Unit 5: Economic Environment

Transcription

1 Canadian Investment Funds Course Unit 5: Economic Environment Welcome to Economic Environment. In this unit, you will learn about the macroeconomic environment and the purpose and function of a financial marketplace. You will also learn about other investment products that either complement or compete against mutual funds. This unit takes approximately 1 hour and 30 minutes to complete. You will learn about the following topics: The Macroeconomic Environment Marketplace Competitive Products To start with the first lesson, click The Macroeconomic Environment on the table of contents

2 Lesson 1: The Macroeconomic Environment Lesson 1: The Macroeconomic Environment Welcome to The Macroeconomic Environment. In this lesson, you will learn about the changing tax laws and economic circumstances, the common economic indicators and how they affect economic activity, and how financial market participants can affect the marketplace. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: explain the concept of business cycles describe the common economic indicators explain how they affect economic activity

3 Canadian Investment Funds Course Economic Activity The Canadian economy moves in cycles. A period of economic expansion is called a recovery, while a period of at least six consecutive months of economic contraction is called a recession. Not all economic contractions are recessions. The period of economic expansion is not of the same length in every cycle. Furthermore, a period of economic expansion is not necessarily as long as a period of economic contraction. These irregular waves in the level of economic activity are called economic cycles or business cycles. This graph illustrates the variations in Canada's and the United States' economic output over the last two decades. Gross Domestic Product (GDP) Source: S. Chen, J.M. Curtis; International Trade Canada; How Does International Trade Affect Business Cycle Synchronization in North America? Gross Domestic Product (GDP) is a measure of the total market value of all the final goods and services produced in the economy in a year. "Final goods and services" means goods and services sold to their final users. For example, wooden furniture sold to a household is a final good because the household is the final user of the wood, in the form of furniture. Wood sold to a producer, such as a furniture manufacturer, is used in a process of production. It is not a final good. If the wood sold to the furniture manufacturer was included in GDP, then it would be counted twice: once to the manufacturer and once to the consumer. This would provide a misleading measure of the overall health of the economy. GDP is measured in dollars but inflation causes the purchasing power of the dollars to change. Higher inflation means you can purchase less with a given amount of dollars, so the actual dollar amount of GDP has a different meaning at different times, depending on what those dollars can buy. When the GDP value is based on current market prices, it is referred to as Nominal GDP (sometimes called current dollar GDP). Because GDP is the sum of the market value of all the final goods and services produced in the economy in a year, Nominal GDP changes if either the quantities produced change or the prices of the goods change. In order to take out the effect price changes have on GDP, economists use Real GDP (sometimes called constant dollar GDP). Real GDP is a measure of the value of the economy's output in a given year using the prices of a base year. Changes in Real GDP from year to year therefore reflect actual changes in the quantities of output only

4 Lesson 1: The Macroeconomic Environment GDP is one of the primary measures used to evaluate the health of the economy. An increase in real GDP is interpreted as a sign that the economy is doing well, while a decrease indicates that the economy is not working at its full capacity. However, even though it is a measure of the quantities of goods and services produced and supplied in the economy, as a measure of economic well-being, it has certain deficiencies: Our well-being is also influenced by non-market activities that are not included in GDP, such as: work done at home by members of the household volunteer work goods produced for final use that are not sold on any market, such as homegrown food GDP includes final goods and services that are harmful, as well as beneficial. For example, furniture and food are included in GDP, but so are toxic chemicals. GDP does not account for the effects of water and air pollution. GDP does not include the value of leisure because leisure is not a produced good or service. The following graph illustrates that in the last ten years, Canada has experienced an almost continuous economic expansion. Source: Statistics Canada For the most recent information click here to view the Statistics Canada Web site and click Gross Domestic Product near the bottom right-hand corner. Exercise: Economic Activity

5 Canadian Investment Funds Course Prices and Price Level Indices A price index measures the average level of many different prices in the economy. The most well-known and widely used price index is The Consumer Price Index (CPI). Statistics Canada tracks the retail prices of about 600 goods and services from an average household's expenditure. This includes food, housing, transportation, furniture, clothing, and recreation. Items in this basket of goods and services are weighted to reflect typical consumer spending habits. For example, since in general people tend to spend more on food than on clothing, food takes up a larger percentage of the basket than clothing. Therefore, changes in the market prices of food have a greater impact on the overall CPI than changes in the cost of clothing. To make a meaningful comparison of the CPI from one year to the next, prices are compared to those in a base year. The quantities of the goods and services in the basket remain unchanged, but the prices that prevail in each year are used. The current market value of such a basket divided by its value in the base year, and multiplied by 100, becomes the Consumer Price Index, or as follows: The CPI basket is updated periodically by Statistics Canada to reflect broad changes in consumer spending habits and to incorporate changes in products and services. The following graph shows the changes in CPI over the last few years, with 2002 as the base year. Source: Statistics Canada

6 Lesson 1: The Macroeconomic Environment Inflation Inflation is a rise in the general level of prices in an economy over a period of time. The amount that you can buy with your dollar, called purchasing power, falls as the rate of inflation rises. If the general price level falls, it is called deflation. The rate of change in the general price level is called the Rate of Inflation. On a year-toyear basis, the rate of inflation is measured as follows: Assume the December Year 2 number for the Consumer Price Index (CPI) was while the December Year 1 CPI number was The rate of inflation was 2.28%, calculated as (( ) 109.6). This graph shows Canada's inflation record in recent years. Source: Statistics Canada For the most recent information click here to view the Statistics Canada Web site and click Consumer Price Index on the right-hand side of the page. Distributive Effects of Inflation A major effect of unanticipated inflation is a redistribution of real income from lenders to borrowers. Caitlyn borrows $100 from Terence in a year when prices are stable (the rate of inflation is zero) at a 2% interest rate. After one year, Terence expects to receive $102 in real income. However, if prices rise by 5%, then $102 will not even buy what $100 would have bought a year ago. Terence would need $105 to buy what $100 bought a year ago. The $102 he receives represents a reduction in real income. Because $102 cannot buy what it used to, Caitlyn's real income was reduced by less than it would have been when she repaid her loan. Unexpected inflation therefore redistributes real income from lenders to borrowers

7 Canadian Investment Funds Course Inflation also adversely affects people on fixed incomes. Pensioners who contributed to pension funds when inflation rates were low and are repaid with dollars that are worth much less than anticipated are among those harmed by inflation, if their pensions were not indexed for inflation. Measures of Employment and Unemployment A number you often come across is the unemployment rate. The unemployment rate is the percentage of the labour force that actively seeks work but is unable to find any at a given time. The labour force is defined as the total of all those employed and unemployed in the economy. Individuals who do not have a job and are not actively looking for one are excluded from the labour force. In Canada, employment and unemployment numbers are collected monthly by Statistics Canada. The most common measure of unemployment is the unemployment rate, which is defined as: Labour is one of many inputs used in the production of goods and services. As production fluctuates, the level of employment also fluctuates. New technology often replaces labour or forces it to be employed in another way. Variations in employment numbers therefore reflect variations in the level of economic activity as well as structural changes in the economy. The unemployment rate is a key indicator of the health of the economy. When economic growth is strong, the unemployment rate tends to be low. When the economy is stagnating or in recession, unemployment tends to be higher. This graph shows how Canada's real GDP and the unemployment rate have fluctuated. The unemployment rate moves in a pattern opposite to the movements in GDP. Canada s Unemployment and Economic Cycles Source: Statistics Canada For the most recent information click here to view the Statistics Canada Web site and click Unemployment Rate

8 Lesson 1: The Macroeconomic Environment Exercise: Inflation and Employment Economic Stabilization Policies To various degrees, governments try to stabilize their economies. They want to maintain high employment, steady economic growth, and price stability. There are two main tools to accomplish this: fiscal policy and monetary policy. Fiscal policy Fiscal Policy is the government's use of taxes, spending, and transfer payments to influence the overall level of economic activity. The government may decide that more or less taxes should be collected from Canadian citizens. Changes in government spending include payments for goods and services purchased by the government. Transfer payments are payments from the government to the private sector without an exchange of goods or services. Examples of transfer payments are unemployment benefits, subsidies, social security payments, and other welfare benefit payments. A person's disposable income is equal to their income less taxes plus transfer payments. Reduced taxes or increased transfer payments increases their disposable income. This represents an expansionary fiscal policy. Eventually, this sort of policy can result in increased inflation as prices adjust to new levels of disposable income. An expansionary fiscal policy is meant to stimulate economic growth through increased spending and employment. A restrictive or contractive policy, reducing transfer payments or raising taxes, is meant to slow down an overheating economy. Real GDP and the price level eventually drop as economic activity slows. Monetary policy Monetary policy is an economic stabilization policy whereby the government controls the supply of money in the economy by affecting interest rates. If increasing demand for credit and consumer products during a period of economic expansion causes prices to move upward too rapidly, the Bank of Canada can raise interest rates. This increases the cost of borrowing money and eventually, reduces the amount of money moving around the economy. This can help to slow down an overheating economy. In contrast, during periods of recession, the government may reduce interest rates to stimulate growth. The cost of borrowing money goes down, more people and corporations borrow, there is more money in the system and economic activity accelerates. Governments use both fiscal and monetary policies to various degrees, sometimes focusing more on one than the other, due to specific economic situations or philosophy

9 Canadian Investment Funds Course Lesson 2: Marketplace Welcome to the Marketplace lesson. In this lesson, you will learn about the concept of supply and demand and how it affects financial markets. This lesson will give you a basic understanding of how financial markets work, the different types of markets, and the various market participants. This lesson takes 30 minutes to complete. By the end of this lesson, you will be able to do the following: describe the concept of supply and demand explain the characteristics of financial markets

10 Lesson 2: Marketplace The Concept of a Market A market is a place where buyers and sellers meet. It can be a physical building or an electronic network. It can be local, national, or international. Markets are often categorized according to the products or services in which they deal. For example, there are labour markets, consumer goods markets, and financial markets. At the heart of each transaction in these markets are two elements: a selling side and a buying side. In economic terms, the selling side is often referred to as the supply side, while the buying side is called the demand side. The forces of supply and demand in a particular market determine the price at which goods and services will change hands. Just about any situation in economics can be explained in terms of supply and demand. Supply and Demand: Supply Supply is the quantity of goods or services supplied at a particular price per unit. The quantity increases if suppliers can charge a higher price per unit to cover increases in costs, such as paying overtime, hiring more employees, or purchasing more materials. A manufacturer may be willing to produce 40 calculators if it can charge $20 per unit; 60 calculators if it can charge $30; and 120 calculators if it can charge $60. The supply curve indicates the behaviour of suppliers of goods and services. The supply curve slopes upward to the right. As more input is being used in production, output will rise. However, as more and more input is used, the amount of output will taper off. This is called the law of diminishing marginal productivity. Assume that the wage per worker is $10 per hour. If we hire 10 workers for one hour, it will cost $100. If these 10 workers can produce 40 calculators in that hour, then the cost per unit is $2.50, calculated as (total cost units produced) or ($100 40). Let's say the manufacturer wants to increase production and now employs 11 people for one hour. However, they may produce only 43 calculators. Now our cost per unit is $2.56 or ($110 43). On the other hand, prices may decrease because of economies of scale. This means the unit cost of a good or service is reduced as the scale of a company's output increases. This may be due to factors such as a more efficient production process or decreased labour costs. In other words, producing more of a good or service generally reduces the average cost

11 Canadian Investment Funds Course Supply and Demand: Demand Demand is the quantity of goods or services that consumers want to consume or purchase at a given price per unit. Consumers demand more goods or services if the price decreases. For example, consumers are willing to purchase 20 calculators if the price is $50 per unit; 60 calculators if the price is $30; and 100 calculators if they pay only $10. The demand curve slopes downwards to the right because consumers tend to buy more when prices decline. Market Equilibrium Market equilibrium is the point where the supply curve and demand curve intersect. You can see from this graph that at a price of $30 consumers are willing to purchase 60 calculators and the producers are willing to sell the same amount. We say that the market for calculators clears at a price of $30. If the producer tried to produce 80 calculators and sell them at a price of $40 the market would not clear since consumers would be willing to purchase only 40 calculators at that price. Consequently, there would be an oversupply of calculators

12 Lesson 2: Marketplace Changes in Supply The supply curve is not fixed; it can change. It is a reflection of the costs a company incurs to make a product, and the price that must be charged to cover those costs. If the company can lower its costs (for example, due to more efficient technology or lower labour costs), then it can lower the price charged per unit and the whole supply curve shifts to the right. As we can see from the graph, the new equilibrium point is now 70 calculators at $25. In other words, the company has lowered its costs by $5 and can now produce 70 calculators and charge only $25. Along the demand curve, consumers are willing to buy those 70 calculators at $25 and the market still clears. If the company's costs rise, then the supply curve shifts to the left and a new equilibrium is established. Changes in Demand Like the supply curve, the demand curve can shift. A positive shift means that at any given price consumers are willing to pay more for a unit of product. In this case the equilibrium point shifts to a price of $35 and a quantity of 75 units

13 Canadian Investment Funds Course The demand curve shifts for the following reasons: change in tastes: If a product suddenly becomes very popular, consumers are willing to pay more for that product. For example, a particular toy could suddenly become very popular. increase in income: If consumers have more disposable income, they spend more on products. For example, if the government gave everyone a 20% decrease in income tax there would be more disposable income and demand for products would rise. complementary goods: A complementary good is one that is positively associated with another good. For example, DVDs and DVD players are complementary goods. It is safe to assume that if there is an increase in demand for DVD players, there will be a corresponding increase in demand for DVDs. Therefore, the demand curve for DVDs shifts to the right and the price increases. substitute goods: A substitute good can be used in place of another good. One example is butter and margarine. If the price for butter rises, consumers demand more margarine and there is a positive shift in the margarine demand curve. Supply and Demand in the Financial Markets Financial markets are subject to the same supply and demand influences as any other market and can be viewed in the same manner. If there is a sudden increase in demand for stocks or bonds, then the cost of those investments rises as the demand curve shifts. Money can be viewed as a commodity with the price being interest. In financial markets, just as in any other markets, there are suppliers of capital and consumers of capital. The more common terms are lenders and borrowers. For example, if a government needs to borrow funds it issues bonds. Investors purchase those bonds and act as lenders to the government. Financial markets serve borrowers and lenders in three ways: to channel funds from lenders to borrowers to facilitate the timing of purchases through borrowing and lending to provide a mechanism for government policy The Flow of Funds Funds can flow from lenders to borrowers in two ways: directly or indirectly. Direct financing In the case of direct financing, a borrower deals directly with the lender. For example, if a person needs to borrow $1,000 he or she might approach friends and family members to find someone with $1,000 to lend. This is not efficient. Indirect financing In the case of indirect financing, a borrower does not deal directly with the person who has money to lend. Instead, he or she approaches a financial intermediary who acts as a

14 Lesson 2: Marketplace middleman, bringing many borrowers and lenders together. The most common financial intermediaries are banks. Banks have a large pool of funds from their many depositors (lenders) that they can make available to borrowers. There are several benefits to intermediation: efficiency: It is easier for a borrower to go to an intermediary to access funds rather to search for a person or entity with excess funds available. diversification: The risk for a financial intermediary is much less than for a direct lender. The financial intermediary can lend to many different types of borrowers, such as homebuyers, business owners, or corporations. Therefore, if a borrower defaults on a loan, the intermediary will be only partially affected. A direct financier, on the other hand, has all its eggs in one basket. reduced costs through economies of scale: Doing many similar transactions reduces the cost of doing business. It may cost $500 to have one loan contract drawn up but if 1,000 similar contracts are being established the price is much lower. Other Aspects of Financial Markets Timing of purchases Financial markets enable people to time their spending and saving to fit their lifestyle and circumstances. Through financial markets, households have the opportunity to spend in some years and save in others. Mechanism for government policy When the federal government wants to change interest rates or the amount of money circulating in the economy, it uses financial markets to implement its policies. Financial markets then transmit these changes to the rest of the economy. Types of Financial Markets There are three main types of financial markets: capital markets money markets foreign exchange markets Capital Markets The capital market is a trading place for financial assets. Capital markets bring together corporations, governments, and other organizations seeking capital, with investors and lenders. The capital market has the following characteristics: trades mainly stocks and bonds trades derivatives, which base their value on capital market securities generally a long-term market (as opposed to the money market, which deals with short-term fixed income securities)

15 Canadian Investment Funds Course Capital markets consist of the primary and secondary markets. Money Markets The money market is a trading place for short-term financial assets, typically those with a maturity of less than one year, but sometimes up to three years. Money market instruments are used for raising short-term capital or for investing cash surpluses for a short period of time. In order to understand the money market, it's important to understand the purpose of money and the role of the Bank of Canada. Money Money is a financial asset because it has value; it represents a written claim against the issuer in this country, the Bank of Canada. Money has the following purposes: a medium of exchange: it can be used to purchase goods and services a store of value: money stores purchasing power from the moment it is received to the moment it is used a unit of account: money is used to measure the value of goods and services

16 Lesson 2: Marketplace Bank of Canada The Bank of Canada serves as the federal government's bank, the bank to banks, and the government agency responsible for monetary policy. Monetary policy is about making changes to the money supply for the purpose of changing interest rates. These are the duties of the Bank of Canada: to regulate currency and credit in the best interests of the economy to control and protect the Canadian dollar to influence the level of production, trade, prices and employment through monetary action To fulfill these duties, the Bank of Canada may do the following: increase (redeposit) or decrease (drawdown) the Government of Canada's deposits with the chartered banks participate in open market operations by buying or selling treasury bills through a designated group of investment dealers and banks change the bank rate to signal its intentions regarding monetary policy For more information, click here to visit the Bank of Canada Web site. Foreign Exchange Markets Currencies are traded on the foreign exchange markets between various international and domestic banks and dealers. Foreign exchange trading involves selling one currency and buying a different currency. In a currency market, the price of one currency in terms of another is called the foreign exchange rate. For example, if the exchange rate is $1.37 Canadian(Cdn) dollar/u.s. dollar, then $1 U.S. dollar can purchase $1.37 Canadian dollars. If you were to purchase a litre of milk for $0.75 U.S., how much would it cost in Canadian dollars? $ 0.75 U.S. x $1.37 Cdn/U.S. $1.03 Cdn If an American were to purchase a book worth $15.00 Cdn, how much would it cost in U.S. dollars? $15.00 Cdn $1.37 Cdn/U.S. = $10.95 U.S. The Bank of Canada is also involved in the foreign exchange market. Through Canadian chartered banks and investment dealers, the Bank of Canada buys and sells Canadian and foreign currency in order to regulate the Canadian dollar

17 Canadian Investment Funds Course How foreign exchange affects investments Jane wants to purchase a U.S. Growth Fund denominated in U.S. dollars. Currently, the exchange rate is $1.45 Canadian dollar/u.s. dollar. Jane has $10,000 Canadian to invest. How much will she be able to purchase in U.S. dollars? $10,000 Canadian $1.45 Canadian/U.S. = $6, U.S. After five years, Jane's U.S. Growth Fund is worth $15,750 U.S. She wants to sell the investment and convert it back to Canadian dollars. The exchange rate is $1.39 Canadian dollar to U.S. dollar. What will Jane receive in Canadian dollars from this redemption? $15,750 U.S. x $1.39 Canadian/U.S. = $21, Canadian Exercise: Marketplace Newly Issued Shares Corporations issue new shares for many reasons such as: to go from a private to a public corporation by way of an initial public offering (IPO) to raise additional capital for an expansion, research and development, or an increase in working capital to raise funds in a private company for the sale of an owner's share of the business A corporation issues new shares in what is called the primary market. To do this, it will usually hire an investment dealer to help bring the shares to market. The dealer is a financial intermediary between the company and the primary market. The issuing company relies on the dealer's distribution channels instead of selling the shares itself to the market. The dealer assists the company to create what is called a preliminary prospectus. The preliminary prospectus is a document that describes the company, the characteristics of the shares to be offered, the use of the funds raised through the sale of shares, and any relevant material information that is pertinent to a prospective buyer. The preliminary prospectus is not an offer to sell securities. It is a draft version of what will later become the prospectus after it is filed with and approved by the securities commission in each province where the shares are to be sold. Because it is not an official prospectus but has some of its characteristics, it is also referred to as a "red herring" prospectus. When a securities commission approves a preliminary prospectus, it is not an endorsement that it is a good investment. It only means the prospectus contains all the information that must be disclosed for an investor to make an informed decision. Once approval has been

18 Lesson 2: Marketplace granted, a final prospectus is issued with the price at which the shares will be sold. Dealers are not permitted to make sales of the security before the registration is approved and a final prospectus issued. The Underwriting Process Underwriting is the process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities. In general, underwriting takes two forms, either as a bought deal or on a best-efforts basis. A bought deal, or firm commitment, is when a dealer makes a commitment to purchase all the shares from the issuing company and then distributes them to investors. The dealer sells them to the public for slightly more than it paid the issuing company. A best efforts basis is a commitment by the dealer to sell as many of the new shares as possible at the best price available. The dealer does not actually purchase the shares from the issuing company. Exercise: Bringing the Shares to Market Secondary Markets When investors purchase an issue of new shares, money flows from the investor, through an underwriter, to the corporation that issued those shares. This is the primary market. Earlier this year, Amp Fiddle Inc. issued 4,000,000 common shares at a price of $5.10 for gross proceeds of $20,400,000, calculated as (price per share number of shares) or ($ million). The underwriters' fee was $1,326,000. The net proceeds to the company were $19,074,000, calculated as (gross proceeds - underwriting fees) or ($20,400,000 - $1,326,000). Once these shares are purchased in the primary market, they subsequently trade among investors, changing hands whenever a match can be found between people who want to sell their shares to those who want to buy them. These shares are said to be trading on the secondary market. The original issuing company has no further direct financial interest in the subsequent trading of these shares. The secondary market includes the many organized stock exchanges, as well as the over-the-counter markets

19 Canadian Investment Funds Course Stock Exchanges A stock exchange is established for the purpose of trading shares between members of the exchange and their clients. Members of the exchange are regulated by a strict code of conduct to ensure that markets operate smoothly and investors are treated fairly. Companies must apply to be listed on an exchange. If accepted, companies must obey its listing requirements, including rules concerning the disclosure of information. The following table lists some of the most important global stock exchanges. Largest International Stock Exchanges by Domestic Market Capitalization in Millions of US Dollars, June 2007 Exchange Domestic Market Capitalization NYSE Group (merged with Euronext) 16,603,601 Tokyo Stock Exchange 4,681,046 Euronext (merged with NYSE Group) 4,240,062 NASDAQ 4,163,092 London Stock Exchange 4,036,986 Hong Kong Exchanges 2,027,998 Toronto Stock Exchange 1,980,839 Frankfurt Stock Exchange (Deutsche Borse) 1,956,079 Shanghai Stock Exchanges 1,693,017 Madrid Stock Exchange (BME Spanish Exchanges) 1,519,588 Source: World Federation of Exchanges Some of the benefits a company enjoys by listing on an exchange include: increased marketability of shares due to greater market exposure increased public confidence in the company due to the exchange's disclosure rules an active secondary market that can broaden a company's shareholder base

20 Lesson 2: Marketplace Over-the-Counter (OTC) The shares of publicly traded companies that are not listed on a stock exchange may still be traded on the over-the-counter market (OTC), sometimes referred to as the unlisted market. Unlisted securities trade in the OTC market through a network of dealers. There are many reasons a company might consider listing in the OTC market including: unwillingness to abide by the disclosure rules of an exchange low volume of trading in its shares low investor interest inability to meet the requirements to be listed, usually because it is a small company The OTC market also plays a part in the primary market. Many new stock issues that are underwritten by securities firms are first sold over-the-counter before becoming listed on a stock exchange. Large blocks of outstanding shares offered for sale by a single investor, whether listed on an exchange or not, are sometimes sold in the OTC market. Often a securities firm will underwrite the block itself and offer it for sale in the OTC market in the same manner as a new issue. This process is referred to as secondary distribution. The disclosure standards for the OTC market are not as stringent as those imposed by an exchange. A corporation whose shares are listed on an exchange is generally not allowed to list or trade in the OTC market, with the exception of secondary distributions. Exercise: Examining the Marketplace Initiating a Trade on the Stock Exchange To trade stocks listed on a stock exchange, you start the transaction by instructing a stockbroker to buy or sell a certain number of shares of a specific corporation. Shares are traded in standardized units called board lots according to the Universal Market Integrity Rules. The number of shares in a board lot depends on the market price of the shares. The following table outlines the standard board lots. Board Lot Sizes Share Price Number of Shares in a Board Lot $ Less than $0.10 1,000 $ $ $1.00 and over 100 Any number of shares that is less than the number required to make up a board lot is called an odd lot. Odd lots usually cost more to purchase per unit than board lots

21 Canadian Investment Funds Course Ysabel purchased 100 shares in GGK Inc. as a birthday gift for her daughter. Shares in GGK traded at $37.95 per share. Therefore, Ysabel purchased a board lot of GGK Inc. Satoshi expects the price of Tomiie Progressive Ltd. to rise significantly above its current $0.65 share price. He purchased 250 shares of the company. Satoshi purchased an odd lot of Tomiie because the current market price of the stock is less than $1.00, but greater than $0.10 per share so a board lot is 500 shares. Types of Orders When you tell your broker what you wish to buy or sell, you may also place some additional conditions on the sale: Market order The broker buys or sells the shares immediately at the best price currently available. Nemo instructs his broker to purchase 200 shares of Jammz Inc. at the market. Since the current price available is $35 per share, Nemo gets his order filled at this price. Limit order The broker completes the transaction only once a particular price or better is reached. A limit order sets the maximum price the client is willing to pay as a buyer, and the minimum price he or she is willing to accept as a seller. Melissa has instructed her broker to buy a board lot of DiTecco Inc. if the price drops to $10 per share. She also wants him to sell 200 shares of Azores Ltd. if the price reaches $20 per share. Day order An order that is valid only for the day it is entered. The order expires if it is still outstanding when the market closes. Unless otherwise specified at the time the order is placed, all limit orders are day orders. Danny owns shares in Howell Inc. He suspects the company's second quarter earnings will be less than the market expects. He believes that when earnings are announced today, the price of the stock will drop, but then rise again shortly thereafter. He instructs his broker to purchase a board lot if the price drops to $10.50 per share on that day. This is a day order that will expire at the end of the day

22 Lesson 2: Marketplace Open order Stop-loss order An order that remains in the system for more than a day. It is a limit order that remains in effect until the order is filled, up to a pre-defined time limit of, for example, 30 days. Jasmine wants to sell her shares of Taylor Match Co. at a price of $60. She places an order to sell her shares at $60 and leaves it open for 30 days. If during that time, the price reaches $60 or above, she will get filled on her order. An open order that instructs the broker to sell securities at "the market" if the price falls below a specified level. A stop-loss order is designed to limit a loss if the market drops. Richie is concerned about his shares of Hawtin Inc. The stock is currently trading at $ He calls his broker and places a stop-loss order to sell 500 shares if the price reaches $9.25. The next day, the stock price falls to $9.00, Richie's stop-loss order converts to a market order and gets filled at the market price. Although, he set a price of $9.25, he is not guaranteed to receive it. Once a broker relays an order to the market, it is either filled immediately if it is a market order, or recorded in an order book if it is a limit order. Whenever an order is filled, the exchange floor notifies the stockbroker who provides the investor with a confirmation slip providing details of the transaction including the volume of shares traded, the price, and the commission due. The broker does not buy or sell the securities directly. He or she only acts as the agent for the investor trading on an exchange. The only compensation that the broker receives is the commission on the transaction. Quotations When you see a listing for a specific stock, you will see two prices: the bid price and the ask price. At a particular time, the bid price is the highest price that someone is willing to pay for a security that you are selling. The ask price, or offer price, is the lowest price that someone is willing to accept for a security you want to buy. If you are selling, you get the bid price; if you are buying, you pay the ask price. The ask price is higher than the bid price, and the difference between them is called the spread, which is the broker's profit. A quotation or quote consists of the bid and ask for a particular security at a particular time. Stock X is traded on the TSX Venture Exchange. On Sept 2nd, the bid was $26, the ask was $28 and the spread was $2, calculated as ($28 - $26). Together the bid and ask comprise a quotation as shown

23 Canadian Investment Funds Course A Quotation for Stock X, Sept 2nd Trading occurs when either of the following occurs: a prospective purchaser accepts the asking price a prospective seller accepts the bid price For an actively traded stock, millions of shares can trade in a day with the quotation changing constantly as individual investors and institutions purchase and sell. Because of the large volume traded, the spread is usually quite low. Buying on Margin Buying on margin involves gaining access to a certain amount of a security without being responsible for the whole cost of buying it. You are required to contribute a percentage of your own money and you borrow the rest. Josette purchases 100 shares of Abaysay Ltd. at $10 per share on 30% margin. Josette will put up 30% of the money, or $300, calculated as (100 shares x $10 x 30%). The broker will lend her the remaining $700 calculated as (100 shares x $10 x 70%). The amount of margin required by the investor depends on the market price of the stock. The advantage to the investor of buying on margin is leverage. Leverage is a way to magnify returns on an investment by using borrowed funds. You pay for only a fraction of the underlying security's value. You gain exposure to a lot more of a stock than you would if you had to use only your own funds. If the stock goes up in value, your rate of return is a lot higher than if you had been obliged to purchase the whole amount yourself. However, there are risks. Returns are magnified, but so are losses. You are required to maintain a minimum amount of margin in your margin account at all times. If the market value of the stock declines, you will experience a loss of capital and be required by the broker to deposit more money in your account. The significant risk associated with this strategy is that the balance of the loan may be greater than the value of the shares purchased. Josette purchased her shares on 30% margin. Therefore her maximum loan was 70%. If the price of Abaysay Ltd. dropped to $8 per shares. Her maximum loan would be $560, calculated as (100 shares x $8 x 70%). When the share price was $10, her maximum loan was $700. At the new price, she is under-margined by $140 or ($700 - $560). Her broker would issue a margin call of $140. If she could not contribute the additional $140 to her margin account, her broker could sell the shares to make up the difference

24 Lesson 2: Marketplace If shares are sold to satisfy a margin call, it usually results in a significant capital loss. Mutual funds are not normally purchased on margin, except when purchased through an investment dealer. For such purchases, the regular margin rules apply. Short Selling Another typical transaction involving borrowed funds is short-selling, a process that provides investors with opportunities to profit when prices fall. Short-selling takes place when investors place sell orders for securities they do not own. To do this, investors must inform their brokers that they are making a short sale, so the broker can arrange to borrow stock for delivery to the purchasers. The idea behind short-selling is speculation that the market value of a security will decline. An investor would then purchase the securities when the price is lower in order to repay the loan of stock. The difference between the selling price and the lower buying price represents the investor's profit. Similar to buying on margin, the investor is required to deposit as margin, a percentage of the stock's market price. If the investor is incorrect about the stock's price movement and it rises instead of falling, the investor will receive a margin call. He or she will have to deposit additional funds to the margin account. Exercise: Secondary Markets Secondary Debt Markets There is a large and active market for bond trading. Except for a few exchange listed debentures, bonds trade in the dealer market or over-the-counter (OTC). In other words trading is conducted directly between financial institutions. There is no commission charged on bond trades, rather the dealer takes a spread. This means they will purchase for one price and then sell at a higher price, keeping the difference. Several electronic trading systems such as CanDeal and CBID have been established to facilitate trading. Although the public is not as familiar with the bond market as with the stock market, secondary trading in bonds is well over 10 times the trading volume in stocks

25 Canadian Investment Funds Course Lesson 3: Competitive Products Welcome to the Competitive Products lesson. In this lesson, you will learn about investment products that either complement or compete with mutual funds. Once you have an understanding of these products, you can better serve your clients by contributing to the formulation of their overall financial strategies. This lesson takes 30 minutes to complete. By the end of this lesson, you will be able to do the following: describe S&P/TSX 60 index participation units describe equity-linked GICs describe labour sponsored investment funds describe direct and indirect real estate investments describe mortgage-backed securities describe wrap accounts describe pooled funds describe hedge funds describe income trusts describe principal protected notes describe the various life insurance products (term, permanent, and universal) describe the various annuities (accrued, prescribed, deferred, and variable life) describe segregated funds

26 Lesson 3: Competitive Products Specific Investment Products As a mutual fund salesperson, you should be aware of the different features of various investment products in the industry. Some of the more popular products include the following: S&P/TSX 60 index participation units equity-linked GICs labour sponsored investment funds real estate mortgage-backed securities wrap accounts pooled funds hedge funds income trusts principal protected notes Please be aware that your mutual fund license does not entitle you to sell these products. Contact your compliance department for information on the necessary licensing requirements. S&P/TSX 60 Index Participation Units (i60s) S&P/TSX 60 Index Participation Units (commonly known as i60s) are trust units that hold the stocks of the S&P/TSX 60 index. This index consists of stocks from 60 large corporations that represent the major sectors of the Canadian economy. Similar to index mutual funds, investors receive a diversified portfolio of Canadian companies that fluctuates in value with general market trends. This type of investing is known as basket trading. i60s also have the following characteristics: They are traded on the TSX. They are purchased or sold through an investment dealer or broker. The trading price, or core asset share value, is 1 / 10 of the value of the S&P/TSX 60 index plus undistributed net income. Units pay a quarterly dividend based on the dividends received by the individual companies in the portfolio. The management fee, or trustee fee, is substantially lower than the fee for mutual funds, approximately 0.15% of the core asset share value. They are eligible for RRSPs and other registered plans

27 Canadian Investment Funds Course Index-linked GICs Index-linked Guaranteed Investment Certificates (GICs) guarantee investors the full return of principal plus a variable return based on the performance of a stock index. Indexed-linked or equity-linked GICs are issued for terms of one to five years and their returns are linked to the cumulative market returns of a specified stock index or equity mutual fund over the term. Return of principal is guaranteed. However, the deposit does not earn a specific rate of interest or minimum rate during the investment period. Rather, at the end of each year, the GIC will earn a rate of interest that is the same as the change in the stock index to which it is linked. Often, the institution may cap the maximum rate that the GIC can earn in a given year or the cumulative rate for the entire term. For example, if the S&P 500 rises by 14%, the rate of interest on the GIC will also be 14%. However, if the GIC has a cap of 10% per year, then the GIC rate will be 10% even though the index records a higher return. If the index has a negative return for the period, the guarantee of principal ensures that the investor will not incur any losses. However, the GIC will not earn any interest. Similarly, if on maturity, the index it follows has a cumulative negative rate of return over the entire period, these deposits will not pay any interest. This table illustrates the return and maturing value of $10,000 invested in an index-linked GIC for a term of three years. Year Stock Index Return (%) Return on Index-linked GIC GIC Annual Return (%) GIC Cumulative Return (%) Value $11, $11, $12, Stock market indices commonly used include the TSX/S&P 60 Index, S&P 500, or a weighted average of a basket of international stock market indices. Some financial institutions offer GICs with returns linked to the performance of a basket of equity mutual funds. Even though the return is linked to a stock index or other equity return, it is interest income for tax purposes. Most issuers base the interest payment on an averaging formula for the term of the GIC, but some base the payment on the stock index's value when the GIC matures. Investors should be aware of these details. Labour Sponsored Investment Funds (LSIFs) Labour sponsored investment funds (LSIF) invest in small high-risk companies to provide funds in the early stages of the business. By providing tax incentives to investors, the federal and some provincial governments hope to help provide finance to Canadian entrepreneurs and support small business. This form of venture capital financing is risky due to all the risks that a start-up company faces. Many do not survive. LSIFs are also a lot less liquid than mutual funds. In recognition of the higher risk they pose to shareholders, the Income Tax Act offers attractive tax

28 Lesson 3: Competitive Products incentives to investors at the time the investment is made. To qualify, the LSIFs must invest a specified portion of their assets in qualified private companies within a specific period. Labour sponsored investment funds (LSIFs), like mutual funds, pool capital from many different shareholders for investment purposes. However, LSIFs are significantly riskier and have the following differences: LSIF portfolio investments are more speculative; they may be relatively new companies not listed on any exchange. Valuation of the portfolio is based on appraisals of securities, not market prices. Units or shares are priced monthly, rather than daily, which affects liquidity. Redemptions may be restricted to 20% of their assets in any one year. Portfolios are less diversified. Funds may borrow for purposes other than making redemptions. There are significant tax penalties for early redemption. Investors receive tax incentives from these investments. Although there is no limit on purchases, an investor receives a 15% federal tax credit on the first $5,000. Some provinces support the LSIF program with their own tax credit scheme. However, the percentages and maximum qualifying amounts may differ among provinces. These funds can be purchased in an RRSP, which can magnify the tax savings. However, investors should be aware that LSIFs have to be held for a minimum of eight years, otherwise, there is a clawback on the tax credits. By law, LSIFs can only be sponsored by labour organizations, such as unions or workers' cooperatives. For tax purposes, LSIFs are established as corporations. Real Estate Most Canadians are familiar with real estate investing when they purchase their home. However, they can also participate directly through purchasing a second property or indirectly through investing in shares of a development company or real estate investment trust. Direct real estate investment Revenue property is the most common type of direct real estate investment. There are many residential and commercial properties that can provide rental income and potential capital gains. This type of investment can be quite costly; therefore, it is not accessible to all investors. In addition to the cost of the property, there are property taxes, maintenance, repairs, sales commissions, and legal fees. Some of these expenses are tax-deductible. There are significant risks involved in direct ownership: fluctuating real estate values vacancy rates lack of liquidity