Series 65 Study Guide Navigation
- Series 65 Study Guide Home
- Module 1 – Business Information and Economic Factors
- Module 2 – Characteristics of Investment Vehicles
- Module 3 – Investment recommendations and strategies for clients
- Module 4 | Guidelines, Laws and Regulations
A. Cash and Cash Equivalents: Types and Characteristics
We begin by looking at cash and cash equivalents.
Here’s the cash equivalents that you should know from this section.
- Checking accounts
- Passbook savings
- Money market accounts
- Money market funds
- CDs insured by a bank
These offer excellent liquidity, something an investor might be looking for if they want to raise cash from their investments quickly.
Let’s look at a few examples of securities that are seen as cash equivalents.
In the world of investing, Treasury securities are one of the most popular investments.
The reason is that many T-bills remain outstanding.
You can also think of Treasury notes and bonds when you hear the term Governments with short term.
These are in their last year before they mature.
Consequently, they are traded similarly to other securities with a year or less before maturity.
Negotiable Certificates of Deposit
This is normally called a CD.
Usually, with these, money is loaned to a bank for a specific period of time, so these deposits are unsecured.
Unsecured means that the bank is not pledging any of its assets as collateral for the loan.
It is possible to sell CDs on the open market before their maturity date.
It is either the original investor or the person who purchased the CD who has this option.
How about the bank that issued the CD?
At maturity, it’s at face value that the CD can be redeemed and they will also receive interest.
When compared to other money market instruments, CDs are the only ones that pay periodic interest and this is usually semiannually.
Negotiable CDs are those that have a face value of $100,000 or more.
CDs maturities can be up to 10 years but when they have one year or less remaining to their maturity date, they are classified as money market instruments.
Here are the three key points to remember about CDs
- They pay interest semi-annually.
- They have up to $250,000 FDIC insurance
- Negotiable CDs have no prepayment penalties
These are typically short-term and unsecured bonds issued by finance corporations (but not only these institutions).
They are mainly used as a tool to raise working capital for specific short-term needs.
If 270 days is the maximum maturity of commercial paper, then the securities won’t need to be registered either at the state or federal level.
Commercial paper is issued at a discount which is different from CDs which are issued at face amount.
If a commercial paper matures, the investor receives the face value without receiving any interest.
Foreign currency markets and Eurodollars
Capital is not only raised in the United States.
Many international money factors can affect both the money markets and businesses in the United States.
Foreign exchange rate changes, the interbank market, euro securities, and the Eurodollar are some examples of these factors.
We begin by looking at the Eurodollar.
Eurodollars are U.S. dollars deposited in foreign banks.
However, they cannot be converted to the currency of the country where they are deposited and thus remain as U.S. dollars.
Time deposits involving Eurodollars are for short-terms mainly, anything from overnight to 180 days.
Banks in foreign countries lend Eurodollars to other banks just as U.S. banks lend federal funds.
Most interest rate calculations for the loaning of Eurodollars are based upon the London Interbank Offered Rate (LIBOR).
Bank deposit accounts
Other than money market securities, there are other investments that are comparable to having cash in the bank as part of an investor’s asset allocation.
Demand deposits are legally referred to as checking accounts.
It is one of the best ways to keep funds available when you need them quickly
Certificates of deposits/Time deposits (CDs)
This is a non-negotiable variant of a CD which cannot just be sold to anyone and is only redeemable at a bank.
$500 is the minimum deposit for one of these and they mature in three to five years usually.
This is what you should remember about these for the exam:
- A time deposit CD might be the best option for an investor who wants to preserve their capital with little risk
- Despite fluctuations in interest rates, insured bank CDs are not affected
- Even though there is a penalty for early withdrawals, these assets remain fairly liquid.
B. Fixed Income Security Types
The money loaned in the process of purchasing bonds of an issuer is called debt capital.
The bond represents the insurer’s indebtedness.
In this case, a contract exists between the lender (or the investor) and the borrower (or the issuer).
As part of the bond’s indenture (also known as a deed of trust), the terms of the loan will be included.
Also stated here is the issuer’s obligation to pay the investor, with payments of a specific amount and on a specific date.
More information is detailed here too including:
- The specific rate of interest is often called the coupon rate
- Collateral pledged that acts as added security
While in this section, we need to discuss what the term debt capital refers to.
The first thing to note is that it is long term debt financing.
This means that it’s a minimum of five years that the loan is made for, but usually, it’s between 20 and 30 years.
When we speak of debt securities, there are three primary issuers:
- The U.S. governments
- Towns, cities, counties, and other political entities connected to states
U.S. government securities
A U.S government bond is the safest investment available to investors and has two types of backing:
- Guarantee from the government, for example, a Treasury issue
- Federal agency moral guarantees
U.S. Treasury Bills
Treasury bills are U.S. government direct short-term debt obligations issued each week and generally called T Bills.
A competitive bidding process is used for these issues and they have a range of maturities including:
- 4 weeks
- 8 weeks
- 13 weeks
- 26 weeks
- 52 weeks (only available once every four weeks)
T-bills pay no interest to investors and are issued at discount from their par value, which means those buying them do not pay the full value for them.
Because investors don’t receive money through interest, when the T-bill matures, they are paid back its full value.
Key points to remember about T-bills include:
- Issued at discount from their par value
- They do not have a stated interest when issued
- They are very liquid
- In calculating the risk-free rate, treasury bills with a maturity of 13 weeks (or 91 days) are used
U.S. Treasury notes
U.S Treasury notes are direct debt obligations with the following characteristics:
- Semi-annual interest payments are made
- It is calculated as a percentage of the par value of the U.S. Treasury note
- Maturity is at par value
- These notes cannot be called
U.S. Treasury bonds
This is another debt obligation offered by the U.S. Treasury.
They have the following characteristics:
- Semi-annual interest payments are made
- It is calculated as a percentage of the par value of the bond
- They have long-term maturities between 10 to 30 years
- Maturity is at par value
Treasury Inflation Protection Securities (TIPS)
Investing in TIPS protects investors against purchasing power risk but how do they operate?
To start, their interest rate is always fixed and every six months, the principal value will be adjusted.
This adjustment is based on the change to the Consumer Price Index which measures inflation.
This adjustment is how TIPS are used to beat purchasing power risk.
In terms of maturity, TIPS offers three options: 5, 10, and 30 years.
Let’s just expand on the semiannual interest rate payments that TIPS investors receive.
The payment will represent the newly adjusted principal plus the fixed interest rate.
Earlier, we mentioned that the principal is adjusted semiannually according to the Consumer Price Index.
Investors will receive higher interest payments if inflation rises, while payments drop when inflation drops.
Because they are adjusted twice per year, when compared to other fixed-rate Treasury notes, it’s at a lower interest rate that TIPS are sold.
Income generated by TIPS isn’t subjected to state or local taxes but federal taxes do apply.
Any increase in the principal is considered as reportable income, however.
These are known as Ginny Mae or GNMA and are issued by a corporation that’s government-owned with full faith and credit backing from the U.S. government.
Two pools are available to investors with these securities.
- Veteran Administration guaranteed mortgages
- FHA-insured mortgages.
GNMAs are also called modified pass-through certificates, but what does the term pass-through have to do with them?
It has to do with homeowners’ mortgage payments because these payments are all pooled together.
These payments are then passed through to the investors in a proportionate manner, hence the term “passed through”.
GNMA payments differ significantly from payments from other securities in two major ways.
Firstly, investors will receive monthly payments since the underlying security is a home mortgage pool.
Secondly, payments made to investors include both principal and interest.
So why is this?
Well, the pooled payments include both principal and interest and so, when the payments are made to investors, they include both these components too.
The yearly portion is determined by the state and takes into account both state and local taxation.
Federal income tax will also play a role.
The last thing to know about GNMAs is that $25,000 is their minimum denomination and they are in increments of $1,000.
U.S. Federal Agency Securities
We have examined some securities that the U.S. Treasury issues directly.
The Series 65 exam includes others that U.S. government agencies issue called GSEs or government-sponsored enterprises.
It is important to note that, while they can raise funds through borrowing, they don’t enjoy the Federal government’s full faith and credit and so debt is not guaranteed.
The exam will focus mainly on mortgage-backed securities.
Despite the fact that they have no direct Treasury support, these are considered to be moral obligations of the United States government.
Because of this, in terms of safety, they are second only to government-issued securities.
Federal National Mortgage Association
This is also known as Fannie Mae.
The Federal National Mortgage Association buys and sells real estate mortgages.
These are guaranteed by the Veterans Administration (VA) or insured by the Federal Housing Administration (FHA).
With these mortgages backing it up, Fannie Mae would then issue bonds that investors can buy at par value and that pay semiannual interest.
Issued in book-entry form, Fannie Mae stock will be publicly traded.
The debt obligation for Fanny Maes is secured by the pool of mortgages.
It’s important to note that because people refinance their mortgage or sell and move, only a very small percentage of these mortgages will end up going full term.
But how does this impact investors?
Well, it means that prepayment risk is a factor with this type of investment.
Well, there is a risk associated with buying into these kinds of securities and that’s prepayment risk.
Those homeowners that are tied to a high interest rate are going to look to refinance should they get the opportunity for a lower rate.
When this happens, the investor will receive the principal paid back to them.
If they look to reinvest the principal, because interest rates have dropped, this will be at a lower rate, hence the prepayment risk.
The major benefit when investing in mortgage-backed securities is their rate of return, which is higher than other debt securities.
These are the risks associated with mortgage-backed securities.
- They can be complicated and not suitable for new investors.
- Prepayment risk is a concern. Mortgages are refinanced when interest rates drop and so, often, this investment won’t reach full maturity.
- Default risk can also be associated with subprime mortgages. In this case, homeowners have difficulty paying their loans back
- Reinvestment risk. When prepayment occurs after interest rates drop, investors will have to reinvest the principal, usually at a rate of interest.
- These investments offer very little liquidity.
Tennessee Valley Authority (TVA).
A U.S. government corporation, this is the country’s largest public power company but the bonds they issue don’t have government backing.
TVA bonds are backed by agency projects and revenue generated by them.
For the exam, know that when issued by a political subdivision or the state, these are commonly referred to as a debt security and are short-term obligations primarily.
Bonds, which are long-term debt, are more likely to be found on the exam, however.
The features they offer are important for investment.
For example, they are less risky and are not taxed at the federal level.
Another unique point is that they can be purchased with added insurance.
This ensures the scheduled payment of interest is always made to the investor and the principal is received once they mature.
There are two basic types of municipal bonds:
- General obligation bonds (GOs)
- Revenue bonds.
General obligation bonds (GOs)
GO bonds are issued with a full faith and credit guarantee of interest and principal payment promptly.
Taxes on all taxable property, which are levied against all bonds issued by cities, counties, and school districts, also offer additional security.
Since they are usually geared towards tax resources, the size of the resources that are taxed is the focal point of an analysis of GO bonds.
GO bonds are considered to be very safe investments from the viewpoint of investment risk.
Bonds are typically tied to enterprises that generate revenue.
These could include toll roads and bridges, airports, college dormitories, and many others, and the revenue produced is used to pay the bonds.
While not as secure, from a yield perspective, these bonds generate higher returns than GO bonds.
To diversify portfolios, foreign bonds are an option many investors look to.
They have many advantages and disadvantages you should know about.
Depending on which foreign bonds you choose, risk can play a role in these investments.
Some, like Gilts, are very safe, while others will be more of an investment risk, for example, those countries with volatile economies and where there isn’t an established financial structure.
Rating agencies call bonds like these junk bonds.
There will also be foreign business entities that issue corporate debt securities and these too have varying risk levels.
Here are some of the advantages provided by foreign bonds.
- Potential for high returns
- Provide portfolio diversification
- Should the dollar drop in value, they provide hedging
Foreign bonds have the following disadvantages:
- Currency risk
- Default risk
- They are less liquid
- Higher trading costs
Eurodollar bonds and Eurobonds
These long-term debt instruments are issued and sold outside the country in which they are denominated.
Let’s look at Eurodollar bonds, which are issued by either a foreign company or government.
These are considered to be foreign bonds because they are sold both outside of the United States and the issuing country.
While it’s called a Eurodollar bond, the interest and principal is not only paid in U.S. dollars but stated in it as well.
Foreign governments, foreign corporations, domestic corporations, and domestic governments are among the entities that can issue Eurobond dollars.
The U.S. government, however, won’t issue them.
They aren’t only a European thing either and are issued across the world.
On the Series 65 exam, you can be asked about the difference between Eurobonds and Eurodollar bonds.
The name of an instrument indicates how interest and principal will be paid.
Eurodollar bonds pay in U.S. dollars while Eurobonds pay in a foreign currency.
Due to their lack of registration with the SEC, these bonds also have lower issuance costs.
While they offer higher yields in general, they are not particularly liquid and there are risks associated with them as well.
Other bond types that might pop up on the exam include the Yankee bond.
This bond is denominated in U.S. dollars and is issued on the U.S. market but by a non-U.S. entity.
They are governed, however, by the Securities Act of 1933.
Maple bonds are the same thing, but they are issued in Canada and denominated in Canadian dollars, while a Matilda bond is issued in Australia.
Additionally, let’s talk about the fixed rate of interest that investors get when they pay for bonds using foreign currencies.
The currency in which it was purchased is how these bonds are paid for which brings currency risk into play, especially when converted back to U.S. dollars.
Payments at maturity can also be affected by this currency risk
To exchange commercial bank loans that defaulted in smaller, less-developed countries, Nicholas Brady, came up with this type of bond in the late 1980s with Mexico the first country to sign the agreement.
These bonds use U.S. dollars as a denomination mostly and maturities are from approximately 10 and 30 years.
Brady bonds come in various forms and can be interest-bearing, zero-coupon, or discounted.
Pledged collateral (normally a U.S. Treasury zero-coupon) ensures that Brady bonds have somewhat of a built-in safety factor too.
Currently, however, trade for these bond types is not that active as most of the countries that were linked to them have matured economically.
They offer excellent liquidity when compared to other energy market debt securities.
A possible exam question related to these bonds is whether they are backed by a U.S. government guarantee and the answer is no.
Issued by corporations, These are paid off before maturity but offer investors a convertible feature.
The privilege to convert is exercisable at the investor’s discretion.
The conversion ratio will be written into the indenture when the bonds are issued and even if issued by the same company, will differ from bond to bond.
The indenture itself won’t give exact numbers but will show how the conversion will be calculated.
It’s interesting to note that most convertible bonds are debentures.
It is not uncommon for an indenture to state only how many shares a bond can be converted into.
For example, if this is 50 shares, the bond has a 50:1 conversion ratio.
Also worth noting is the conversion price.
This is the price per share at which a corporation will sell its stock in exchange for a bond (which is always a $1,000 debt to the corporation, something the current market price cannot affect).
By dividing the par value by the conversion price, you can calculate the number of shares the bond converts into.
You already know that the par value is always $1,000.
So if the conversion price is $40 per share, divide the par value by that and the conversion will then see the investor receive 25 shares for one bond.
While most bonds also include a call provision because if the stock price rises, so will the bond price.
As a result of this call provision, the company can make investors convert their shares in what is known as a forced conversion.
It is in the interest of investors holding the bond if it is called at a lower price than the current market.
In this scenario, the issuer owes nothing but the investor now owns stock instead of the bond.
We will examine the differences between secured debt and unsecured corporate debt here.
It is possible to find both secured and unsecured corporate debt securities with the latter backed by assets of the issuing corporation.
No backing is available for unsecured debt securities.
This means the investor should judge them carefully based on their credit record, overall reputation, and their financial stability.
With both secured and unsecured debt securities, preferred stockholders are always paid dividends before common stockholders.
The physical assets of the corporation back the money borrowed by corporations associated with mortgage bonds.
Essentially, it is much the same as how a homeowner can provide collateral on a mortgage.
Pledged asset values will always be more than the amount borrowed under the bond issue.
If the corporation runs into financial difficulties, its mortgage bondholders will be paid by selling off the assets put up as collateral.
Equipment trust certificates
Equipment trust certificates finance the huge operational assets needed by corporations, for example, aircraft for airlines.
This is how they work.
To begin, a 20% down payment is made with the balance owed financed over a longer period.
Since the equipment wears out with use, part of the loan is always repaid annually but the loan principal that remains will never be higher than the value of the asset.
Once the loan is paid off, the title of the equipment is passed onto the company.
Should repayments not be made, the equipment can be repossessed.
Collateral trust bonds
If corporations looking to borrow money don’t have assets to act as collateral, they can put up their securities instead but they will need to be put into a trust.
These securities can come from the corporation or include any other they own.
The only proviso is that they can be liquidated quickly.
Bond ratings will be higher if they choose to use high-quality securities in the trust.
Debentures are unsecured debt obligations backed by the creditworthiness of the company issuing them.
When a debenture is made, it’s a promise by the company that the principal invested will be paid out on the due date.
The investor will receive recurring interest payments too.
Debentures remain binding, even though they are not secured by any assets.
Companies with high credit standings can provide investors with debentures that are less risky than those issued by other issuers with low credit ratings.
This bond guarantees that the corporate entity (but not the issuer) will pay interest, or the principal and the interest.
You can judge the value of this bond by looking at the strength of the company making the guarantee.
Senior and subordinated
In terms of a security, senior refers to the relative priority of claims.
Secured bonds have a senior claim over debentures and other unsecured debt too.
The term can be applied to securities as well.
For example, preferred stock has seniority over common stock when investors make claims.
What about the term subordinated?
Well, it generally means secondary or lower rank is and used with debentures and it means that other creditor claims come before it.
Debentures are senior to stockholder claims, however.
C. Fixed Income Securities: Characteristics and Valuation Factors
In this section, we look at characteristics and valuation factors attached to fixed income securities.
To begin, we look at how bond market prices are quoted by looking at a range of bonds.
In these examples, the par value is always $1,000.
Pricing examples for municipal and corporate bonds
- Always quoted at a percentage of their par value with 100%=$1,000
- Bond points are the equivalent of $10.
- Fractions always appear in eighths and the value of an eighth is $1.25
Pricing examples for government bonds
- Always quoted at a percentage of their par value
- Bond points are the equivalent of $10.
- These bonds use decimals and 0.1 is 1/32 of $10 which is $0.3125.
So if a government bond is quoted at 90.8 (also shown as 90.08) it will be equal to $902.50
When bonds are listed, it will generally be shown like this:
- XYZ 6s30 @104
Here’s a breakdown of what that all means.
- XYZ = name of the issuer
- 6 = coupon rate
- 30 = maturity date (2030 in the example shown)
- 104 = bond price of $1,040
There is no need to worry about the “s” as it only decouples the maturity date from the coupon amount.
To determine the overall safety of a bond, broker-dealers and investors turn to bond ratings.
For debt securities, Standard and Poor’s and Moody’s are the go-to ratings agencies.
These are important to know for the exam.
Standard and Poor’s rating system:
- AAA – Highest quality bonds
- AA – Debt obligations of high quality
- A – While they may be affected by other influences, these bonds are considered to be more than capable of paying both principal and high interest.
- BBB – The capacity to pay interest and principal on these bonds is considered by S&P to be adequate. Changing circumstances as well as unfavorable economic conditions can make them more vulnerable.
- BB – With limited positive investment characteristics, these bonds are of lower medium grade
- B – When exposed to unfavorable conditions, these speculative bonds are filled with major risk and uncertainty
- CCC – These bonds may be defaulted and are in poor standing
- C – No interest is being paid on these income bonds
- D – Bonds with this S&P rating are in default.
As part of its bond ratings, S&P will also use a + and a – to indicate relative strength, so a BBB+ is rated higher than BBB-.
Moody’s bond rating system:
- Aaa – Highest quality bonds
- Aa – High-quality bonds
- A – While their security of principal and interest is adequate currently, Moody’s think that in the future, they may be impaired
- Baa – These bonds are considered to be neither poorly secured nor very well protected. They are medium-grade bonds.
- Ba – The future of these bonds is not considered to be well assured by Moody’s. As far as quality goes, they are seen as speculative.
- B – These bonds are seen as not having any characteristics that would make them a suitable investment target
- Caa – These bonds may be defaulted and are considered by Moody’s to be in poor standing
- Ca – These bonds are often in default and considered by Moody’s to be speculative
- C – These are the lowest rated bonds in the Moody’s system. They are not considered to offer any investment value at all.
Bonds in the AA to B category are further classified by Moody’s.
They are assigned added numbers with 1 being high, 2 being middle and 3 being low.
Bonds rated in the top four categories as seen in both examples above are considered to be investment-grade debt.
These are the bonds that insurance companies, banks, and fiduciaries look for when buying bonds.
A massive advantage also is the liquidity these bonds offer, which is higher than those bonds with lower ratings.
While these bonds can result in high yields, they are a lower grade (or junk bonds) and are far riskier.
They are BB and lower on Standard and Poor or Ba and lower on Moody’s.
Other than the obvious risk, when the economy slows down, this can cause an erosion in the price of these bonds.
This will also be a factor when the creditworthiness of the bond issuer is questioned.
These bonds are only for sophisticated investors.
Tax equivalent yield
An important factor to consider when analyzing debt securities is their taxability.
Interest earned on corporate bonds is taxed as ordinary income and it’s for both state and federal returns.
It’s only at the federal level that treasury debt interest will be taxed.
A distinguishing factor for municipal bonds, when compared to others, is that federal income tax is not paid on them.
In some cases, it can be free of state taxes if the issuer and investor are in the same state.
There’s another way to work out tax-equivalent yield (TEY).
You need to know two pieces of information:
- The municipal bond’s coupon
- The investor’s tax bracket
Then you divide the coupon by (100 – tax bracket).
If you have a municipal bond’s coupon as well as the tax bracket of the investor, you can then divide the coupon by (100 – tax bracket).
Principal debt repayment
Investors want regular income from their investment and their principal returned.
In some cases, the issuer may pay off the debt before it matures.
Because these bonds have no coupon rate, they are issued at discount.
Since they don’t pay interest, at maturity, the investor doesn’t receive the discounted price they paid but instead, the full par value of the bond.
Here are some key points about zero-coupon bonds:
- They are always issued at a discount
- No interest payments mean that these bonds don’t have reinvestment risk
- They are more volatile than similarly rated bonds
- Investors will need to complete a Form 1099-OID and send it to the IRS even though they don’t receive periodic repayments.
- The zero-coupon bond is a good investment if you have a specific goal in mind, such as funding a college education or retirement.
They do have credit risks associated with them.
An investor who purchases a 20-year bond receives nothing until the maturity date, and the issuer may have gone bankrupt by that point.
Price volatility is also a factor as a result that they provide no current return and are sold at discount.
A callable bond can be redeemed by the issuer before it has reached maturity and this means the investor is paid the principal.
This occurs when there has been a significant drop in interest rates and the issuer wants to take advantage of that by issuing a new bond at a lower rate.
If bond prices have dropped and interest rates have risen, the issuer will never consider recalling their bonds.
Now let’s talk about call protection.
Before purchasing a bond, determine the length of the call protection offered.
This allows investors to find out how long it will take for an issuer to exercise its call provision.
So a bond that has just been issued might have 10-year call protection and so a decade must pass before the issuer can recall it.
The best protection for an investor is a noncallable bond.
Price parity computations
Here, we look at convertible securities and how their price parity is calculated.
Price parity is related to both convertible and convertible preferred bonds and how they move in comparison to common stock.
When we talk about the word parity, we think of something being equal with something else.
Investors who hold convertible bonds always have two options.
- They can convert it to common stock
- They can hold onto it
If they opt to convert, that conversion is in parity because the value of the common stock received and the bond originally held, is equal.
In reality, the parity price is a theoretical concept since you are looking for a price that would make the bond and stock equal.
The market price of convertible securities, whether they are preferred stock or bonds, is always above their parity price.
The advantages and disadvantages of convertible securities
Convertible securities afford investors various advantages.
They provide downside protection.
An investor is a creditor of the company in which they have invested.
If the stock value declines or if the business of the company does not prosper as expected, this is very true.
As bondholders, investors are guaranteed income as long as the company does not go bankrupt.
Convertible stock has a lower interest rate than non-convertible stock when we compare them and that’s because they can be converted.
Upon a decline in the underlying stock to the point where it is no longer worth converting, the bond will sell based solely on its yield, much like any other debt security.
They provide upside potential.
If a company does well, its underlying stock will increase in value.
Convertible bonds are linked to the increase in common stock in this scenario.
That’s because the bondholder has the right to convert at any time to stock.
This means an upside potential for common stockholders.
Compared with non-convertible debt, convertible bonds will receive a lower interest rate,
So before an investor is ready to convert a bond, it may be called away.
This is the only major disadvantage of this type of bond.
Dividends and stock splits may affect convertible securities and bring about potential dilution.
Computing bond yields
Comparing current yield with yield to maturity and yield to call are examples that you could come across.
These are the computations you should understand:
- Current yield
- Yield to maturity
- Yield to call
Look for examples of these, understand how they work, and practice a few of your own.
The relationship between price/yield
We know that bond prices are affected by rising and falling interest rates.
Bond prices fall when rates rise and vice versa.
But what role does that play on the market?
If you compare a newly issued bond to older bonds already on the market, it pays a higher interest rate, which makes it more attractive to investors as they would get greater returns.
The market price of a bond is influenced by its duration.
Duration is a very specific financial term and it’s linked to interest rate changes.
Essentially, it measures debt security sensitivity when these changes take place.
A lengthy duration, the greater the movement in market prices and vice versa.
There are two main elements here to understand.
These are the invested principal and the cash flow generated (or interest payments).
In other words, duration refers to the amount of time it takes for the interest payments to produce the invested principal.
To compute duration, there are two important aspects: the maturity date and the interest rate.
Bonds that pay higher coupon rates will have a shorter duration and those that pay lower coupon rates even if the bonds have different dates on which they mature.
And if the coupon rates are the same?
Then the bond with the shorter duration matures first, followed by the bond with the longer duration.
Here are the key points you should understand when it comes to duration.
- Short duration is because of a high coupon rate. A long duration is because of a low coupon rate
- The further a bond is from maturity, the longer the duration
- In relation to coupon bonds, the maturity is always less in comparison to its maturity
- In relation to zero-coupon bonds, the maturity and duration are always equal
- The longer the bond’s duration, the greater the impact of a 1% change in interest.
The manager of a bond portfolio will look to increase the average duration if they expect interest rates to fall and as a result, bond prices will rise.
Likewise, the opposite is also true.
Convexity is a measurement used to plot bond prices as interest rates fluctuate.
It’s essentially a measurement of the resulting curve when this is carried out.
It’s a far more accurate representation of what duration provides when bond prices fluctuate because of interest rate changes, especially if those changes are substantial.
For the exam, you need to remember these three critical points with regard to convexity.
- While duration is a straight-line or linear measurement, convexity will follow a curve.
- The bond with the higher convexity shows when yields drop, the price goes up. The decrease is smaller, however, when yields rise, which is ideally what you want to occur.
- When two bonds have equal duration, the one showing higher convexity provides more protection when interest rates change.
D. Equity Securities
Common and preferred stock are examples of equity securities, but there are many more.
Let’s look a bit more at the types and characteristics of these types of securities.
Equity securities: Types and characteristics
In terms of what a security is, it can be either an ownership stake or a debt stake.
An investor acquires ownership stakes in a company when he/she buys stocks in the company.
A debt stake sees the investor making a loan to the issuer when they purchase their bonds.
In the future, the investor will receive income from the interest on that loan and it’s paid off at a future date.
In contrast to the purchase of stocks, there is no ownership of a company in a debt stake.
One of the most popular securities for investors is common stock and we’re going to study this in more detail.
It is equity (or ownership) in a company that an investor buys when they make a common stock purchase.
Many corporations make common stock available to investors to purchase and use this as a way to raise capital to fund projects.
If an investor buys common stock, they become a shareholder in that corporation, even if they just own one share.
This means the businesses’ assets, minus any liabilities it has is something that they can lay claim to.
This is in the form of earnings and they are allowed a portion based on the stock amount held which they receive in paid dividends.
They also have voting rights too, based on the amount of stock they own and this allows an indirect say in how the company is managed.
Stock issues are broken down into common stock, which we’ve mentioned, and preferred stock.
Unless told otherwise, always assume the stock mentioned in an exam question is common stock.
With preferred stock, there isn’t the same opportunity for appreciation as there is with common stock but it still provides the chance of ownership in a corporation and there are no voting rights.
There are other advantages, however, most notably, priority claim.
Preferred stockholders will always receive payment first when dividends are paid out.
In the event of the company going under, they can lay claim to any assets to recoup their losses before common stockholders can.
Preferred stock brings with it an ownership class of the issuing corporation.
For this reason, it’s considered an equity security.
It does have elements to it that are similar to that of a debt security.
While the rate of return for common stock will vary, with preferred stock, it is fixed.
This leads to interest rate risk when rates change.
Preferred stock types
Let’s look at the types of preferred stock you should know.
Straight preferred stock
This is also called noncumulative preferred stock.
There aren’t any extra features, over and above the stated dividend payment.
Investors won’t receive dividends at a later date if a corporation decides to miss a payment.
Cumulative preferred stock
Unlike straight preferred stock, investors holding cumulative preferred stock will receive any missed dividends at a later date as they accrue.
So, until the board of directors decides to pay them, unpaid dividends will appear on the corporation’s financial statements.
When dividends are paid following a period of nonpayment, investors holding this type of preferred stock then receive the current dividend payout as well as those that have accrued.
When this occurs, they are said to have received dividends in arrears.
When investors expect a steady income from the stock they purchase, this is often one of the best options to suggest to them.
Callable preferred stock
This is known as redeemable preferred stock.
With this type of stock, the corporation can buy the stock back from the investor, should they choose to sell it to them.
This isn’t an ongoing thing, however.
There is a certain time frame that callable preferred stock can be bought back by the issuer and there will be a stated price that they will pay for it.
When the cost of money has decreased, corporations can act by calling back stock.
This means they can use a lower fixed dividend obligation to replace one that had a higher dividend payout rate.
Refinancing a mortgage is a perfect example of this concept.
The dividend payments will cease on the call date if a corporation chooses to buy back its stock.
And the investor?
What do they receive?
Well, when the stock is called, corporations can pay investors a premium that is above the par value of the stock
Nevertheless, this can cause problems.
Due to favorable market conditions at the time, the shares might have been issued to the investor during a time when high dividend rates were being paid.
When the new money cost falls, the corporation will probably call the stock.
Yes, the investor might get their money back as well as a premium but now have to reinvest it.
Finding an investment with the same rate of return could prove difficult because of lower interest rates.
This means dividends paid out will be lower.
This is an excellent example of reinvestment risk.
The inconvenience of callable stock and the added risk that it will be called can be compensated for thanks to the call price.
This is especially true if it is at a premium over par.
Corporations also understand the importance of making callable stock attractive to investors.
They do this by ensuring the stock pays a higher dividend.
A convertible preferred stock allows investors to exchange it when they wish to.
This is an exchange that converts this stock type into common shares, but a fixed number thereof.
This affects the dividend too and for this stock type, a lower stated dividend when compared with nonconvertible preferred stock, is in play.
This is because the conversion of preferred stock into common stock can result in greater capital gains.
There is a link between common stock and convertible preferred stock.
If the price of common stock changes, so will that of convertible preferred stock.
This is a preferred stock that includes adjustable dividend rates when issued.
Dividends paid are therefore related to other interest rate benchmarks, like Treasury bills.
The dividends paid can be adjusted often, for example, with some stock, it is each quarter.
The stock price, however, generally remains relatively stable.
For investors looking to generate a fixed income, adjustable-rate preferred stock is not a good option.
That’s all the different types of preferred stock that you should remember for the exam.
If you aren’t told an exact type, assume that it’s straight preferred.
Common stock: Risks and benefits
Common stock provides no guarantee that investments will lead to the returns expected.
The reasons to include common stock in a client’s portfolio include:
- Potential for capital appreciation
- Their dividends generate income
- They act as an inflation hedge
Here are the risks associated with common stock:
- Market risk
- Business risk
- Low priority at dissolution
The concept of market risk refers to economic conditions that negatively affect the market and they will cause the value of stock to drop.
Stock prices are not stable.
As buyers and sellers act on the market, the price of all stock, including common stock, will fluctuate.
However, investors can never be sure that their stock investment will return what they invested.
This is especially true during times of economic downturn.
Business risk is associated specifically with the company in which the investor holds stock.
Poor management decisions that lead to a drop in the price of a stock is a perfect example of this.
This could result in a loss on an investor’s investment.
Low priority at dissolution
Stockholders are paid out in specific order when a company they have invested in goes bankrupt.
The last to get paid are common stockholders.
They do receive residual rights, however, and this means that they can recoup their losses because they have rights to the company assets on dissolution thereof.
Preferred stock: Risk and benefits
What are the benefits of adding preferred stock to a client’s portfolio?
Well, the biggest advantage they provide is priority over common stock and preferred stock dividends are always paid out first.
That’s perfect for those investors who want a guaranteed fixed income, especially in the case of cumulative preferred stock.
Convertible preferred stock provides unique advantages as well.
These are linked to potential appreciation but also when stock is turned into shares.
Although it is a fixed-income investment, it is different from other debt securities.
Preferred stock does not have a preset maturity date, unlike bonds which makes it a perpetual security with no redemption date.
What about the risks?
Market risk is a concern for preferred stock, especially in economic downturns.
This could lead to a drop in price and the company the investor owns stock in might not pay regular dividends anymore until the economy picks up.
Two other risks associated with preferred stock are interest rate risk and purchasing power risk.
This could lead to the investor’s principal being lost if the company goes under.
Employee stock options
Employees of a company sometimes have the option to purchase stock from that company.
Let’s elaborate on that a little:
If they do have the options to purchase company stock an employee can:
- Purchase a certain number of shares only
- Only purchase them for a period specified by their employer
Unlike qualified retirement plans, employee stock option plans are not subject to non-discrimination requirements.
If employees can buy publicly traded stock, the strike price is always the current market price of the stock.
A vesting period also comes into play when buying stock and this relates to how long the employee has worked for the company.
New employees don’t get the chance to buy stock, for example.
Those that have been employed for the vesting period, which is defined by the company, can buy stock.
There’s numerous reasons why an employee would buy company stock.
The one that’s probably the best, however, is the fact that they are given the chance to purchase the stock at a discount, more often than not.
Obviously, however, they aren’t allowed to buy millions of shares, and we’ve already seen that what they can buy is an amount already determined by their company.
Stock programs for employees will come in two types: Nonqualified stock options (NSOs) and incentive stock options (ISOs).
These both have distinct rules that govern them and cannot be bought into by investors that are not employees of the company.
Nonqualified stock options (NSOs)
Between NSOs and ISOs, this is the employee stock option that’s most prominent.
And it’s for employees of the company and other parties that are connected to it as well.
This can include anything from a board member to a supplier of the company.
What is the process of NSOs?
To start, they are seen as a form of compensation to employees and on their tax returns, they are indicated as wages.
It is only when they are exercised, however.
The only part included is the variance – called the bargain element – between the current market price of the stock and its strike price.
For tax purposes, this won’t be treated as capital gains at all, only as ordinary income.
There’s benefits for the company as well, as they receive a tax deduction for the variance too and it’s recorded as a salary expense.
Lastly, payroll taxes will be applied to the spread between the strike and market price as it’s considered to be a salary.
Incentive stock options (ISOs)
Generally, there are no tax consequences for employers with ISOs.
They also are more advantageous to employees than NSOs, but only when used effectively.
We learned earlier that NSOs, when taxed, are done so as ordinary income and there’s nothing to do with capital gains.
For ISOs, however, the profits that an employee might make from them are long-term capital gains and must be reported as such but there are certain conditions in place.
For example, when an ISO is exercised the bought stock:
- Must be held for a period of two years or longer after the grant date
- Must be held for one year after the exercise date
If the limits above are exceeded, then ISOs are taxed in the same way that NSOs are.
There’s a period of time in which an ISO must be exercised as well and that’s within 10 years.
The difference in the strike price and the market value at purchase is considered a preference item if an ISO is exercised.
Here’s what you should remember about ISOs:
- There is no income recognized when the option is granted
- Taxes are not due when the option is exercised, only when the stock is sold are they due, but with the time constraints explained above.
- The difference between the FMV and the option price is added on the date of exercise for the purpose of alternative minimum tax
Stocks are freely transferable and can be gifted or sold to anyone at any time after they have been bought.
This is the general rule but there are some exceptions.
For example, it won’t apply to the following:
- Restricted stock
- Stock owned by control persons
Securities don’t have to be registered when sold as part of a private placement.
Securities such as these must be held for a certain amount of time before retail investors can sell them, this means that once bought, immediate resale isn’t an option and usually, six months will have to pass.
The term given to securities in these types of situations are restricted securities.
There are volume restrictions associated with these securities too, but only when the retail investor is affiliated with the issuer in some manner.
Another example of a restricted security is control stock which is stock held by the control person associated with the company.
Below are affiliates seen as control persons:
- Corporate directors and their direct family
- An officer of the company and their direct family
- A large stockholder and their direct family
- Anyone that owns 10% or more of the voting stock of a corporation
Regulations stipulate that any time that control stock is both purchased or sold, those parties carrying out the transaction must inform the SEC.
When it comes to the sale of control and restricted stock, the SEC covers this in the Securities Act of 1933 and Rule 144 specifically.
Here, you will find the ways in which the sale of these two stock types will need to be reported.
American depositary receipts (ADRs)
An ADR allows foreign stocks to be traded on U.S. markets in dollars and using the English language with dividends paid in dollars as well.
ADRs deal with negotiable securities and give investors access to shares from foreign corporations.
ADRs can be bought and sold just like domestic stocks and they have exactly the same rights you’d find with common stock.
They pay dividends as well, although those that invest in them have another option available to them.
ADRs can be exchanged for foreign shares if the investor requests it but the benefits that are associated with them stop as soon as the conversion is carried out.
Foreign market investment
Foreign markets are categorized as either emerging or developed markets.
These are found in less developed foreign countries and are linked to the following characteristics:
- Low levels of income, measured by the GDP
- Low levels of equity capitalization
- Liquidity of the market is uncertain
- There could be restrictions regarding currency conversion
- Markets are very volatile
- There is the prospect for both economic development and growth
- Foreign investors will pay high commissions and taxes
- There are restrictions on converting foreign currency
- Foreign ownership restrictions
- Lower regulatory standards lead to a lack of transparency
These are tricky places to invest but can provide investors with rapid growth rates.
These markets are found in countries with highly developed economies and offer more stability while having the following characteristics:
- Capitalization levels are high
- Low rates of commission
- Limited currency conversion restriction (and often none)
- Highly liquid markets
- Regulators ensure that market transparency is high
Here’s the reasons why you might suggest investing in foreign markets to a client:
- They provide an excellent diversification option
- Foreign securities often perform better than domestic ones
- High correlations don’t exist between domestic and foreign securities. This lowers overall risk for an investment portfolio.
There are risks associated with foreign markets including:
- Country risk
- Currency risk
- Tax and fees being withheld
First, we have country risk.
This pertains to the country in which an investor purchased securities.
Examples of country risk are linked mainly to an unstable political environment that could result in profits or dividends not being received or capital gains taken away.
Country risk also could include constantly changing interest rate levels, privatization and inflations.
Second, investors can be exposed to currency risk due to exchange controls.
Buying foreign market shares can be influenced by currency movement.
Currency conversion could also have various stipulations in place.
The last risk is fees and taxes being withheld.
Parts of the dividend earned can be held back as a way to pay the taxes linked to foreign investments.
This can happen to capital gains as well.
Furthermore, commissions are often higher and extra fees and taxes are added to foreign securities that are not found with domestic ones.
E. Equity securities and their basic features
Equity securities have various features that you should understand.
Capital gains (growth)
A rise in the market price of the securities results in capital appreciation and historically, this is above the inflation rate and therefore, acts as a hedge.
Of course, stock prices can drop, but most investors are in it for the long term and will benefit from capital appreciation.
Securities generate income in the form of dividends and that’s why people invest in them.
These dividends can change too, so when the stock profitability increases, so do they.
Income isn’t always constant, however, because there is no obligation for a company to pay dividends.
Dividends could also be passed on to investors in other forms, like stock dividends.
Here we also have to mention realized and unrealized gains.
You have an unrealized gain of $1,000 if you bought 100 shares at $10 per share, which are now worth $20 per share.
As soon as you sell the stock and make that $1,000 profit, it’s become a realized gain.
At this point, you will be taxed.
An investor has certain rights as a common stockholder.
This includes voting rights as to who sits on the board of directors.
Other rights include the ability to transfer stock without needing permission.
So they can pass it on as a gift.
They also can request relevant financial statements at any time.
Common stockholders also have a preemptive right to maintain ownership in the corporation in the form of a proportionate share.
In contrast, preferred stockholders do not have this right.
A critical aspect of equity ownership, whether it is common stock or preferred stock, is limited liability.
In the event that the corporation becomes bankrupt, at no point will any personal assets of the stockholders be at risk.
However, they may lose their investment.
In the event a sole proprietorship or partnership goes bankrupt and does not pay off all its obligations, the personal assets of the owner are at risk.
F. Determining the Value of Equity Securities
Numerous methods are available to determine the value of equity securities but the most common are fundamental analysis and technical analysis.
In fundamental analysis and technical analysis, however, you have the two most common
Analysts are also divided into these two groups.
This considers an individual company, the industry in which it operates, and economic conditions.
Based on that, a study is carried out on the business prospects of the company.
This includes not only looking at the financials, but also the leadership.
By incorporating this information along with various analysis models, the value of the common stock price is analyzed.
This model determines the value of stock using current or anticipated dividends.
This only works with companies that pay out dividends regularly, like large, well-established organizations.
There are two types of dividend models used and we will start with the dividend discount model.
Here stock’s current value is tied to the future dividends and the present value thereof.
It operates on the basis that these two elements should be equal.
Even though there are several methods that can be used here, the concept remains the same, including assuming that dividends are constant or variable.
To begin, take the dividends the stock will pay the investor which are the future returns expected.
In order to calculate the present value, you must then discount that amount.
This is just necessary to understand, you won’t be tested on the formula during the exam.
Also know that sometimes, preferred stock can be valued using this model too.
Dividend growth model
The model assumes that dividends grow at a constant rate.
When it comes to making future growth predictions, this model is often used in conjunction with other analytical forecasting tools.
Don’t worry about the formula for this model, it won’t appear on the exam.
As long as analysts forecast dividend growth, the computed value will be higher.
What is the difference between technical and fundamental analysis?
Unlike fundamental analysis which studies the company, technical analysis looks at the market.
Technical analysis can be used to determine if investing in a particular stock is prudent by measuring the market risk.
This means looking at stock price trends and then making a prediction on them over a near-term period (four to six weeks).
The stock price trends that are analyzed include current price trends and how they relate to prior trends.
The future price movement can be predicted using charts of price movements as well as stock volume to measure these trends.
This also reduces timing risk.
Looking at the history of stock prices can help analysts try to predict where it might be headed in the future.
This is achieved with a trendline and it’s used to make near future predictions on stock price as well as volume
Support and resistance
Many analysts carry out their function using charts.
These can be used to study different indicators and in doing so, they can learn more about a stock.
There are two important indicators that charts do provide information about: support levels and resistance levels.
The support level is where the stock price bottoms out at.
This is due to an imbalance that occurs and is based on the buyer and seller numbers linked to the stock.
However, what is the cause of the imbalance?
Simply put, more investors are looking to buy stock than there are those selling it.
When this happens, the stock price will begin to rise.
The opposite of the situation above is resistance level.
Here, the stock price has reached a ceiling and there are more sellers than buyers.
You need to understand what a breakout is as well.
A price movement penetrates a support or resistance level is when this will take place.
In this scenario, analysts suggest either a new support or resistance level is reached in the stock price and the stock price will soon move in the direction of the breakout.
In the event that a breakout moves through a resistance level, there may be a good buying opportunity.
Opportunities exist for sellers (particularly those selling short) too.
This can happen when they can anticipate a breakout through a support level.
Analysts use moving averages to minimize stock price volatility.
Moving averages attempt to modify stock price fluctuations by looking to find a smoothed trend and in doing so, ensure minimal overall distortions.
Technical market theories
Here are some of the technical market theories used to determine market trends.
Short interest theory
This theory looks at the number of shares sold short.
Because short positions must eventually be repurchased, short interest will show a mandatory demand and therefore there is the establishment of a support level for stock prices.
Despite its illogicality, with a high short interest, this is seen as a bullish indicator and with a low short interest, it’s a bearish indicator.
Odd-lot trading is carried out by smaller investors with 100 shares or less involved in these transactions.
Generally, small investors choose the wrong times to buy and sell shares, or so this theory holds.
Accordingly, odd-lot analysts are bearish when these investors are buying and bullish when they are selling.
Market breadth on a trading day is measured by how many issues have closed up or down.
The number of advances and declines can be used to gauge the relative strength of the market.
If the market closes higher, using the advance/decline theory, it is seen as bearish if declines outnumber advances by a large amount.
The market is considered bullish when the number of advances is significantly greater than the number of declines.
A technical analyst using this theory will plot advances and declines each day and produce a graph that shows an advance/decline line.
Discounted cash flow
DCF allows you to estimate the value of an investment by looking at fixed-income securities’ future expected free cash flow.
This is achieved by discounting the interest payments and what the principal will return in the future (the free cash flow) to get the present value.
In simpler terms, it’s looking at a certain future period and talking about all the money the security receives.
This is then adjusted using the time value of money.
There are three parameters that allow you to work out the future cash flow of a security:
- The principal amount invested
- The coupon rate of the bond
- The amount of interest payments that will be carried out
The higher a DCF value is, the better for a potential investment.
Understanding the concept of DCF is all you need for the exam, there are no calculations.
G. Pooled Investment Types
Pool investments include the following:
- Mutual funds
- Exchange-traded funds (ETFs)
- Variable annuities and variable life insurance
- Real statement investment trusts (REITs)
One of the reasons these are called pooled investments is that numerous investors contribute to a massive pool of funds.
To start, we must explore how these pools are governed.
Investment company types
There are three we will cover:
- Face-amount certificate companies
- Management investment companies
- Unit investment trusts
Face-amount certificate companies
The thing that stands out here is the face-amount certificate but what does that refer to?
Acting as a contract, this assures that the investor will receive a stated or fixed amount at a set date in the future, which will be paid out by the issuer
Management investment companies
Probably the most familiar of investment companies, these have a portfolio of securities that will be managed actively at all times to reach a specific objective.
Management investment companies can be either open-end or closed-end.
Investment company regulations
As part of the Investment Company Act, these companies must adhere to many rules and regulations.
Take a look at some of these regulations that are the exam often covers.
First, the board of directors.
When it comes to the board of directors only 60% of them can meet the definition of an interested person.
The other 40% have to come from outside the company and have no connection with it at all.
These are usually company directors, academics or community leaders.
Second is prohibited activities.
- Purchase securities on margin
- Joint basis account trading
- Short selling securities
- Purchase at least 3% of the outstanding voting securities of another investment company
While there are some exceptions to these, for the Series 65 exam, you won’t have to worry about that.
Third is changes in investment policy.
If any underlying changes are to be made to an investment policy of these companies, an outstanding voting stock vote will need to take place and a majority secured.
These changes include:
- Subclassification changes: Or changing from an open-end to closed-end company, for example.
- Abandoning any registration statement policies
- Changing how they do business and stopping being an investment company
Fourth is the size of the investment company.
Only companies with a specified net value ($100,000 and above) can make a public offering of securities.
Fifth is underwriting contract and investment advisory.
Shareholders will have to vote in the majority before any contracts are entered into with principal underwriters and investment advisers.
Renewal of these contracts needs the new terms approved by a majority vote of directors, with none affiliated with the adviser or underwriter.
Sixth is transactions of underwriters and certain affiliated persons.
Associated underwriters or investment companies working with the investment company are subject to restrictions, including:
- Securities owned then cannot be sold to the fund. In the case of personal shares of the fund, they must redeem them.
- No money can be borrowed from the fund at any time by them
- They cannot buy any other securities from the investment company besides fund shares
What is an affiliated person?
An affiliated person is one who directly or indirectly controls, holds, or owns at least 5% of the outstanding shares of an investment company that has voting rights.
The control person must either own or control at least 25% of the outstanding shares.
Custodian is our sixth regulation.
As required by law, the assets of a registered investment company are kept by a custodian.
Banks often play this role, hence the term custodian bank.
The bank will not be required to be insured by the FDIC but must meet other financial requirements.
Seventh is mutual funds and the redemption of shares.
According to the Investment Companies Act, investors who request that shares be redeemed must receive the proceeds within seven days.
Our eighth and last regulation is periodic and other reports.
All investment companies must submit annual reports to the SEC which should always include audited income statements and balance sheets.
Furthermore, the regulations stipulate that shareholders must receive financial information on the investment company semiannually.
Capitalization: Investment companies
Let’s move on to open-end and closed-end investment companies, particularly in the way capitalization works with them.
Initial capitalization of open-end investment companies
An open-end company is simply a mutual fund.
The number of shares a mutual fund will issue will not be specified when it does so.
It will first register an open offering with the SEC as a first step.
Open-ended investment companies can raise unlimited amounts of investment capital by issuing new shares whenever they wish.
How does this affect investors?
In any case, when they invest in mutual funds, the purchase they make is always a new issue from that fund in what is known as a primary offering.
As for the stock issued by mutual funds, it’s only ever common stock.
Through its sale, the mutual fund then looks to buy securities via the fund manager.
The securities purchased must meet the objective of the fund.
There is no limit placed on the type of securities that can be purchased, as long as they meet fund objectives.
Initial capitalization of closed-end investment companies
Closed-end investment companies differ from open-end ones in the way they trade and how they raise capital.
First, let’s talk about how capital is raised.
Well, they do issue common stock for investors to purchase but this is a fixed number of shares in the initial offering which must be SEC-registered.
Through an underwriting group, investors can buy these shares but they are available for a limited time.
A fixed amount for the fund’s capitalization exists unless another public offering is made.
While they offer common stock to investors, they can also provide preferred stock and bond purchase options.
They have similar capital structures to other companies.
Mutual fund loads and share classes
When FINRA members underwrite fund shares for open-end investment companies, sales charges of over 8.5% of the POP are prohibited.
An explanation of the charges will be included in the prospectus.
A lot of investors want to know about management fees, sales loads, as well as operating expense figures as it impacts investor income.
In the past, mutual funds charged front-end loads as fees.
But there is another method called a back-end load and only when money is taken out of the fund by an investor, are these processed.
There’s a third fee charging method as well.
They can be taken off annually to cover marketing and distribution costs.
We also need to mention expense ratio which takes into account the fund’s net assets, management fees, and operating expenses.
To calculate the expense ratio, they are expressed as a percentage of the net assets and both no-load and load funds can have this.
These funds do not have sales charges.
Brokerage commissions are paid by investors in agency transactions while markups or markdowns are paid by principals in principal transactions.
When it comes to open-end funds, all sales commissions will be deducted from the sales charges collected.
Underwriter commissions, broker-dealer commissions, and agent commissions are all included in these sales charges.
There are other extras too, like public communication advertising the fund.
Whenever the sales charges are presented, they are expressed as a percentage of the POP per share.
Let’s talk a little more about how these funds collect these fees.
We start with front-load funds.
The funds POP will reflect the front-end sales load.
A charge will be added to the NAV when an investor buys shares in the fund.
This class of shares, which will have fewer operating expense ratios than other classes, is called Class A shares.
What about back-end loads?
This is also known as a contingent deferred sales load.
When the investor redeems their shares, the fee is charged to them.
It is important to note that the sales load is applied each year, but will drop each time.
The sales load is applied to the proceeds of the shares sold that year and within six to eight years, it will drop to 0%.
At this point, the shares are converted to Class A shares due to their lower operating expense ratios.
Lastly, let’s consider the 12b-1 asset-based fees.
Mutual funds can only distribute their own fund shares under section 12b-1 of the Investment Companies Act.
According to the regulation, a mutual fund that conducts sales-related or promotional activities can charge a fee for doing so as long as they are linked to share distribution.
To calculate the fee, the average total NAV of the fund during the year is taken and a percentage is allocated.
This fee will be recorded in the prospectus but the fee can never be more than 0.75% of the value of the net assets of the fund.
It’s usually around 0.5%.
For no-load funds, the fee must be 0.25% or less for them to claim this distinction.
If a mutual fund wants to charge a 12b-1 fee, they need to meet various requirements:
- The plan must be approved by a vote involving the outstanding voting securities
- Once initial approval is achieved, it will need to be reapproved annually
- A majority vote can terminate the plan. This can be achieved by the board of directors who are not interested persons as well as the shareholders.
Fund share classes
Mutual funds offer a variety of fund classes.
Therefore, investors can choose the way they pay their sales charges.
Here’s the different types:
- Class A shares: These are front-end load shares
- Class B shares: These are back-end load shares
- Class C shares: These shares are subject to a continuous 12b-1 charge, but there is no sales charge when investors buy. They are also subject to a 1% CDSC charge for one year.
An investor’s operating expenses and sales charges will vary according to the class of shares they purchase.
As a result, the costs of a Class A share are lower than those of a Class B or Class C shares.
Other than that, the rights that come with owning shares of a mutual fund remain the same.
While these are the most prevalent share classes, there are others that have come to the fore:
- Class I shares: Only available for institutional investors to purchase. These have lower fees and expenses
- Class R shares: These are only available to investors who have bought retirement plans. They can be associated with a 12b-1 fee but not front or back-end fees.
Sales charge reductions
When purchasing Class A shares, investors can take advantage of reduced sales charges which include:
- Breakpoints: A scale of declining sales charges based on the amount invested
- Rights of accumulation: This allows breakpoints to be reached through the aggregation of shares purchased in the same fund family.
We start with breakpoints.
These are for single investors.
Other entities like an investment club, for example, do not qualify.
Here’s an example of a breakpoint schedule:
- Purchase amount: $25,000 to $49,999 | Sales charge: 5.5%
- Purchase amount: $50,000 to $99,999 | Sales charge: 5%
- Purchase amount: $100,000 to $249,999 | Sales charge: 3%
- Purchase amount: $250,000 to $449,999 | Sales charge: 2%
- Purchase amount: $500,000 to $999,999 | Sales charge: 1%
- Purchase amount: Over $1 million | No sales charge
In order to qualify for a breakpoint, investors have a variety of options.
They could invest a large lump sum, for example, or they can use what is termed a letter of intent, which we will cover in greater detail in a bit.
When it comes to breakpoints, regulations are stringent.
A registered person is not allowed to make a sale that is just below the next breakpoint in order to earn higher commissions, known as a breakpoint sale.
They would have to tell the investor about the easily achievable breakpoint and give them the option of reaching it.
Regulators will also scrutinize Class B shares, especially when large purchases are involved.
Letters of intent
This is another way a mutual fund can help investors reduce sales charges overall.
Signed by the investors, this letter tells the mutual fund that an investor intends to reach further breakpoints by adding more funds.
Regulations give them 13 months to do so.
This is a one-sided contract binding on only the fund.
In order to reduce the sales charge, the customer must carry the investment as the letter indicates.
The extra shares bought through the reduced sales charge will be held in escrow until the letter of intent is completed by the investor depositing the necessary funds.
Regarding a letter of intent, appreciation and reinvested dividends aren’t considered.
The letter of intent can also be backdated.
Letters of intent can sometimes be signed after initial purchases, and this period can be for 90 days afterwards.
By doing so, the investor will be able to include any prior purchases made.
There is a proviso, however, and these prior purchases cannot be beyond a 13-month period.
If a customer signs the letter of intent after 90 days, they have 10 months to complete it.
Mutual fund loads and share classes
Let’s now look at the characteristics of both private and venture capital funds.
Because these funds limit ownership, they are not regarded the same as investment companies.
Often referred to as 3(c)(1) funds, they are governed by various regulations.
Two of these are:
- The fund must be 100 investors or less
- Investors must be classified as qualified
In some cases, these funds might receive an exemption under the 3(c)(7) provision.
So how are these private funds organized?
Well, mostly as partnerships.
Hedge funds should also be mentioned because they are deemed to be a special type of private fund.
The main difference when you compare it to a regular one, however, is the holding period for the investments, where it’s a far shorter time as their positions are actively traded.
In addition, there are two categories of private funds to know about.
First, there are those that make direct investments.
Their objective is to influence the operation as well as the management of the operating company
This is possible as they have a majority voting interest.
Funds that make portfolio investments will construct one filled with various securities.
Here, the fund is not in a controlling position.
Private liquidity fund options have become popular and we must mention them as they essentially are money market funds.
Because of this, they have some restrictions placed on them by the SEC, although this won’t appear in the exam.
Venture capital funds
These funds are structured as limited partnerships, with the LPs contributing the capital for the fund.
Investment decisions for the fund are by the general partner.
LPs can include individuals as well as other entities such as pension funds, hedge funds, or endowment funds.
The aim of most of these types of funds is to generate as high returns as possible by investing in promising, up and coming companies and not already established ones.
The aim is to work in a time frame of 10 years or less and have a clearly planned exit strategy in place.
A common characteristic of both venture capital and private equity funds is the compensation paid to the fund manager.
This compensation is called carried interest and is usually in the form of a management fee that is paid annually.
This fee is based on capital committed to the fund and is usually 2% of that.
A fund manager will also be paid from the profits generated when the business is sold with this amount usually around 20% of the money generated.
Here, we look at the structure of hedge funds, compensation, and suitability requirements for investors.
While portfolio-managers governing hedge funds need to be SEC-registered, the funds are not.
As far as the number of investors, well, hedge funds are only allowed 100 or less.
Hedge funds are organized as limited partnerships and when compared to mutual funds, certainly are not as transparent.
As for a prospectus, well that’s not necessary and again, that’s linked to the fact that they need not register with the SEC so are guided by specific regulations.
If an investor is looking for information about a hedge fund, they will find it in the private placement memorandum.
As far as risk goes, well hedge funds do take a riskier approach to investment than open or closed-ended funds.
This risk sees them using arbitrage strategies, for example, or during a bear market, opting to take short positions.
In addition, they use derivatives and borrowed money (leverage).
However, this does not mean that investing in a hedge fund is guaranteed to fail because of these risky techniques.
The goal of hedge funds is to preserve capital and reduce risk and volatility overall.
Regardless of the market conditions it operates in, hedge funds aim to deliver positive returns to their investors.
When it comes to compensation, hedge fund management fees are higher than most other investment vehicles.
Most will charge performance-based fees, with a 2&20 structure used.
What this means is that a 2% management fee is charged by the fund and they also take 20% of the generated profits.
A hedge fund may also have something called a hurdle rate.
Fund managers will receive incentive fees if the fund exceeds a certain threshold, such as 5%.
Investors should note that there are rules in place that will mean they have to keep their investments in the funds for a certain minimum length.
This is known as a lock-up provision and means that hedge funds aren’t particularly liquid.
The reason this is done is to ensure that the necessary capital needed is always available for the fund manager to use.
Lastly, hedge funds are only for accredited investors to participate in, such as institutional clients, but individuals can partake in them as well.
Ordinary investors can take part indirectly as well, and this can happen with a mutual fund of a hedge fund which offers more liquidity and is excellent for helping to diversify portfolios.
Unit investment trusts (UITs)
UITs are also considered investment companies under the Investment Company Act.
What are they?
Well, there are two key points associated with them.
Firstly, they are not managed while secondly, they are organized under a trust indenture.
So they don’t have:
- A board of directors
- An investment advisor running it
They won’t actively manage a portfolio or trade securities either.
UITs issue what is known as redeemable securities which are generally called units or shares of beneficial interest.
When an investor buys a unit, they’re buying an undivided interest in specific securities in a portfolio.
By purchasing securities that will help achieve the stated objective of the trust, the investor invests capital into the trust to meet that objective.
Also, once the portfolio is compiled, it remains fixed.
Exchange-traded funds (ETFs)
EFTs are available in two types:
- Unit investment trust (UIT EFT)
- Open-end ETF
Whatever the type, they must be SEC-registered.
Both types will also perform daily NAV calculations.
As for what they invest in, well, that’s usually a specific index, like the S&P 500.
So what do ETFs invest in?
Any asset class with a published index that offers liquidity and can be used for EFTs including:
- Real estate
In this respect, index mutual funds and ETFs are quite similar.
There are differences between them.
Like stocks traded on an exchange, ETFs are traded in the same way and in that way, share a similarity to closed-end investment companies.
The investor is thus able to benefit from market-induced price changes rather than just the stock’s underlying value.
Actively traded ETFs have gained in popularity in recent years.
These are not passive, like regular ETFs, and are based on an index that they attempt to mirror assets selected by managers.
Regulations allow ETFs to be sold short and to be bought on margin, just like other listed stocks.
They offer tax advantages for investors too.
If small investors are planning to invest at regular intervals, ETFs cannot compete with no-load index funds.
That’s because brokerage commissions are charged on all trades made.
Some ETFs are considered UITs by law, and are legally classified as such,
Others are seen as open-ended companies, however.
An ETF can never be referred to as a mutual fund because its shares are not redeemable.
ETFs can incur small and persistent premiums because of structural inconsistency
They differ from closed-ended funds, where supply and demand determine a price that differs from the NAV.
Usually, market activity late in the day will see the premium or discount between the trading price of an ETF and the NAV with the gap narrowing in early trading the next day.
Real estate investment trusts (REITs)
REITs, which are publicly traded, generate income from a portfolio of real estate investments.
They are a great way for investors to diversify their portfolios and are professionally managed.
REITs provide real estate projects with long-term financing.
They come in three types:
- Equity REITs (that own commercial property)
- Mortgage REITs (that own commercial property mortgages)
- Hybrid REITs (a combination of both of the above)
Shares of a REIT can be bought and sold by investors and they are organized as trusts.
Stock exchanges and over-the-counter markets allow investors to purchase these shares, but unlike mutual funds or UITs, they cannot be redeemed.
They have somewhat of a hybrid status when it comes to federal tax rates, that’s because they receive a dividend paid deduction
REITs are seen as a corporation for tax purposes.
As for the way in which they are taxed, there are two scenarios.
They are taxed when dividends are paid out and then gains are taxed on the disposition of shares.
REITs are not subject to corporate taxes if the majority of their taxable income is distributed to shareholders.
There are provisos for this, however.
What do we mean by most of the taxable income (often the term used here is substantially)?
Shareholders must get 90% or more of the taxable income received and 75% of the proceeds must have come from real estate.
H. Pooled Investment Characteristics
The purpose of this section is to discuss the various characteristics of pooled investments.
Management and investment company pricing
How is pricing for open-end and closed-end investment companies different?
Let’s first look at closed-end companies, or publicly traded companies as they are often called.
The shares will begin to appear on the secondary market after the stock has been distributed meaning anyone can buy or sell them.
But how is the bid price – the price they can be sold at – determined?
Well, it is purely supply and demand.
We’ve mentioned the bid price but there is an ask price too and this is the price at which the investor can buy at.
Closed-end funds shares are linked to their NAV and will trade at either a discount or premium to it.
As for open-end investment companies, investors can buy the shares from the company or the underwriters they have working for them.
The price of these shares is simply known as the POP, or public offering price and it’s worked out in a specific way.
This is done by taking the NAV per share and adding any applicable sales charges to determine the POP.
Each day, the NAV of a mutual fund is recalculated by taking the assets the fund holds and taking off any liabilities.
NAV per share is calculated by dividing the NAV of the fund by the outstanding shares.
Note that with these funds, their capital reduces when investors redeem their shares.
In contrast to stocks, a mutual fund’s shares can be bought as a full unit or fractional unit.
Because of this fractionality, investors owning these shares think of them in dollar terms instead of the number of shares they own.
Investors cannot purchase fractional shares of closed-end funds.
Let’s recap what we’ve learned about open-end and closed-end funds with these helpful tables.
- Capitalization: Because the offering of shares is continuous, capitalization is unlimited
- Issues: This takes the form of common stock. Open-ended funds do not include other types of securities, like debt issues for example
- Shares: These can be both fractional and full
- Offerings and trading: It is through the fund only that these are sold and redeemed and there is a continuous primary offering
- Pricings: Sales charge + NAV. The prospectus will include a formula as to how the selling price was devised but this will never be lower than the NAV.
- Capitalization: A single, fixed offering of shares
- Issues: Like open-end funds, issues can be common stock but also preferred stock as well as debt securities
- Shares: Only full
- Offering and trading: Primary offering initially. Secondary trading takes place on exchanges or OTC
- Pricings: Supply and demand will determine the price of closed-end fund shares. This means it can be equal to the NAV but also higher or lower than it
The NAV of open-ended funds will be worked out once per day, usually at the close of market.
For both sales and purchase price determination, a forward pricing principle is in effect and the next computed NAV will determine the selling or purchasing price.
An investment company’s portfolio should always be considered to be very elastic as money is always moving in and out of the fund.
This affects the value of securities too and they will fluctuate because of new investments but also as a result of redemptions.
An investor’s account value will be affected by this and it too will move up and down.
A proportional relationship exists here depending on how many shares an investor holds.
Pooled investment: Benefits and risks
Since we have covered a range of pooled investment vehicles, we will cover each in turn, looking at the benefits and risks.
We begin by discussing the advantages that mutual funds can bring to a client’s portfolio.
First up, diversification.
The majority of investors will want a diverse portfolio of assets, and with mutual funds, you can easily accomplish this.
Second, they are professionally managed.
An individual who manages a mutual fund portfolio must be registered with the SEC.
The prospectus also contains the objectives of the mutual fund, and they must follow those objectives as required by the Investment Company Act.
As a result, when they purchase or sell securities, they make their buying and selling decisions based on various market parameters.
Third, we have chosen objectives.
There is a mutual fund that can match any investor’s investment objectives.
As an example, if they want to grow their investment, a growth fund is a wise choice and within that, there are more specific choices, for example, an aggressive growth fund.
With income funds, investors can expect higher returns but at a risk, while government bonds are less risky with lower yields.
If they want to preserve capital, investors need to look no further than a money market fund.
These are just some of the choices available and in some cases, like growth and income funds, they can be combined.
Fourth, they provide convenience for investors.
They are very easy to invest in and simple to use and that’s excellent news for investors, especially those starting out.
They can even control their investments online by buying and selling shares or making other adjustments with the click of a button.
The fifth benefit is that of liquidity.
Mutual fund investors must follow certain rules in order to redeem their shares easily if they invest in mutual funds.
If they choose to exercise that option, they will be redeemed at the next computed NAV per share.
The redemption request indicates that there is a seven-day period for the investor to receive payment.
Even though the value of the shares may be less than their cost, liquidity is assured as a redemption cost is also paid.
Sixth, they have minimum initial investment.
A mutual fund is a good investment option for those who are just starting out and may not have a huge capital lump sum to invest.
After the initial investment, subsequent ones don’t have to be as large either
Some funds even allow investors to put in as little as $100 at a time.
Seventh, they provide convenient tax information.
Mutual fund investors won’t have to worry about complicated tax details.
Investors will receive 1099 forms from the fund each year.
They will be able to determine the taxability of distributions made by the funds based on these documents.
The eighth and final benefit is combination privilege.
Mutual funds can be packaged as a family of funds, which means that investors have access to more than one offering.
Investors can reach various breakpoints by buying into more than one fund of the same family,
Let’s move on to risks that are associated with mutual funds.
Fluctuating market prices cannot be controlled no matter how much management or diversification you employ.
In addition, there are different risks associated with different mutual funds.
Bond funds are frequently impacted by interest rate risk, while market risk affects stock funds’ impact on equity funds, for example.
Bond funds, unlike individual bonds, do not have a maturity date, either.
For a mutual fund that doesn’t fluctuate too much in price, a money market fund is the best choice, but that has a disadvantage too as it doesn’t have massive income.
Mutual fund expenses and fees are the next risk to consider and there can be quite a few, including:
- Sales charges
- 12b-1 fees
- Redemption fees
- Management fees
- Tax fees
Other factors should be considered, especially when comparing funds that have similar objectives and these include:
- Services offered
- Levels of taxation
- Fund manager experience
- How the fund has performed in relation to its benchmark
Lastly, we must mention net redemptions.
This is when there are more shareholder redemptions compared to purchases of new shares and it’s often a result of declining markets.
It is up to the portfolio manager to decide which assets to liquidate because prices are falling.
The performance of a fund suffering from a net redemption isn’t very good.
What are the benefits of private funds?
First, they can provide investors with the opportunity for large profits.
When an investment is made at the right time, for example, before a company has matured, this is possible.
The company could make large profits if it makes its first public offering after someone has invested.
Second, investors can have a say in private funds.
This is due to the way they are structured.
Investors can not only have a say in the management of a company but its development as well.
Thirdly, due to their low correlation when compared to the overall market, private funds have added diversification.
And the risks associated with private funds?
The first major risk is that of business risk.
An investor who invests in a start-up that fails may lose some or all of their money.
It is possible that this will happen since many start-ups fail.
There’s also liquidity risk.
Private funds shares aren’t really available on the secondary market and this means trying to sell shares can be a problem.
Overall, they aren’t a particularly liquid investment and this holds true, even when a public offering has been made by a company.
Even when the company has made a public offering, that holds true for public funds.
Lastly, private funds have a lack of transparency.
The securities associated with these funds are not registered with regulatory bodies.
Our next topic is hedge funds, so let’s take a closer look at their benefits.
First, they generate positive returns.
Even in falling markets, hedge funds can generate positive returns and are designed strategically to do so.
Second, they provide different choices to investors as well.
Hedge funds offer many different investment options, so no matter what investment goals an investor has, they will be able to find one that meets their needs.
Third, they reduce portfolio risk.
They can reduce volatility and increase returns when part of an asset allocation class too.
The fourth and last benefit of a hedge fund is that they provide a level of diversification.
By selecting hedge funds carefully, you can create uncorrelated returns.
We move on to hedge fund risks.
First, they are expensive.
Investing in them is certainly not the cheapest, and hedge funds share in the profits too.
Numerous hedge funds work on a 2&20 basis.
They take 20% of profits if any are made, and they charge a 2% management fee.
Second, liquidity risk is something associated with hedge funds.
Because hedge funds have a lock-up period, investors will not be able to access their money.
Liquidity risk remains thereafter.
This is because hedge fund securities do not trade on exchanges, and because they are unregistered, there is no active secondary market for them.
Thirdly, they could lead to a loss of capital.
Some hedge funds do operate with risky strategies regarding the investments they make.
The fourth and final risk is the necessity of partnership approval.
When partnership interests in a hedge fund are sold, approval is necessary as they are structured as limited partnerships.
Next, we will discuss REITs and the benefits they provide to investors.
First, they are a real estate investment opportunity.
REITs do not have the same level of liquidity risk as direct ownership.
Second, it’s professionals that select the properties.
This means far more negotiating power than any individual would have.
Third, because of their negative correlations to stock markets, REITs make for excellent investments.
The fourth advantage is that they provide both reasonable capital appreciation and income.
First, investors have little control over their REITs.
They are fully in the hands of those who manage them.
Second, they have greater price volatility compared to other investments, like direct ownership of real estate.
That’s because REITs are impacted by stock market conditions.
Third, they are taxed heavily.
That’s because they do not qualify for the purposes of the 15% maximum tax rate, so it’s at ordinary income tax rates that are applied to them.
Fourth, they can suffer from limited liquidity, specifically those that are not publicly traded.
A portion of the outstanding shares can be redeemed every year, subject to limitations.
When priced, however, this redemption could be lower than the current price and the price the investor initially paid for the shares.
The fact that in certain circumstances, REITs can be taxed is another risk you need to remember.
Also, if distribution rules are not met, REITs can have added taxes.
The fifth and final risk relates to problem loans and this can cause not only income, but capital to decrease as well.
I. to M. Types of Derivative Securities and Their Characteristics
Our next unit in this section looks at the various types of derivative securities as well as their characteristics.
Derived is the key word here.
They are linked to an underlying asset from which their value comes.
In the case of options, the asset they derive their value from could be a range of things including, stock, a stock index, or a foreign currency amongst others.
What is the purpose of an options contract?
Well, they are used as hedging, which offers a form of protection for investors.
And that protection is towards the investment’s overall value but they are also sometimes used as a way to speculate price movements on markets, securities, foreign currencies, and others.
Options are a contract for an underlying instrument.
They will look to set a price and time frame for either the sale or purchase of that instrument.
Two parties are involved in this:
- One party is buying or selling (they have the right to exercise the underlying contract)
- It will be the other party’s responsibility to comply with the contract’s terms
Any item that has a fluctuating market value could have an option.
The exam will cover equity options, which are associated with common stocks.
These standardized options have three specific terms.
Firstly, the underlying asset.
Secondly, there is the expiration date.
Thirdly, there is the strike or exercise price.
Because of this standardization, secondary trading in options does take place.
Two critical factors will influence the price of derivatives.
- The underlying asset’s price movement
- The time left until the contract will expire
Calls and puts
Our next task is to determine the difference between a call option and a put option.
- Call option: This gives the holder the right to buy a specific stock in a specific time period. A call buyer buys the right to buy the stock when they purchase a call option. The call seller has the obligation to sell the stock.
- Put option: This gives the holder the right to sell a specific stock in a specific time period. A put buyer has the right to sell the stock when they purchase a put option.
Each of these options contracts covers a round lot of stock.
This is 100 shares.
The cost of the option is the premium and it is always quoted in dollars per share.
A round lot of $100 will cost $300 if the premium on an option is $3.
For those who want to invest in options, four transactions are available:
- Buying calls
- Buying puts
- Selling calls
- Selling puts
With an option buyer, they are long the position, whereas the seller is short the position.
An option only grants the rights and obligations for a limited period of time.
As a result, there is an open or a close for each of these transactions.
A position in an option is opened when an investor buys a call.
A position is closed when a call expires, is sold, or is exercised.
When an investor is in a long position and owns a put or call option contract they have three ways to close it.
- They can sell the option before it expires
- They can exercise the option. If they do, the security specified in the contract is either bought or sold
- They can leave the option to expire
It is the most common and simplest way for an option position to be closed by an investor entering the transaction opposite to the opening transaction.
For example, the opening transaction was buying a call.
By selling the call, the investor closes the option contract.
The closing transaction on the option contract would be to buy a put if the opening transaction was to sell a put.
Exercising an option
As part of their rights of ownership, option owners have the choice of exercising it or not.
An exercised call, for example, results in the purchase of the underlying stock at the strike price thereof.
When a put is exercised, a sale of the underlying stock occurs, also at the strike price.
When it comes to exercising an option, you will also need to be aware of the differences between American and European styles.
- American style: An option may be exercised at any time up to the expiration date thereof
- European style: The option can only be exercised on the trading day before it expires.
Option contract length
Options are available in various time frames, from a week long to a year or two.
Long-term options contracts can include LEAPS or Long-Term Equity Anticipation Securities, while those that are only a week long are aptly named Weeklys.
Most options contracts, however, are standardized by the fact that their expiration dates are a maximum period of nine months.
Strategies related to options contracts
Option strategies are either bullish or bearish based on the underlying stock.
Those who hold bullish positions believe the price of securities will rise, while those who hold bearish views believe that it will decline.
Buying and selling options is primarily motivated by making a profit or protecting (hedging) against the movement of stock prices.
A bullish investor hopes the calls they bought will lead to a profit if the underlying stock price increases.
It is the hope of a bearish investor that the puts they bought will lead to a profit if the underlying stock price drops.
There are other ways for them to make money on their options too.
A bullish investor can make a profit when the stock price rises or even stays stable when they write (sell) puts.
In contrast, a bearish investor can make a profit by writing (selling) calls when the stock price stays the same or declines.
As a result of speculating on the price increase of a stock, investors will purchase calls on the stock.
Through the purchase of a call, they can profit from an increase in the stock’s price by investing just a small amount of money.
Even if the price doesn’t rise, their losses won’t be too great, as they will only lose the amount paid for the option.
A call buyer’s gains are theoretically unlimited since a stock can rise to any point.
There are no dividends paid to owners of options on the underlying stock with both puts and calls.
Investors who are concerned about an increase in stock prices will benefit from this.
Investors who are neutral or bearish can write (sell) a call and collect a premium and they believe that the stock price will either drop or remain the same.
Should this be the case, a call can be written to:
- Generate income. This is thanks to the option premium
- Hedge or provide partial protection for long stock positions. In this case, any loss generated by the sale of stock would be offset by the premium received
- Exercise the call when the price of the stock goes up. In other words, the writer will receive both the premium and the strike price of the stock. A covered call is low risk. In this case, the option writer owns the stock on the call that is being written. No matter what the stock price does, the writer will be able to make a delivery with the stock they own. If the writer does not own the stock, it is an uncovered or naked option.
A bearish investor will purchase puts if they believe that the price of a particular stock will decline.
In doing so, they buy 100 shares of the underlying stock at the strike price and before the expiration date.
Puts are written by investors when they believe a stock’s price will remain stable or rise.
The writer or seller of the put must buy the stock at the exercise price if the put buyer puts it to the put writer.
When the stock price is above the strike price of the put by the expiration date, the put will expire unexercised.
As with call writing, the put writer will then keep the premium, which is a source of income.
In the event the stock prices fall, the buyer wins and the put writer loses, although the loss will be limited as it can never fall below zero.
It can sometimes be difficult to predict which way the market will move.
Investors do have an investment option called a straddle (like a combination of a put and a call) which covers both upward and downward movement in the market.
Purchased on the same stock, it will have the same expiration date and exercise price.
The call option is profitable if the stock moves up and the put option is profitable if the stock moves down.
Buyers of straddles will profit from market volatility, while sellers will do so when the market is stable.
Warrants and rights
The majority of rights and warrants are viewed as equity securities.
Their value is derived from common stock which can be acquired by exercising a warrant or right, so they are actually derivatives and share many similarities and are compared to call options.
We will explore the differences between warrants, rights, and calls starting with rights, sometimes called preemptive rights.
The existing stockholders of a company are granted rights that allow them to buy additional shares before the investing public can.
This stops the dilution of ownership of the shares.
By buying enough shares, investors can maintain a proportionate interest in the company.
Warrants differ from rights in three key ways:
Firstly, their exercise price is higher than current market prices.
Secondly, there is no relationship between a stockholder’s proportionate interest and a warrant.
Thirdly, they expire over a far longer period than rights, sometimes up to 10 years.
How do they operate?
The majority of the time, a warrant is attached to another security, like a bond issue.
By lowering the interest rate on a bond, investors will be more interested in it.
When a warrant is attached to a stock, the entire package is viewed as one unit.
An investor who owns a share of stock with a warrant will be able to buy another share through that warrant.
While warrants are often attached to other securities, they are sold separately as well.
There is one important difference between rights/warrants and call options and that is where they originate.
For options, the origination point is the exchange where they are traded but for rights/warrants, they originate with the stock issuer.
What does this mean?
Well, new shares will be issued when a warrant or right is exercised.
When a call option is exercised, an assigned seller must deliver existing shares.
Non-security derivatives: Forward contracts
We will explore how futures and forward contracts differ in this section.
The forward contract was created for a specific reason and is linked to commodity users and producers.
When the relevant commodity needs to be exchanged, they help to determine an agreeable time for the parties involved.
Forward contracts accomplish two things:
- In the future, you won’t have to worry about finding a buyer or seller for cash market transactions
- There is a reduction in price risks that arise from the dynamics of supply and demand.
We refer to forward contracts as commitments and they are considered non standardized with a buyer and seller engaged in a contract.
There is no third party involved.
The forward seller must deliver the goods when the closing date on the forward contract arrives with the position still held.
These are also direct obligations because of the contract that exists.
When a buyer and seller enter into a forward contract, you must also take their credit and trustworthiness into account.
- Due to the lack of a secondary market, forward contracts are considered illiquid investments
- Forward contracts are not easily transferable
Forward contracts usually consist of these five components:
- Quantity of the commodity in the contract
- Quality of the commodity in the contract
- When it will be delivered
- Where it will be delivered
- The price the buyer must pay the seller for the commodity
Futures contracts are seen as exchange-traded obligations, unlike forwarding contracts.
Buyers and sellers are responsible for the full value of the contract.
Here’s how it all unfolds.
It begins with the buyer who has an obligation because they have taken up a long position.
So a commodity will be delivered to them at a future specified date.
The seller, however, is in a short position.
The commodity must be delivered on the delivery date specified in the futures contract.
They can suffer a potentially unlimited loss if they do not own the commodity since they need to acquire it at the price it currently trades at.
All open future positions are calculated daily for gains and losses and on the daily settlement price.
Losses and gains will be credited and debited for each open position, both long and short.
Both firm and trader accounts need to be settled before trading opens the next day.
Clearinghouses can be beneficial to both buyers and sellers when it comes to contracts.
That’s because, before delivery, they make it easy to offset futures positions.
An investor must close, offset, or liquidate a position with an opposite transaction to the trade that opened it.
When this is done, three factors are important:
- It must involve the same commodity
- The month of delivery must be the same
- It must be done on the same exchange
Is it common to have an offset before delivery?
Approximately 98% of all futures positions which are highly leveraged follow this pattern.
Having a long position will result in a profit when the settlement price is greater than the delivery price at expiration.
In the same circumstances described above, a short position will lose money.
Consequently, the short position profits if the settlement price is lower than the delivery price, and the long position held will lose.
These five components are typically included in exchange-traded futures contracts:
- The quantity of the commodity (100 oz of silver, platinum, or gold, for example)
- The quality of the commodity
- The price the buyer will pay for it
- Delivery time
- Where it will be delivered
For the Series 65 exam, you should know that forward contracts are generally used by commodity producers, while futures contracts are typically used by speculators.
Futures and Forwards: Regulations
The SEC does not regulate futures since they are not securities but the market is regulated by the Commodity Futures Trading Commission (CFTC).
However, forward contracts are not regulated by any agency.
The use of derivatives is a useful strategy investors can employ when the circumstances require it.
It is usually free to open an options account, for example.
In the case of those who take a long position (or buy options), they have to pay only the premium along with any commission fees incurred.
Although there is an exception, no interest can be charged since options cannot be purchased with borrowed funds.
The seller receives the premium paid by the buyer when they take a short position (or sell options), minus brokerage charges.
In the case of a call, or put is uncovered, a margin requirement applies to the transaction
Let’s examine the benefits and risks of derivatives.
The most significant benefit of derivatives is their ability to leverage an investment.
The reason for this leverage is that the option is much less expensive than the underlying stock.
With only the relatively small amount they would have paid for an option, they can control an investment that would have normally required a massive amount of capital.
Additionally, an investor can make unlimited profits if their intuition about the stock is right.
Investing in options can lower the risk of an investor.
One of the simplest examples is when a call option is written on investor-owned stock and this is known as a covered call.
Following the purchase of a stock by an investor, three situations can occur:
- Stock prices can rise
- Stock prices can decrease
- Stock prices can remain stable
It’s the first example that the investor is hoping to occur.
They don’t want it to drop or even remain stable because they’ve then earned nothing but paid out money in doing so.
The capital spent could have earned interest in a bank account rather.
Should the stock price rise or remain stable, an investor will be better off writing a call on the stock.
By writing a call, their position may even improve if the stock price drops.
A selling short alternative
As a way to profit from the decline of a stock’s price, an investor can sell the stock short.
This topic will be covered later in the guide, but here’s a basic explanation.
A margin account is used when stocks are sold short.
Using this account, the investor places a deposit and then borrows the stock to sell.
Obviously, this scenario carries the chance of unlimited losses.
It wouldn’t be the same if the investor had bought a put.
In that case, the investor will only need to pay the premium if the stock price falls and that’s all they stand to lose.
After discussing short-selling stocks and the possibility of unlimited losses, we should also mention options and a similar situation that can occur.
An investor might write a specific call option that causes that to happen and that’s called an uncovered or naked call option.
There is also the possibility of unlimited loss when this happens.
Let’s see how it works in the following situation.
When it comes to options, time decay is something to keep in mind.
They expire, so investors cannot hold onto them forever.
At some point, time runs out while the investor holds onto the option hoping that the stock price will move as they want.
Time decay means the option’s value will decrease the closer it is to its expiration date.
If an investor makes a profit from either selling or buying an option, it is typically considered a short-term capital gain.
The tax paid is higher when compared to long-term capital gain rates.
This is due to the fact that it’s as ordinary income that the gains are taxed and this will extend to both futures and forwards as well.
Other Assets and Alternative Investments
Alternative investments or alts started getting popular in the 1990s.
At the time, they included: financial derivatives, leveraged ETFs, and exchange-traded notes.
When it came to alts, there was a variety to choose from, but they all had one thing in common – their complexity.
This means they are only for investors that meet suitability requirements.
Direct participation programs (DPPs)
DPPs are mostly structured as limited partnerships with investors gaining or losing the economic consequences of a business that moves through them.
Here the income gained or losses made are passive and that’s because, as a limited partner, they cannot take an active role.
Also because DPPs are limited partnerships, they won’t pay dividends.
As a result, any income, gains, credits, deductions, or losses will be directly distributed to investors who have a limited liability in the program.
In other words, should their debt be defaulted on and creditors look for money, it cannot be taken from the limited partners, only the general partners.
The only loss a limited partner can suffer is their investment, nothing more.
Any losses or gains incurred by investors is seen as passive income when it comes to taxation.
Limited partnership investors
A DPP offers an alternative way to invest in a business instead of buying stock.
An investor gains one of the tax advantages of a DPP through the flow-through of income or losses.
A DPP, in reality, is simply someone investing in a particular business that is structured in a certain way.
This includes management who runs it using capital provided by the investors.
A DPP consists of two roles: the general partner and the limited partner which are the management and investors respectively.
Analyzing a DPP as an investment opportunity is largely the same as doing so with stocks or bonds, but there are a few different variables at play.
Investors should look to become LPs for the following reasons:
- It’s economically viable
- There are potential tax benefits on offer
- GPs have run equivalent businesses before or have shown the managerial aptitude to do so
- Both the investment objectives of the client and that of the program correspond to the investment time frame.
- In comparison with similar ventures, start-up costs and revenue projections are comparable
Promoters structure DPPs in a way that allows them to achieve a variety of goals.
However, they can be viewed as abusive tax shelters.
In these cases, the IRS views the program as having no economic purpose or the promoter has taken an aggressive tax stance which could lead to action being taken.
This includes looking into penalties, back taxes, interest, deductions and more which could lead to criminal charges being brought against the promoter.
The stated objectives of the program should always meet not only the current but also future objectives the investor has.
For instance, let’s say an investor wants a DPP that will generate current taxable passive income.
An oil or gas exploratory drilling program is the wrong choice because it has a lower chance of meeting that objective (it’s only exploratory), and income won’t be there straight away, if at all.
Also, if a client wants their investment to be liquid, DPPs can’t provide that.
Money invested in them is for the long haul, even selling units isn’t that simple.
Before an investor can carry out a sale, authorization must be obtained from the GPs of the DPP.
GPs or general partners
A general partner is the active investor in a limited partnership and they control all of the operational aspects which include the following:
- Take any decisions that bind the partnership
- Purchasing and selling property for the partnership
- Managing money and property
- The GP supervises every facet of the partnership
- A financial interest of 1% or more in the partnership
They also have unlimited liability unlike an LP so all incurred losses, they will be personally liable for.
To recover money owed to them, creditors can even take action against a GPs personal assets.
In their fiduciary relationship, the LPs rely on the GPs to run the business in their best interest meaning no conflicts of interest should arise, for example.
Furthermore, personal funds cannot be borrowed, competed with, or merged with those of the partnership.
As for profits, these will be paid to LPs before GPs can collect theirs.
LPs or limited partners
As passive investors, they are not involved in any management decisions.
If they do so, they could lose their limited liability protection.
Those holding LP positions receive cash distributions as well as capital gains from the partnership.
Partnership investments and their issuing
DPPs are offered in a number of ways.
For example, some may be private placements, while others are publicly registered.
Investors who buy a limited partnership unit in a DPP will be required to sign a subscription agreement.
This means passing on information such as their net worth and their annual income.
A power of attorney form must also be completed so the GP can operate in the capacity of the partnership’s agent.
In talking about alts as investment vehicles, we must look at different pooled investments too.
Here’s some that appear on the exam.
Exchange-traded notes (ETNs)
While they come from the same family, don’t confuse ETNs and ETFs, they have critical differences between them.
The main one, however, is their structure.
For example, ETFs are registered under the Investment Companies Act, and ETNs, the Securities Act.
In other words, ETFs are investment companies while ETNs are debt instruments.
As an exchange-traded security, ETFs (sometimes called ELNs) pay out periodic interest payments to investors and are linked to a market index or other benchmarks.
ETNs are issued and redeemed in order to keep their price in line with their calculated value.
The value of the ETN is calculated and published at the end of a trading day.
If an ETN trades at a premium, more notes will be issued to bring the price down and when trading at a discount, the opposite is true.
When this happens, the number of notes on the market decreases as the issuer begins to redeem them instead and this makes the price of ETNs rise.
Because primary control over their issuing and redemption is with the issuer, ETNs can lead to a conflict of interest.
Unlike an ETF, an ETN is not trying to copy an underlying index’s performance.
ETN risk includes:
- Conflicts of interest. There is a chance that trading activities conducted by ETN issuers might not be in line with noteholders’ needs.
- Early redemption, call, and acceleration risk.
- Liquidity risk. ETNs may not develop an adequate trading market.
- Credit risk. They are an unsecured debt obligation
- Market risk
These funds track a benchmarked index and seek to provide a high percentage of its return.
If an investor were to invest in a 3x leveraged fund, it is attempting to return three times the return. `
No regulations are in play when it comes to the portfolio and the amount of leverage applied to it which results in many 2x and 3x funds.
Yes, these can provide excellent returns, but there is risk involved as well because they can be extremely volatile, more so than other investment types.
As an example, if the benchmark drops, there will be triple the number of losses in a 3x leveraged fund.
Most leverage funds look to swaps, futures, options, and other derivative products to reach their stated goals.
As for suitability, these certainly aren’t an investment option for all clients.
Inverse or reverse funds
Sometimes called a short fund, these will also track a benchmark but the aim is to deliver the opposite of it.
A fund tracking an inverse benchmark would aim to gain 1% if the benchmark fell 1%.
To accomplish this, they too use derivatives-like options.
Some are also leveraged funds with 2x or 3x the opposite returns as their aim.
On a daily basis, leveraged and ETFs will strive to achieve their stated objectives and effectively are reset come the end of the trading day.
A benchmark’s performance over a longer period of time, like weeks, months, or years, might differ considerably from these funds and this means that on the whole, they are not for investors who buy and hold.
When they are traded on an exchange, leveraged and inverse index funds are known as EFTs which means that:
- Price is determined by supply and demand
- They may be traded on margin
- At any point during the day’s trade, they can be bought and sold
Inverse mutual funds, for instance, are not traded on exchanges.
They will be priced, purchased, and redeemed, just like other investment company shares.
Any of these funds cannot guarantee that they will reach their stated objective.
Structured products are often selected as an investment option when specific investment needs must be met.
Most of these are debt issues.
They are structured in a manner that sees them increase the return potential for lenders while the issuer pays lower borrowing costs.
In this case, investors gain certain advantages, but in exchange, they accept a lower rate of interest on the debt.
These aren’t just for any investor, however, as they are extremely complex products.
Generally, only sophisticated investors that understand the risk associated with structured products should be given the opportunity to invest in them.
One of their major benefits, however, is that they offer excellent diversification for investment portfolios.
Structured notes with added principal protection
This is a structured product that includes a bond with a derivative component
Once mature, it will offer a partial or full return of principal (the principal protection aspect).
In most cases, they combine an underlying asset, an option for example, together with a zero-coupon bond.
This then means that there is no interest until bond maturity of the zero-coupon bond but also the investor will receive the underlying assets payoffs.
The issuers promise the partial or full return of principal at maturity, but this is not guaranteed and ultimately, is determined by the financial strength of the issuer.
Risk associated with structured product
Whenever we discuss structured products, we must also mention their risks.
Perhaps the biggest is the fact that they aren’t liquid at all.
This is due to the fact that they are custom-made.
They aren’t short-term investments either and are only for investors that are willing to wait on returns that are fully realized at maturity.
Credit risk is a factor as well, based on the financial institution that issued them and their overall financial strength.
Sometimes, they have a lack of efficient pricing as well, which affects their value which may not be apparent in the way they are priced on the market.
Life and viatical settlements
While these two investment products do share many similarities, they are different.
It’s prudent to note those differences as these can appear on the exam.
Viaticals are available to clients with less than 24 months to live due to a terminal illness and they can be any age.
The idea behind them is to help pay medical expenses through their settlement.
Age, however, is a factor with life settlements and usually, it is for those in good health but over 65.
Life settlements are paid out when the insured person dies and these take the form of defined death benefits.
A transaction involving either of these products occurs when a life insurance policy or right to receive a death benefit is sold to a person other than the insurer.
No matter the health of the insured or their age, the NASAA sees these products as securities, and therefore, those selling them will be governed by state security laws.
Licensing is a little different and is applied differently across states.
Certain states might require that someone selling these products hold only a life insurance license.
However, others will require the seller to have a life settlement license as well.
There are some states that require a securities agent license as well.
Regulators are most concerned with stability and disclosure.
Whenever such a policy is sold to investors, they gain a financial interest in the death of the insured person.
For the duration of the insured’s life, an investor would have agreed that they would pay any necessary premiums to maintain the costs of the policy.
They would also pay a lump sum in addition to this.
As a result, they receive any death benefits outlined in the policy upon the death of the insured.
Here’s the risks that the investor should be aware of:
- It’s difficult to establish a fair evaluation as there is no active secondary market for these policies which can lead to overpayment by the investor.
- If the insured lives longer than initially expected, investors will receive lower returns.
- No payouts from the investment company because they are in a poor position financially. This isn’t something that happens too often, but it’s worth being aware of.
Investments in real estate
There are forms of real estate investment, such as REITs, where investors remain passive.
There are other options for those that want to take a more active role, with flipping houses something that’s become extremely popular over the last decade.
Another example of active real estate investments would be when someone buys properties to rent them out to others.
These could be both residential and commercial properties.
Investing in commodities and precious metals remains popular.
Earlier in this guide, we discussed how investors can invest in commodities using futures contracts.
Exchange-traded products provide a manner for indirect investment in commodities too, including certain EFTs and mutual funds but also those that track a commodity index.
In the case of mutual funds, the business offering them must be tied to the commodity.
Consider an oil and gas fund.
Stocks would be held in other companies, like those in the refining, storage, and distribution of crude oil, or energy exploration.
Popular commodities include coffee, industrial metals, and precious metals.
Alternative investments: Risks and benefits
All parties interested in alternative investments should be informed of the risks and benefits associated with them.
These are generally the same for all alternative investments.
Providing portfolio diversification is one of their main benefits thanks to their low, and in certain instances, negative correlation.
This means larger returns on investments and reduced risks.
DPPs provide these investment advantages:
- Investments are managed by others, and therefore are passive
- They provide flow-through income
- DPP investors are limited partners and cannot be accountable for any debt it owes. If they do make a loss, it’s only on what they have invested or committed to invest.
DPPs have the following disadvantages:
- Liquidity risk: DPPs have a limited secondary market and it is very difficult to find buyers for them.
- Legislative risk: An LP can lose a great deal of money when tax laws change. Legislative risk isn’t limited to tax laws, however, as other legislation changes can impact DPPs.
- Risk of audit: The IRS often audits taxpayers who report ownership of DPPs in their tax returns.
- Depreciation recapture: Fixed assets provide a tax benefit through depreciation. This is especially true when the option for asset depreciation is accelerated. In comparison to the asset’s tax basis, the effect of that depreciation is not lower, however. If an asset is sold for more than its tax basis, then the excess will be recaptured and so it’s subjected to tax.
Real estate investments offer these benefits
- Historically, they provide an effective hedge against inflation
- Real estate can provide an investor with rental income and some of this is tax-advantaged due to depreciation and interest deduction.
- It provides high leverage and there isn’t a huge down payment required for loans
- Stock market returns and investment real estate are normally uncorrelated.
- As per Section 1031, real estate permits tax-free exchanges.
Here are the risks:
- A high level of leverage can hurt an investor in a down market
- Managing a property without the skills or time to do so can greatly reduce profits if the investor cannot do it himself meaning a professional might need to be hired to do so.
- Real estate investments don’t offer much liquidity
- If bought to provide rental income, money is being lost for each month it takes to find a renter.
Here are the benefits of investing in commodities:
- Potential inflation hedge: When commodities increase in price, inflation usually does so as well. Normally, investors in commodities that increase in price keep pace with or even exceed the rate of increase.
- Diversification: Because they are not correlated to stock market returns, and generally are negatively so, commodities are excellent for diversification which can reduce the volatility of a portfolio.
- Potential returns: Due to supply and demand on a global basis, if investors can predict future commodities shortages, they can make excellent returns.
Here are the risks:
- Principal risk: World events, import controls, competition, regulation, and the overall economic conditions can affect commodities greatly, so they are a volatile investment. A principal investment can be lost easily.
- Volatility: We’ve just mentioned how volatile commodities can but that can extend to other investment products like mutual funds or ETFs that are linked to an underlying commodity.
- Foreign market exposure: Foreign markets can impact commodities because they are a global investment. Currency risk is a real concern but also those risks as a result of political and economic uncertainty.
- High cost: Commodities like precious metals are not cheap to invest in
- Lack of income: Commodities do not provide dividends to investors. The only way to make money through them is by capital gains.