo. Stock at
$10 within 5 years. If the price goes up to $14 and you EXERCISE (use) your
warrant, you save $3 every share. You can then sell the shares at a higher
price to make a profit.

Companies sell warrants if they plan to raise money by issuing new stock
or selling stocks they hold in reserve.

BUYING ON MARGIN

Investors who want to buy stock but do not want to pay the full price can
LEVERAGE their purchase by buying on margin. They set up a MARGIN
ACCOUNT with a broker, sign a margin agreement, and maintain a minimum
balance. Then they can borrow 50% of the price of the stock and use the
combined funds to make the purchase.

Investors who buy on margin pay interest on the loan portion of their
purchase but do not have to repay the loan itself until they sell the stock.

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Despite its advantages, buying on margin can be very risky. For example,
the price of the stock you buy could drop so much that selling it would not
raise enough cash to repay the loan to your broker. To protect themselves
in cases like this, brokers issue a MARGIN CALL if the value of your
investment falls below 75% of its original value. That means you have to
put additional money into your margin account.

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The Fixed Income Securities


The Money Market Vs The Capital Market

* Investor gets par The Individual as a


value at maturity Lender
* Investor gets interest
payment at specific Investors willing to
intervals lend money

Municipal Bonds

Corporate Bonds
U.S. Treasury Bonds

States, cities, counties and towns Corporations use bonds The U.S. Treasury floats debt
issue bonds * to raise capital to pay for expansion, issues
* to pay for public projects: modernization * to pay for a wide range of
schools, highways, stadiums,... * to cover operating expenses government activities
* to supplement their operating * to financnce corporate take-overs * to pay off national debt
budgets or other changes in management
structure

Bond
Matures

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Money Markets

Money Market Vs Capital Market

LONG TERM DEBT refers to debt that has a maturity of one year or longer.
This type of debt is traded on what is called the CAPITAL MARKET while
SHORT TERM DEBT refers to debt that has a maturity of less than one year.
This type of debt is traded on what is called the MONEY MARKET, as the
liquidity of these instruments makes them almost as fluid as money. A
company or government would issue short term debt in order to cover
temporary shortfalls in cash flows. An investor would buy short-term debt
to earn interest on excess cash.

The second type of capital available to companies -debt- is divided into


many classifications. Debt is the most widely used method of raising capital
and the capitalization of the major money and bond markets exceeds that
of the stock markets many times over.

The major classifications are quite simple: debt is broken down into two
short- and long-term instruments. Short-term debt is traded on the money
markets while the long-term debt trades on the bond markets.

As debt markets, the primary function of the money markets is to


redistribute funds from those economic units in society possessing a
surplus to those in deficit. Since most of these markets are institutional in
nature, surplus households do not normally lend directly to deficit
borrowers but do so through financial intermediaries. The intermediaries in
the money markets are financial institutions and banks whose very
business it is to perform this function.

Behind this maze of operations which occurs in daily in money markets,


one basic economic distinction has to be made. This has to do with the
difference between the PRIMARY AND THE SECONDARY MARKETS. As with
equities, only a primary market operation actually raises money for the
borrower. If the original investor decides not to hold the instrument until
maturity and sells it in the secondary market, the borrower is no longer
affected since it already has its money. Then the buying and selling of
these instruments become a matter of importance only for investors.

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Most money market instruments are sold on what is known as a DISCOUNT


basis; that is, they are sold at a price lower than par and pay back principal
at redemption. The example employed here will use a Treasury bill of one-
year maturity returning 10%. The price the investor will pay will be 90% of
par, or in bond market terms, simply 90. At redemption, 100% will be paid
back.

The Federal Government, state and local governments, and corporate


entities issue American money market instruments.

TREASURY BILL OR T-BILL

TREASURY BILLS are issued so that the central government can finance its
short-term cash needs, and are auctioned at regular intervals. They
normally come in a variety of term structures, with 3 months, 6 months and
1 year being the most common.

They are the lowest money market yields available because the
government is considered the highest quality credit risk in the country.

Since a large and ready secondary market exists for Treasury Bills, their
prices will vary during their outstanding lives. If interest rate conditions
change, the price of the bill will also change reflecting this.

COMMERCIAL PAPER

COMMERCIAL PAPER, a type of promissory note, is issued by large


corporations, and generally not secured by any collateral. CP is used to
finance short term cash needs of a corporation. The issuer promises to
pay the buyer of the paper a set amount on a future date. When issued,
CP usually has a maturity date of 1 to 3 months.

Large investors who have excellent credit ratings may sometimes be able
to negotiate favorable terms with issuers, such as arranging short term CP
for as little as 3 days.

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Traditionally, CP was issued at a discount (known as DISCOUNT PAPER) but


it is increasingly being issued at par. CP may be issued as either STRAIGHT
PAPER having a fixed rate, or FLOATING RATE PAPER having interest rates
that vary periodically.

CP may be resold on the secondary market to other investors. As such, an


issue of CP may have many owners over its lifetime.

CP issued by companies with excellent credit is called "PRIME CP". Prime


CP can either be sold directly to the public, called DIRECTLY PLACED PAPER,
or through a dealer. The latter type of paper is called DEALER PAPER and
generally carries a longer maturity term than directly placed paper.

Types of CP include Financial Paper, Industrial Paper, Line of Credit


Paper, and Eurocommercial Paper.

FINANCIAL PAPER is CP that is issued by a financial company such as


General Motors Acceptance Corporation (GMAC).

INDUSTRIAL PAPER is CP issued by a non-financial firm such as a public


utility.

LINE OF CREDIT (LOC) PAPER is a note issued by smaller or less marketable


firms and is accepted by a Letter of Credit from a bank, which guarantees
that payment will be made to the investor who accepts this LOC. Smaller
firms and cross-border firms may opt to use LOC Paper as they do not
have to disclose financial data to the public upon registering, but only
furnish this information to the bank. LOC paper is sold at a discount.

EUROCOMMERCIAL PAPER is CP issued, at either par or at a discount, by


European corporations. It is denominated in U.S. dollars but payable
through foreign banks or foreign branches of U.S. banks.

BANKER’S ACCEPTANCE

A business that owes money to a second party may go to a bank and


arrange for that bank to pay the money that is owed directly to the second
party. The bank agrees to pay on behalf of the business and charges a
stated interest rate for the loan. The business agrees to repay full principal

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and interest at the end of the term of the loan. This arrangement is known
as a BANKER'S ACCEPTANCE (BA). Businesses usually enter into this type
of arrangement in order to finance the purchase of goods from other
countries.

Before the loan is repaid, the bank can sell the BA on the secondary
market to an investor. This investor now is due to receive the repayment of
the loan from the business. The bank guarantees payment on the BA; if
the business does not pay the loan, the investor has the legal right to
collect the money from the bank that originated the BA. BAs are issued at
a discount.

CERTIFICATES OF DEPOSIT

As the name indicates, CDs are a type of security that acknowledges a


certain deposit of money in a bank with terms to pay the depositor a
specific interest rate plus the principal amount deposited, at a specific
future date (MATURITY DATE). CDs are issued in negotiable form (may be
resold) or non-negotiable form (may not be resold). If negotiable, the
depositor that receives the CD from the bank may choose to either hold the
CD until it matures, or sell the CD on the secondary market. If the CD is
sold, the buyer now has claim to the principal and interest that is due at
maturity. CDs can be sold repeatedly but the originating bank may not
purchase the CD that it issued.

Banks that have excellent financial standing are called "prime banks" and
the CDs that they issue are referred to as "prime CDs". This is because
the bank has a recognized ability to honor the maturity payments. Prime
CDs have a minimum denomination of $1 million.

Most CDs are denominated in the currency of the country in which they are
issued. Eurodollar CDs, however, represent U.S. dollars that are
deposited in foreign banks or foreign branches in U.S. banks. U.S. dollar
denominated CDs, issued by foreign banks through foreign branches in the
U.S. market, are called Yankee CDs.

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THE EURODOLLAR MARKET

After WW2, the US dollar demand increased in international transactions,


replacing sterling as the premier reserve currency. In the 1960s, the U.S.
began to run large balance of payments deficits. This meant that many
dollars were being held in the hands of non-American citizens and
corporations. This created a large pool of offshore dollars, ultimately
nicknamed “EURODOLLARS”. This term denotes dollars held in banks
outside the US, primarily in Europe and also in other offshore banking
centers.

Eurodollars have their own market rate quoted by the major banks in
London holding and trading eurodollars. The rate is quoted on a term
basis, in addition to overnight money. The usual term structures are 1, 3, 6,
9 and 12 months, and 3 and 5 years. Rates for these terms are quoted on
a spread basis, called the interbank rate. A quote of 11-11 ¼ % means that
a bank will take a deposit at 11% and loan (to a prime customer) at 11 ¼
%. It is from the offer side of this spread that the eurodollar rates derives its
name, LIBOR; the London, Inter-Bank Offered Rate.

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The Bond Market

In order to raise capital, a firm may issue DEBT SECURITIES. Issuing debt
securities is, in effect, taking out a loan, with the buyers of the security
being the lenders. The issuer of a debt security is therefore obligated to
pay the buyers of the security INTEREST according to a predetermined
schedule, and to return the investment PRINCIPAL to the investor at a
specified future date, known as MATURITY DATE.

Creditor Vs Owner

Debt has one general advantage over equity which again serves to
underscore the basic differences between these two forms of financing.
Bond holders are CREDITORS of the issuer, not OWNERS. This means that
creditors are senior to equity holders in the capital structure of a company.
In the event that bankruptcy arises, bond holders must be paid before the
equity holders are compensated. This holds true for the payment of interest
as well as the payment of principal.

For the company, on the other hand, this also means it will be able to raise
the money it requires without adding new shareholders to the rolls.
Bondholders are, for the most part, a silent majority whose interests are
more muted and less politically and organizationally significant than the
interests of actual owners of a company.

Registration

All new security issues must be registered with the Securities and
Exchange Commission (SEC). REGISTRATION involves the filing of financial
statements regarding the firm and other related information. A firm wishing
to issue debt must qualify by possessing adequate financial status within
established guidelines. Issuing debt places constraints on the firm;
because the firm has an obligation to repay creditors, it must maintain the
ability to meet these commitments.

A debt security is usually registered in the name of the owner. The


registered holder's name will appear on the debt certificate and on the

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books of the paying agent. Registered holders receive the interest


payments and any applicable corporate action notifications.

Figuring a Bond’s worth

The Value of a bond is determined by the interest it pays and by what’s


happening in the economy.

An interest rate of a bond never changes, although other interest rates do.
If the bond is paying more interest than is available elsewhere, investors
will be willing to pay more to own it. If the bond is paying less, the reverse
is true. When interest rates drop, the value of existing bonds usually goes
up.

If the bond investors buy at par, and holds the bond to maturity, INFLATION
(or the shrinking value of the currency) is the worst enemy. Generally,
when inflation is up, interest rates go up. Conversely, when inflation is low,
so are interest rates. It’s the change in interest rates that causes bond
prices to move up or down.

For example: If Xcorp. Floats a new issue of bonds offering 6% interest.


You buy some bonds at the full price (par value) of $1000 a bond. Three
years later, interest rates are up. If new bonds costing $1000 are paying
8% interest, no buyer will pay you $1000 for a bond paying 6%. To sell
your bond, you will have to offer it at a DISCOUNT. Consider the reverse
situation, if the interest rates reach only 5% interest rate, you’ll be able to
sell your 6% bonds for more than you paid: the PREMIUM - since buyers will
agree to pay more to get a higher interest rate.

VALUE

The major factors that dictate bond prices and yields are credit quality of
the issuer, market interest rates, length of the bond’s maturity, and supply
and demand.

"PAR" is the term used for the principal value, or the face value of a debt
instrument, and is the amount that will be paid to the holder at maturity.
Debt can be sold at, below, or above par value.

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A security can be issued at a DISCOUNT (below par) when the interest is


scheduled to be paid only at maturity. Full par value is paid to the holder at
maturity; thus, the difference between the purchase price and the maturity
value represents the income earned on the security. This type of
arrangement is common with money market instruments, which have short-
term maturities. A zero-coupon bond is an example of a long-term debt
security issued at a discount.

Securities can also sell at a discount from the current accrued value if
market interest rates have increased since the security was issued. A
security with a stated rate below market value is less attractive to investors;
a discounted price will help to equalize the value of the security in the
marketplace.

Securities selling at a PREMIUM carry a price higher than the current


accrued value of the par. This can happen if market interest rates have
fallen since the security was issued, making the security with the relatively
higher rate more attractive to investors.

LONG TERM DEBT refers to debt that has a maturity of one year or longer.
This type of debt is traded on what is called the CAPITAL MARKET, as a
company or government would issue long term debt to raise capital to
cover expenditures, which are expected to have a long-range payback.

Long term debt instruments may pay interest on a monthly, quarterly,


semiannual, or annual basis, or at some other interval as stated in the
prospectus.

Many types of long term debt securities exist with different interest and
maturity terms. There are also several other ways in which security types
differ. Descriptions of some of the most commonly traded long term
security types follow.

They are three major groups of bond issuers in the United States:
corporations, the U.S. Government and municipalities (state and local
governments).

Analyzing Bond Yield

YIELD is the return on an investment, calculated as a percentage of the


amount invested. Nevertheless, it is not that simple because the ultimate

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proceeds to be returned as principal may be more or less than your original


investment.

COUPON RATE is the fixed-dollar amount the issuer contracts to pay


bondholders until the bond matures, expressed as a percentage of the face
value of the bond.

The CURRENT YIELD is the coupon rate on a bond divided by its current
market price.

Coupon rate (in money terms)


Market price

Bond prices are calculated as a percentage of par and then translated in


money terms. This percentage is usually calculated on a bond of $1000
face or nominal, value. Thus, a bond paying 9% per annum, selling at $98,
has its current yield calculated in the following manner:

$90 = 9.18%
$980

Current yield is limited because it ignores the fundamental nature of bond


risk: time.

YIELD TO MATURITY is a bond’s annualized total return if held to maturity.

discount or premium
coupon +/- years to maturity = YTM
market price + redemption price
2

Yield to maturity is therefore the true yield on a bond, reflecting both


current and future return.

YIELD TO CALL is a bond’s total annualized yield if it is called on its earliest


call date.

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BUYING AND TRADING BONDS

Investors can buy bonds from brokers, banks, or directly from certain
issuers.

Newly issued bonds and those trading in the secondary market are
available from stockbrokers and from some banks. Treasuries, though, are
sold at issue directly to investors without any intermediary - or any
commission.

The Federal Reserve Banks handles transactions in new Treasury issues -


bonds, bills and notes.

How Trading Works?

Most already-issued bonds are traded over-the-counter (OTC). Bond


dealers across the country are connected via electronic display terminals.
A broker buying a bond uses a terminal to find out which dealer is currently
offering the best price and calls the dealer to negotiate.

VALUABLE BOND MARKET TERMS

CALL

In some instances, an issuer of long term debt may wish to repay all of the
outstanding principal on a debt security prior to the scheduled maturity
date, thereby retiring the debt. This is known as a CALL. Calls can be
made on the entire issue, or on only a portion of the issue. The right of the
issuer to do this will be clearly stated in the security's prospectus.

DEFAULT

Sometimes a debt issuer DEFAULTS on an obligation by failing to pay the


scheduled interest or maturity proceeds. In these cases, the owners of a

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firm's debt securities are among the first in line with a claim to any
liquidation of the assets of the company. Shareholders, as owners, are last
in line.

COLLATERAL

COLLATERAL is an asset, owned or controlled by a borrower, which is


pledged to a lender in exchange for a loan. The value of the collateral is
generally equivalent to that of the loan. The lender is given ownership or
liquidation rights to the collateral in case of default by the borrower,
thereby giving the lender some protection against loss. Usually, some type
of collateral is required in order to take out a loan, as a guarantee that the
loan will be repaid. Debt securities are often backed by collateral pledged
by the issuer. This collateral could consist of other securities, real estate,
or some other asset that has a value comparable to that of the loan. When
a security is collateralized, it is referred to as "secured". A security that
does not have collateral behind it is "unsecured".

High-Yield (Junk) Bonds

A JUNK BOND is a bond with a credit rating of BB or lower. CREDIT RATING


services assign lower rating to less credit-worthy issuers whose so-called
junk bonds must pay higher returns to investors for assuming greater risk.

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U.S. Government Securities

The two major categories of government securities are TREASURY and


AGENCY.

TREASURY SECURITIES

TREASURY SECURITIES, or Treasuries are debt obligations of the U.S.


government, issued and guaranteed by the U.S. Department of the
Treasury to finance government expenditures and its budget deficits.

Treasury Bills

T-BILLS are issued for 3, 6, 9 months or 1 year. They are available in


multiples of $1,000, but the minimum investment is ten bills. T-Bills
resemble zero coupon bonds because they are bought at a discount from
their face value, and no regular payments are made to holders. The
interest you earn is the difference between the purchase price and the
$1,000 paid out at maturity.

Treasury Notes

T-NOTES are issued in increments of $1,000 for terms longer than 1 year
but fewer than 10 years. Unlike T-bills, T-notes contain coupons and pay
interest semiannually. The minimum purchase is $5,000 on maturities of
fewer than 5 years and $1,000 on maturities of 5 years or more.

Treasury Bonds

T-BONDS are issued in increments of $1,000 for terms longer than 10


years, and pay interest semiannually. The minimum purchase through the
brokerage firm is $1,000. The 30-year long bond is a widely quoted yield
benchmark for long-term interest rate in the United States.

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Trading

PRIMARY MARKET

Treasury securities are initially offered through the Federal Reserve


System in about 100 auctions held each year. This process involves no
more than 39 authorized primary dealers, mostly large brokerage firms and
commercial banks, who bid for blocks of securities to resell their customers
for profit.

SECONDARY MARKET

Most investors buy Treasury securities from brokers so they can know the
yield prior to purchase and can sell them any time.

AGENCY SECURITIES

AGENCY SECURITIES are debt obligations of certain federally owned or


sponsored government agencies. Most are repackaged mortgages on
homes owned by U.S. citizens. All agency securities are assumed to be
rated AAA.

Ginnie Maes (GNMA)

GINNIE MAES are MORTGAGE bonds issued by the Government National


Mortgage Association (GNMA), an organization that buys FHA and VA
home mortgages from banks and auctions them to financial institutions.
The institutions package the mortgages into “pools” to create securities to
market to investors. The government guarantees both principal and interest
whether or not homeowners meet their mortgage obligations. Ginnie Mae
interest is paid monthly and is subject to federal, state, and local taxation.

Ginnie Maes are the most popular agency securities because they are very
liquid, formally backed by the full faith and credit of the U.S. government,
and pay higher yields than Treasury securities.

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Fannie Maes (FNMA)

FANNIES MAE are mortgage bonds issued by the Federal National Mortgage
Association (FNMA), a federally sponsored, quasi-private corporate that
provides funds to the mortgage market by purchasing convential mortgage
loans from banks and other lenders. Like Ginnie Maes, these loans are
packaged into pools by financial institutions and sold to investors. They
lack official government backing, but they are considered a moral
obligation of the U.S. government. Interest is paid monthly.

Freddie Macs (FHLMC)

FREDDIE MACS are securities issued by the Federal Home Loan Mortgage
Corporation (FHLMC), a federally sponsored corporation that loans money
to member institutions so they may supply conventional mortgage loans at
competitive rates. FHLMC issues both coupon bonds and monthly on the
mortgage securities.

Sallie Maes

SALLIE MAES are packaged student loans purchased from financial


institutions.

Tennessee Valley Authority

TVA is a federally owned corporate agency that was established to develop


the resources of the Tennessee Valley region into one of the largest
electric utility systems in the country.

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Mutual Funds

An OPEN-END investment company--usually known as a mutual fund--is a


company with a portfolio of securities managed in accordance with stated
investment objectives and policies that will buy back shares from investors
whenever the investor wishes to sell.

The redemption price depends upon the value of the company's portfolio at
that time (the "net asset value"). There is no secondary trading market for
the shares of such companies.

CLOSED-END FUNDS resemble stocks in the way they are traded. While
these funds do invest in a variety of securities, they raise money only once,
offer only a fixed number of shares, and are traded on an exchange (hence
the name EXCHANGE-TRADED funds) or over-the-counter. The market price
of a closed-end fund fluctuates in response to investor demand as well as
to changes in the value of its holdings.

MUTUAL FUNDS are investment vehicles that purchase a variety of


securities. They're a few different types:

Stock mutual funds own a variety of stocks.

Bond mutual funds own a variety of bonds.

Money market funds own a diverse group of short-term debt instruments,


making them highly stable, if conservative investments. Unit investment
trusts own a group of stocks or bonds whose identity is preselected and
known by the investor before purchase.

Mutual funds are usually managed by investment specialists who decide


what type and quantity of securities the fund will own, and when to buy and
sell those securities. By purchasing shares of a mutual fund, an investor
buys a portion of all the securities in the fund, rather than actual shares of
those securities.

For instance, if you own one of the million shares issued by a certain
mutual fund, your share is worth approximately 1/1,000,000 of the total
value of the securities that the fund owns. And the price of your share will

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fluctuate in a fairly direct relationship with the price of the securities owned
by the fund. This example is simplified, and does not take into account
certain costs of buying or selling shares, or annual fees of owning the fund.

Some funds specialize in small, aggressive foreign stocks, while others


might buy conservative government bonds; there are funds available for
virtually any type of investor.

Advantages of investing in mutual funds:

• The benefit of professional investment management

• Protection from the price fluctuations of individual stocks or bonds

There are several ways that investors are charged for buying, selling or just
owning mutual funds--the mutual fund checklist might will help you
understand some of the more common terms. But be sure to read the
prospectus that every fund must issue before making any purchase.

Paying out the profits

A mutual fund makes money in two ways : by earning dividends or interest


on its investments and by selling investments that have increased in price.
The fund pays out, or distributes, its profits (minus fees and expenses) to
its own investors.

INCOME DISTRIBUTIONS are from the money the fund earns on its
investments. CAPITAL GAIN DISTRIBUTIONS are the profits from selling
investments. Different funds pay their distributions on different schedules -
from once a day to once a year. Many funds offer investors the option of
reinvesting all or part of their distribution in the fund.

Fund investors pay taxes on the distribution they receive from the fund,
whether the money is reinvested or paid out in cash.

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MUTUAL FUND CHECKLIST

The prospectus provides a detailed roadmap of a fund - covering


everything from its objectives and fees to its portfolio holdings and
manager.

These are some of the terms you may come across in reading about mutual
funds:

Objective

Every fund has its own objective: aggressive growth, income, preservation
of capital, etc. Choose carefully before investing, and make sure the fund is
appropriate for your goals. The discussion of asset allocation will help you
decide what strategy is right for you.

The three-letter abbreviation following the fund name in the newspaper


describes its investment objective.

Performance

A fund's total return is the actual increase or decrease in the value of its
investments, including appreciation and dividends or interest paid.
Research a fund's performance over a 1, 5 and 10 year period, and
compare it with others of its kind. Moreover, remember an old maxim: past
performance is no guarantee of future results!

Loads and fees

A LOAD, either front- or back-end, is a commission paid by the investor for


mutual funds purchased through a full-service brokerage firm. In this
instance, a financial consultant provides advice regarding which funds best
suit an investor's needs and investment objectives. A front-end load is
deducted when shares are purchased; a back-end load is deducted when
you sell your shares, and may be contingent upon selling within a certain
period.

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In a NO-LOAD fund, an investor buys shares directly from the mutual fund
company. While these funds carry no sales charges (and a maximum
0.25% 12b-1 fee--see below), they do charge the management fees and
administrative fees found in load funds.

Finally, be sure that the company through which you invest offers a wide
range of funds, and the flexibility to switch your investment from one fund
to another as your needs or overall economic conditions change.

Fees charged by a fund are described in the prospectus.

MANAGEMENT FEES are annual charges to administer the fund. All funds
charge this fee, though the amount varies from a fraction of one percent to
over two percent.

DISTRIBUTION FEES (12B-1 FEES) cover marketing and advertising expenses,


and sometimes are used to pay bonuses to employees. About half the all
the funds charge them.

REDEMPTION FEES are assessed when shares are sold to discourage


frequent in and out trading. In contrast, a DEFERRED SALE LOAD, a kind of
exit fee, often applies only during a specific period and then disappears.

REINVESTMENT FEES are similar to loads; they are charged when


distributions are reinvested in a fund.

EXCHANGE FEES can apply when money is shifted from one fund to another
within the same mutual fund company.

The Net Asset Value

The fund’s NAV is the dollar value of one share of stock in the fund, the
price a fund pays per share when you sell. It is figured by totaling the
value of all the fund’s holdings and dividing by the number of shares.

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Pension Funds

A PENSION FUND is a fund created to pay the pension benefits of retired


employees of a corporation or other organization. Actuaries are employed
to calculate the amount the company needs to contribute regularly in order
to meet their present payout requirements, and to generate cash to meet
future obligations.

Collectively, pension funds are a strong force in the market due to the large
dollar amounts invested in these funds and the volume of trading.

There are two classifications of pension funds, Defined Benefit Plans and
Defined Contribution Plans.

DEFINED BENEFIT PLANS

Defined benefit plans are the largest group of pension funds and are
known simply as pension funds. They are subject to THE EMPLOYEE
RETIREMENT INCOME SECURITY ACT (ERISA) and are not taxed.

In a defined benefit plan the employer is usually the sole contributor to this
retirement fund hence the word "benefit" in the name. The employer funds
the plan based on projected benefits to be paid, and the employee receives
a predetermined amount upon retirement, typically based on a formula of
the employee's length of service and salary. The contributions are
invested according to the employer's investment strategies, and any profits
or losses resulting from the investments belong to the employer. The
employee does not assume the investment risk as in a defined contribution
plan but does not share in the gains either.

DEFINED CONTRIBUTION PLANS

Defined contribution plans are more commonly termed 401(K) or savings


plans. The plans are subject to the Employee Retirement Income Security
Act (ERISA) and are not taxed.

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In contrast to a defined benefit plan, regular contributions are made to a


defined contribution plan by the employee with a preset matching amount
up to a certain percentage made by the employer. The employee decides
how to allocate these contributions between the available investment
options offered by the employer such as various stock, bond and money
market funds. The employee contributions are pre-tax dollars. The
employee bears all the investment risk and although the money is slated
for retirement, there are specific hardship withdrawals that may be made
prior to retirement based on Internal Revenue Service regulations.

Employers tend to favor defined contribution plans over defined benefit


plans since employee participation is voluntary and therefore the employer
is less liable.

Employees favor defined contribution plans because the amount of


contributions and investment allocations are flexible, and withdrawals are
allowed for specific reasons before retirement.

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Markets for Derivative Securities

THE LANGUAGE OF OPTIONS

Option are the RIGHT to buy or sell a specific item for a preset price during
a specified period of time.

OPTION buyers have rights. Option sellers have obligations. An options


contract gives the option purchaser the right to buy (for a CALL OPTION) or
sell (for a PUT OPTION) the underlying security at a pre-specified price by a
certain date. Sellers of options, on the other hand, are obligated to buy (for
a put option) or sell (for a call option) the UNDERLYING SECURITY (or cash for
index options) if the option is exercised by an option holder, but keeps the
premium paid by the purchaser for the option.

Unlike other investments where the risks may have no limit, options offer a
known risk to buyers. An option buyer absolutely cannot lose more than the
price of the option, the premium. Because the right to buy or sell the
underlying security at a specific price expires on a given date, the option
will expire worthless if the conditions for profitable exercise or sale of the
contract are not met by the expiration date. An uncovered option seller, on
the other hand, faces unlimited risk, because it obligates the seller to either
buy (puts) or sell (calls) the underlying security at the market price. Like
stock, options can be sold or bought after the initial transaction. If an option
buyer or seller changes his investment strategy, the investor can sell or
buy the option contract any time prior to the expiration date.

Option Purchaser's Rights Option Seller's Obligations

Buy Call: right to buy Sell Call: obligation to sell

underlying security underlying security

Buy Put: right to sell Sell Put: obligation to buy

underlying security underlying security

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Options are sold as CONTRACTS. An equity options contract generally


represents 100 shares of the underlying common stock, and is settled with
the delivery of the underlying stock. Index options, however, represent the
underlying companies, and are settled in cash.

The number of shares covered, the expiration date and the strike price or
exercise price are all standardized. The price of the option or the premium
is the primary variable, and generally is dependent on the option's exercise
price relative to the price of the underlying security, the time until
expiration, stock and stock index volatility, dividends and interest rates.

There are two types of options contracts: CALLS and PUTS. Call options
contracts allow the purchaser to buy the underlying security, while the
seller of a call is obligated to sell the underlying security. Put options
contracts allow the purchaser to sell the underlying security, while the
seller of a put is obligated to buy the underlying security. The strike price or
exercise price is the price at which the holder can buy the stock (for call
options) or sell the stock (for put options). Each options contract specifies
an expiration date in addition to the strike price. The expiration date is the
last day an options contract can be exercised. Most options expire on the
Saturday after the third Friday of each expiration month.

There are two types of exercise styles: American and European. These
terms refer to when the options are exercisable and have nothing to do with
the geographic location of the markets in which the options are traded.
American-style options may be exercised by the holder on any business
day up to the expiration date. European-style options may be exercised
only on the last business day before expiration.

Call options are referred to as "IN THE MONEY" when the strike price is below
the market price of the underlying security. Call options are "OUT OF THE
MONEY" when the strike price is above the market price. For put options, the
reverse is true. A put option is "in the money" when the market price of the
underlying security is below the strike price. On the other hand, put options
are "out of the money" when the market price of the underlying is above the
strike price of the option. Options are "AT THE MONEY" when the market
price equals the strike price, a situation which rarely occurs. Therefore,
these options are sometimes referred to as "NEAR THE MONEY".

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FUTURES

Futures contracts are financial assets just like stocks and bonds, but with
some important differences. These differences are what make futures such
an appealing investment for traders. Many tend to think that futures are
complicated to understand and consequently, miss many opportunities by
not trading them. It helps to remember a simple but true formula that
applies to futures trading as surely as it does to trading in stocks, bonds,
real estate, and even old comic books and hockey cards. Money is made if
you "buy low and sell high". With futures, you can sell before you buy, so
our simple rule can also read: Money is made if you "sell high and buy
back low". Keeping this rule in mind puts you on your first step to becoming
a successful trader.commodity futures broker, futures trader, commodities
futures trading, financial and commodity futures markets, paper trading, full
service broker assisted accounts.

What is a Futures Contract?

A standard textbook definition reads something like this:

A commodity futures contract is a firm commitment to deliver or receive a


specific quantity and quality a commodity during a designated month at a
price determined by open auction on a futures exchange.

This sounds more complicated than it actually is. Let's take an example.
Suppose you, being hungry and health conscious, go to a grocery store to
buy bananas. You select some bananas, take them to the cashier (express
lane, of course), and pay for them. The bananas are now yours. This is a
simple transaction which you have probably done many times before. The
exchange of money in return for goods, in this case, bananas, occurs now,
in the present. A futures transaction is just like this with one difference, the
exchange of money for goods is deferred until some time in the future. This
is why futures contracts are regarded as deferred delivery contracts. To
continue with the example, buying banana futures would work something
like this: You go to the grocery store, select the bananas that you want,
and tell the cashier, "I'll buy these bananas tomorrow at the price they are
marked at now." The cashier agrees to sell you the bananas tomorrow.
When you return the following day, you pay for the bananas (at yesterday's
price) and then take them home. Of course, the futures market doesn't
quite work exactly like this, but the idea is the same.commodity futures
broker, futures trader, commodities futures trading, financial and

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The Guide to Financial Industry

commodity futures markets, paper trading, full service broker assisted


accounts.

Buying a Futures is Like Buying on Lay-Away

Have you ever bought clothes, appliances, or furniture on lay-away?


Buying on lay-away is just like buying a futures contract. You agree to buy
merchandise at a particular price sometime in the future, say, in two weeks
when your paycheck comes in. The store agrees to sell the merchandise to
you at that price, and holds it for you for two weeks. You probably have to
put down a small amount of money to guarantee the transaction. In two
weeks, you return with the full balance owing and the merchandise is
yours. (This is when the exchange of goods and money takes place.) If the
price of the item went up during the two week period, do you pay the higher
price? NO. The price you pay was decided when you put the item on lay-
away and is fixed over the holding period. Let's take a closer look at the
similarities of buying on lay-away and buying a futures contract. With a
futures contract, the underlying merchandise is known, just like onlay-
away. For example, you can by a futures contract on gold, lumber, pork
bellies, swiss francs, and many other items. The underlying item or
commodity is described specifically in the contract specifications which, in
turn, are determined by the futures exchange on which it trades. Like lay-
away, the price of a futures transaction is agreed upon initially between
the buyer and seller, and remains fixed over the holding period, or length of
the contract. The small amount of money that you need to deposit for lay-
away is also required for buyers and sellers of a futures contract and is
called margin. Finally, the full price of the commodity must be paid only
upon contract expiration at which point you take delivery, if you bought
futures, or make delivery, if you sold futures, of the underlying commodity.
(Don't worry. You don't have to make or take delivery if you don't want to.
You can instead offset or square your position.) However, while you can
transact on lay-away at almost any department store, transactions in
futures can only be done on futures exchanges. These exchanges are
located primarily in Chicago and New York.commodity futures broker,
futures trader, commodities futures trading, financial and commodity futures
markets, paper trading, full service broker assisted accounts.

Understanding a Futures Price

When you buy a futures contract, the price represents the price at which
you are committed to buying the underlying commodity when the futures

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contract expires. Similarly, when you sell a futures contract, the price
represents the price at which you are committed to selling the underlying
commodity when the futures contract expires. (Not all futures contracts
require physical delivery upon expiration, some are simply settled by cash.)
For example, if you buy a COMEX December gold futures at $380 per
ounce, then you have the obligation to buy 100 ounces of gold at a price of
$380 per ounce in December when the futures expires. (COMEX, which
stands for the Commodities Exchange in New York, is the futures exchange
on which gold futures trade. COMEX has set the quantity of gold underlying
the contract at 100 ounces.) The price of gold futures constantly fluctuates
in response to several factors such as supply and demand, interest rates,
and prices of other precious metals. However, no matter what the price of
gold does after you buy the futures, you will be able to buy gold at the
price of $380 per ounce - you have locked in this purchase price.

Futures prices are often different than cash prices for the same commodity.
You may find in some cases that futures prices are consistently above cash
prices, in which case the futures are said to be trading at a forward
premium, or you may find that futures prices are consistently below cash
prices, in which case the futures are said to be trading at a forward
discount. Whether a futures price is at a forward premium or discount
depends upon cost-of-carry considerations, and these may change over
time. Consequently, a futures price can move, for example, from a forward
discount to a forward premium. This can happen for commodity futures in
which there is a shortage of immediate supply of the underlying
commodity.commodity futures broker, futures trader, commodities futures
trading, financial and commodity futures markets, paper trading, full service
broker assisted accounts.

Futures as an Investment

When you buy a futures, you lock in a purchase price for the underlying
commodity. Similarly, when you sell a futures, you lock in a selling price of
the underlying commodity. How, then, do you make money trading futures?
Well, futures prices move around all of the time, that is, they are volatile.
Prices of agricultural commodities, for example, may rise in response to
unfavorable weather conditions, increased demand by importers, or spread
of plant diseases, and fall in response to abundant supplies or a shift in
consumer preference. If prices go up after you buy a futures contract, then
you earn profit since the futures contract has increased in value. For
example, if you buy one gold futures at $340 per ounce and two weeks
later, the price of gold futures is trading at $350 per ounce, then your
futures contract is now worth $10 per ounce more than when you bought it.

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One futures contract represents 100 ounces of gold, so the total profit on
your gold futures position is $1,000. That's the thrill. Be careful, though.
Gold prices could have fallen instead, in which case you would have
suffered a loss. As a trader, your challenge is to anticipate price
movements correctly and make the appropriate trade. If you expect prices
to rise, you will buy futures and if you expect prices to decline, you will sell
futures. If your expectations turn out to be correct, then you will make
money. If not, you will lose money. Realistically, it is virtually impossible to
be right all of the time. In fact, many traders are wrong more often than
right. BUT, they can still be successful traders.

Offsetting Contracts

As a trader looking to profit from movements in futures prices, you do not


want to actually buy or sell bushels of oats, or bars of gold, or whatever is
the underlying commodity of the contract. So, you will not hold a futures
contract to its expiration. In practice, only a small percentage of futures
contracts traded are actually held to delivery. Instead, you will close or
square your futures position by enterring an equal but opposite trade - for
example, buying if you previously sold or selling if you previously bought.
By offsetting a futures contract, the trader cancels any obligation he has to
make or take delivery of the underlying commodity. The difference between
the price of the futures contract when the trade was initiated and the price
when it is offset is the net gain or loss on the trade. Offsetting must be
done prior to contract expiration,and these differ depending upon the
futures in question. Expiration dates for many futures contracts can be
found in Futures and Options Contract Specifications in Step 4: The
Trader's Handbook.commodity futures broker, futures trader, commodities
futures trading, financial and commodity futures markets, paper trading, full
service broker assisted accounts.

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Sources and Bibliography

State Street, Boston

n Global Investor Services Group - International


Jacques Philippe Marson, Executive Vice President

n Global Pricing Services in Global Financial Technology Services

n State Street Brokerage,


Thomas J. Bryant, Senior Trader

Boston Stock Exchange, Boston

n William G. Morton Jr, Chairman and Chief Executive Officer

n William I. Lee, III, Senior Vice President Customer Service and


Communication

n K. and S. Inc., Specialists Boston Stock Exchange


Kenneth M. King, President

n Ward, Conary and Murphy Inc., Member Boston Stock Exchange


N. Withney Conary

n and especially Kathleen M. Radulki, Sales Associate, who organized my


agenda at the Exchange on the Floor

Books

n The Wall Street Journal Guide to understanding money & investing

n Financial Industry Topics for Custody Services , State Street Bank

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The Guide to Financial Industry

n Invest without stress, Anne Farrelly

n Foundations of financial markets and institutions, Fabozzi, Modigliani, Ferri

n A Guide to the Financial Markets, Charles R. Geisst

n The Super Traders, Secrets & Successes of Wall Street’s Best & Brightest,
Alan Rubenfeld

n Reuters Glossary

Internet Resources

http://www.statestreet.com State Street


http://www.quote.com cotations bancaires
http://www.ml.com merryl lynch investor guide
http://www.finweb.com/ finance info
http://www.networth.galt.com finance info
http://nt-mis-pri01.ssb.com/finind.htm liens avec les banques`(intranet)
http://www.nyse.com/ New York Stock Exchange
http://www.reuters.com reuters
http://www.bloomberg.com/welcome.ht bloomberg
ml
http://www.utexas.edu/world/lecture/ Site des cours financiers (syllabus)
http://www.dowjones.com dowjones
http://www.telerate.com/ dow jones telerate, prices
http://emea.telerate.com/ telerate europe
http://www.amex.com american stock exchange
http://www.nasdaq.com/ nasdaq
http://www.euro.net/innovation/Finance Financial Encyclopedia
_Base/Fin_encyc.html
http://www.stockroom.org/ graphical representation of key
financial indicies and market sectors
http://www.telesph.com telesphere, price provider
http://www.ejv.com/ Bridge Price provider
http://www.stocksmart.com/ beyond the news, and provides the
understanding with which Investors can
secure their future prosperity.
http://www.investorsedge.com/ prices, portfolio analysis
http://www.etrade.com/ first electronic trading service available

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The Guide to Financial Industry

on the web
http://www.wallstreetcity.com/ online financial services for individual
and professional investors.
http://www.dbc.com/ consumer-oriented financial
information.
http://www.pcfn.com/ news, investment databases, research,
on-line trading, and realtime market
quotes using Telesphere's Global
Ticker
http://www.brill.com/expert.html A World Wide Web guide to mutual
fund resources.
http://www.secapl.com/secapl/quoteser market watch, indexes every 3 minutes
ver/mw.html
http://www.muller.com/muni.html Muller price vendor
http://www.jjkenny.com/ J.J.Kenny price vendor
http://www.bourse.be Belgium stock exchange
http://www.bourse-de-paris.fr Bourse de Paris
http://www.sec.gov/consumer/weisktc.h What Every Investor Should Know
tm
http://www.sec.gov/index.html The U.S. Securities and Exchange
Commission
http://www.whitehouse.gov/ white house
http://www.whitehouse.gov/fsbr/esbr.ht Economic Statistics Briefing Room
ml (ESBR)

http://stats.bls.gov/cpihome.htm Consumer Price Index

Prepared by Frederic Goblet 01/13/98 page 96