Unit 3: Mutual Fund Investments

Transcription

1 Unit 3: Mutual Fund Investments Welcome to Mutual Fund Investments. This unit gives you an overview of investing and other types of financial instruments available. Before providing your client with an investment solution, you need to know the basics of investing and the different types of products available. This unit takes approximately 2 hours to complete. You will learn about the following topics: Investment Money Market Instruments Long-term Fixed Income Instruments Common Shares Preferred Shares Derivatives To start with the first lesson, click Investment on the table of contents. Lesson 1: Investment Welcome to the Investment lesson. In this lesson, you will learn what it means to invest and why it is important, as well as general investment objectives of each category of fund. Before providing your client with a solution, you should understand why they should invest and how different funds can meet your client's investment objectives. This lesson takes 15 minutes to complete. At the end of this lesson, you will be able to do the following: define investing list the characteristics of investment describe the general investment objectives of each category of fund Investment Capital Supply and Demand You can define investing as the laying out of money or capital to some entity with the expectation of profit. A nation's wealth is connected to the quantity and quality of its capital. The more capital a country has, the higher its productivity, competitiveness, and incomes are likely to be. A country builds capital by saving. Saving means consuming less than total income and using the remainder to invest in new assets. Supply The supply of investment capital in the Canadian economy comes from the following sources: household savings retained earnings that corporations have not paid out as dividends budget surpluses in the government sector savings from abroad 2010 IFSE Institute 1

2 Demand The demand for investment capital comes from the spending decisions of the following: governments (federal, provincial, municipal) corporations Canadian households foreigners interested in the Canadian financial markets The movement of investment capital from the suppliers to those with demand may be done directly but is usually handled by intermediaries such as banks, trust companies, and investment dealers. The Importance of Investment Being able to convert idle savings into investment capital is critical for the long run prosperity of an economy. By lending money to buy new housing, banks help local infrastructures grow and meet the needs of an expanding population. The same is true when governments borrow money to build hospitals and roads or when corporations issue securities to finance expansion of their operations. Without access to investment capital, governments and companies are limited by the amount of capital they can access internally. Nations with low levels of savings tend to have low rates of investment and low rates of economic growth. Nations with healthy economic growth tend to have well developed financial markets that encourage saving and investing. Characteristics of Investment Capital Investment capital has three related characteristics: scarcity sensitivity mobility Scarcity There is a limited supply of investment capital and those seeking capital must therefore compete for it. Sensitivity Sensitivity is the degree to which investment capital is influenced by changes in financial markets and the overall economy. With the growing amount of investment options available and the increased ease of access to information about those investments, investors are becoming more discriminating in their investment choices. Mobility Improvements in technology have made it possible for capital to move quickly from one part of the world to another. The foreign exchange markets trade more than $1 trillion every day on a 24 hour a day basis. This mobility has increased efficiency but it also serves to increase financial crises through rapid flow of capital IFSE Institute

3 Investment Objectives The primary investment objectives are as follows: safety (preservation of capital) income growth Safety (preservation of capital) Investors seeking safety of capital prefer longer term, low return investments. They are willing to give up potential returns to protect their capital. Income Investors seeking income assume somewhat higher risk. They are looking for a steady stream of income through interest and dividends and are willing to assume some risk to their capital. Growth Growth investors are seeking capital appreciation in their investments with little emphasis on regular income. These are riskier investments due to the lack of regular return of capital and also assume the risk of experiencing capital losses. Objective Risk Term Typical Products Sensitivity/ Mobility Safety Low Short Treasury Bills Minimal GICs Term Deposits Long Government bonds Mortgages Income Moderate Long Government and Minimal Corporate Bonds Preferred Shares Mortgages Dividend paying common shares Growth High Short or Long Common shares Derivative Products Prevalent Exercise: Investment Lesson 2: Money Market Instruments Welcome to the Money Market Instruments lesson. In this lesson, you will learn about the features of Treasury Bills, Bankers' Acceptances, and Commercial, Provincial, and Municipal Papers. To fully understand how a mutual fund works, you must first understand the underlying financial instruments. This lesson takes 20 minutes to complete. At the end of this lesson, you will be able to do the following: describe the features of Treasury Bills and how they work describe the features of Bankers' Acceptances and how they work describe the features of Commercial, Provincial, and Municipal Short-term Papers and how they work 2010 IFSE Institute 3

4 Treasury Bills (T-bills) T-bills are short-term money market investments issued by the federal and provincial governments. The Bank of Canada issues treasury bills on behalf of the Government of Canada. Federal T-bills are guaranteed by the federal government and are considered one of the least risky Canadian investment products because the face value is guaranteed if held to maturity. Issuing T-bills The Bank of Canada issues bills on a two-week cycle. The terms of maturity offered at the auction are 98, 182, and 364 days. These T-bills are sold in large denominations to banks and investment dealers. They are then broken up and sold to individual investors, with varying maturity dates anywhere from a few days to one year. Interest rates The Bank of Canada influences interest rates by buying and selling T-bills in the open market before the biweekly auction or through the auction itself. This is part of its monetary policy. Benefits T-bills have three main benefits: Liquidity: They may easily be bought and sold at any time. Safety: They are guaranteed by the federal government. Affordability: The minimum investment is usually $5,000. Purchasing T-bills There is a secondary market run by investment dealers where individuals can buy and sell T-bills. In the secondary market, bills are bought and sold with prices quoted as bid and ask. There is a minimum amount that must be purchased, usually from $5,000 to $50,000. The ask price, or offer price is the price at which an investment dealer would sell you a T-bill. The bid price is the price at which it would buy it from you. The dealer does not charge a commission, but keeps the spread between bid and ask. T-bills do not carry a set rate of interest. They are purchased at a discount to, or less than, their face value and are redeemed for that face value if held until maturity. The difference between the purchase price and face value at maturity is considered interest income by Canada Revenue Agency (CRA) and must be reported on your tax return. J.D. purchased a 180-day T-bill with a face value of $10,000 for $9,800. If he holds the T- bill until maturity, he will receive $10,000 and his return will be $200 or ($10,000 - $9,800). He will report the entire $200 as interest income and pay tax according to his marginal tax rate IFSE Institute

5 Risk There is almost no default risk with T-bills because the Government of Canada issues and guarantees them. T-bills are subject to inflation risk. When they mature at face value, if there has been inflation, their real value will be less than it would be without inflation. Exercise: T-bill Characteristics Calculating the Yield on a T-bill T-bills do not pay a fixed rate of interest based on their face value (or par value). They are purchased at a discount and mature at their face value. The difference between the purchase price and the maturity value is the investment yield. It is considered interest for tax purposes. Face value, par value, and price at maturity all refer to the same thing. Since T-bills are extremely safe and very liquid, they do not offer as high a return as other riskier investments. However, when compared to GICs or term deposits with the same term, they often provide a competitive yield. Quoted yield Treasury bill returns are quoted as yield to maturity. Your return when you buy a T-bill is the difference between the maturity value and the purchase price. The rate of return is calculated by dividing this difference by the purchase price and expressing the result as an annual percentage rate, using a 365-day year. The formula used in Canada for calculating the quoted yield of a T-bill is: Donnie paid $9, for a 91-day T-bill with a face value of $10,000. The quoted yield for this T-bill was 4.0%, calculated as [((par value - price) price) (365 term)] or [(($10, $9,901.30) $9,901.30) x (365 91)]. Calculating the Price of a T-bill The standard method of quoting the price of a T-bill is to give the price per hundred dollars of par value. Rita noticed on the Web site for her discount broker that the price of a 180-day Canadian T- bill was $ This means that she would need to pay $ for every $100 par value of the T- bill. If she were to purchase a $10,000 par value, 180-day T-bill, it would cost her $9, When selling a T-bill, the purchaser will pay an amount based on the prevailing interest rate. Rearranging the yield equation gives the formula for calculating the purchase price: Rona offered to purchase Donnie's T-bill after he had held it for 30 days. This means there are 61 more days until this T-bill matures. The quoted yield for a T-bill will change as it approaches maturity. The prevailing interest rate for a 61-day T-bill, at the time of Rona's offer, was 3.5%. Rona 2010 IFSE Institute 5

6 was willing to pay $9, for the T-bill with 61 days to maturity, calculated as [par value (1 + (quoted yield (term 365)))] or [$10,000 (1 + (3.5% (61 365)))]. Sensitivity to interest rates The price of T-bills is sensitive to changes in prevailing interest rates. This sensitivity is shown by the extent to which its market value changes when prevailing interest rates change. If interest rates rise, the market value of an existing T-bill will fall. If interest rates fall, the market value of the T-bill will rise. The most important factor is the term to maturity. The rule is that longer term T-bills are more sensitive to interest rate fluctuations than shorter term T-bills. Bankers' Acceptance A bankers' acceptance (BA) is a short-term debt instrument issued by a company but ultimately guaranteed by a bank. A company may find that it wants to borrow money in the short term (typically one to three months), but it finds that by itself, its borrowing costs are too high. However if it can rely on the credit rating of a major bank, its borrowing costs will fall, meaning it can pay less interest on its debt. It will also make the company s debt easier to trade in the secondary market because it will be more trusted. If the bank agrees, it advances the company the funds. For a stamping fee, the bank guarantees the company's debt. The company sells the debt to investors at a discount and it matures at face value. If the company fails to pay, the investor may turn to the bank for payment. Helios Trading Company needs to borrow $2 million to pay a supplier. The market is unfamiliar with Helios and uncomfortable with the volatility of the industry in which it operates. Helios finds that to issue debt obligations in the market by itself, it will be forced to offer a yield of about 8%. Helios turns to its bank for a bankers acceptance. For a fee, the bank agrees and now Helios is able to offer a corporate note to the market at less than $2 million, maturing in three months time with a yield of 3%. Since the note is backed by the bank, investors are more willing to purchase the note and because their perceived risk exposure is much less, the market demands less of a return. By using the bank s credit rating instead of its own, Helios has reduced its borrowing costs significantly. Unfortunately, Helios finds itself unable to repay its investors the face value at the maturity date. Since the note is a BA, they are able to turn to the bank for repayment instead of the struggling company. Commercial Paper Commercial paper is a short-term debt instrument issued by a financial or a non-financial corporation. Unlike a bankers' acceptance, the bank does not guarantee the loan; instead the corporate borrower is responsible for repaying it. Instead of having the bank guarantee the debt, a company may choose to borrow money under its own name and credit rating. The amount of the interest rate depends on how solid the company is, and the likelihood of the company repaying the loan IFSE Institute

7 Provincial and Municipal Short-term Paper Provincial and municipal short-term papers are short-term debt instruments that represent borrowings by either a provincial or municipal government. They are underwritten and issued by investment dealers. For example, the town of Milton (a municipality) enlists the services of CIBC Wood Gundy (an investment dealer), because Milton wants to raise $10,000,000 for a new sewer. Wood Gundy establishes an interest rate based on the credit rating of the municipality, and then sells the paper to investors. The interest rate paid reflects the credit rating of the province or municipality. The interest rate is usually higher than for federal T-bills with the same term, because the credit rating of provincial and municipal governments is lower than the federal government. Returns are higher because the investor assumes more risk. Exercise: Money Market Instruments Lesson 3: Long-term Fixed Income Instruments Welcome to the Long-term Fixed Income Instruments lesson. In this lesson, you will learn about the features of Mortgages, Bonds, and Debentures. You will also learn about the different methods of measuring bond yields, including current yield, yield to maturity, and yield to call. To fully understand how a mutual fund works, you must first understand the underlying financial instruments. This lesson takes 40 minutes to complete. At the end of this lesson, you will be able to do the following: describe the features of the various bonds and how they work describe the relationship between bond prices and interest rates calculate current yield for bonds describe the concept of compounding explain how a yield curve is used in assessing a bond measure bond yields compare bonds of different classes using yield curves Mortgages Mortgages are fixed income instruments secured by real property. The Canada Mortgage and Housing Corporation (CMHC) under the National Housing Act insures many of the mortgages against default. These mortgages are called NHA insured. Most negotiable mortgages are first mortgages on Canadian residential property, with maturities of one to five years. However, commercial mortgages are also available. Similar to other fixed income instruments, mortgage prices are subject to interest rate fluctuations. When interest rates go up, mortgage prices go down, and vice versa. One of the benefits of investing in mortgages is the monthly income investors receive. The monthly income consists of a combination of interest and repayment of principal. Bonds Bonds are fixed income investments that are designed to pay a steady amount of interest income. Bonds are a legal contract with set terms that are specifically laid out at the time of issue IFSE Institute 7

8 The bond contract or indenture states the following: term face amount (amount returned at maturity) interest rate paid any other specific terms Breach of the terms of the contract has serious legal implications and typically entitles the bondholder to demand immediate repayment of the principal. All bonds have the same basic features, but there are additional features that may be added that would affect their characteristics. In many cases these features make the bonds more attractive to investors. Bond vs. Debentures Bonds and debentures are both loans from investors to a corporation or government body that wants to borrow money. They are fixed income investments. The issuer raises money by promising to make regular interest payments at a certain rate of interest. In return, it gets the use of the investors' capital. Bonds and debentures are often referred to as debt securities because individuals are investing in the debt obligation of the issuer. Bonds and debentures differ by how they are secured. A bond is secured by specific assets of the issuer such as property, inventories, equipment, or other securities. A debenture is not secured by specific assets but by the general credit of the issuer. This means that if the issuer fails to follow the payment terms of a bond, the bondholder has a legal claim on the assets that act as collateral for the bond. A debenture holder would have no claims on specific assets. Debentures are unsecured. Since debenture holders rank below bondholders for claims on the assets of an issuer in default, they are generally considered more risky than bonds. This higher risk means that debenture holders will demand a higher cost of borrowing to compensate them for this risk. Issuers will pay a higher rate of interest than they would with a bond. The following is a cover page of the prospectus prepared by OSF Inc. to offer 8.40% debentures. A Summary of Offering follows. Although called bonds, Canada Savings Bonds (CSBs) and other government bonds are only secured by the general credit of the federal government and they are technically debentures, not bonds. However, because they represent the highest domestic credit quality, they are classified as bonds for investment purposes. For the purposes of this course, we will use the term bond to refer to both bonds and debentures because most of the material applies equally to both IFSE Institute

9 Basic Bond Terminology Bonds are issued with a face amount, coupon rate, and maturity. We will now look at the basic terminology associated with bonds. Click the green boxes to get an explanation and/or example of each term. 1. Face amount: $5000 Face value (face amount, principal) The face amount or face value refers to the amount that the holder will receive upon maturity. It is the principal amount of the loan from the investor to the issuer and thus is sometimes referred to as the principal amount, Face amounts may vary with the issuer, but they typically run in multiples of a round number, such as $1,000, $5,000, or $10, Coupon rate: 8.5%, semi-annual Coupon rate The coupon rate is the rate of interest that will be paid to the bondholder. It is the nominal annual interest rate (NOM%) and is expressed as a percentage of the face amount. Although the interest is expressed as an annual percentage, most bonds make interest payments semi-annually. An 8.5%, semi-annual $10,000 bond will yield interest payments of $850 each year. The investor would receive two equal payments of $425 each year, calculated as (($10,000 x 8.5%) + 2). The effective annual return will be 8.68%, calculated as (( %) 1). Coupon Each interest payment is referred to as a coupon, a historical reference to the coupons that used to be attached to bearer bonds and that had to be detached and physically redeemed before the holder would receive the interest payment. 3. Maturity Maturity, term to maturity Most bonds have a specified term to maturity) the date on which the issuer must return the full face amount to the current bondholder. The term to maturity refers to the length of time between the current date and the date of maturity. Bonds are initially issued with a term to maturity that is a multiple of 1 year (for example, 1 year, 10 years, 15 years, etc.). Once bonds trade in the secondary market, their term to maturity will depend on the date of the purchase because the maturity date is fixed. On December 1, 1996 Angelo purchased a Government of Canada 7.5% bond maturing on December 1, At the time of purchase, the term to maturity was 5 years IFSE Institute 9

10 4. Maturity: 5 years Short-term and medium-term bond (5yrs) A bond with a term to maturity of less than 3 years is referred to as a short-term bond, while a bond with a term to maturity between 3 to 10 years is referred to as a medium-term bond. 5. Trading at a 100 Par Value Although bonds are often issued or sold initially at par, they seldom trade at par in the secondary market. Bonds that are bought or sold at their face value are said to trade at par value or simply at par. Bonds usually trade in units of par value, which is arbitrarily set at 100. Any difference between the market price and the face amount is then made relative to this base of 100. If a $1,000 bond is trading at par (that is) for $1,000), it is said to be priced at 100. However, if that same bond is sold at 96, the investor must pay $960 for the $1,000 bond, calculated as ((96 100) x $1,000). If the bond trades at 105, the investor must pay $1,050 for the $1,000 bond, calculated as ((105 / 100) x $1,000). 6. Maturity: 12 years Long-term bond Long-term bonds have terms to maturity that are greater than 10 years. In the early 1900s, it was not uncommon for companies to issue bonds with a maturity of 50 years or even more. While most new bonds tend to have a maturity of 20 years or less, a few companies have again offered bonds with very long terms. In 1993, Walt Disney and Coca-Cola were the first companies to issue 100-year bonds, Several other companies including Bell-South Telecommunications, issued century bonds in However, investors are wary of such long-term investments because there is significant risk associated with such a long term. Perpetual Bonds Although they are not common, there are a few perpetual bonds that never mature. The issuer never has to pay back the principal or face amount of the bond, but is committed to making interest payments in perpetuity. 7. Trading at a 110 Discount or premium Bonds that are bought or sold for less than face value are said to trade at a discount while those that are bought or sold for more than face value are said to trade at a premium. Trish paid $11,599 to purchase a $10,000 Government of Canada bond with a coupon rate of 9%, maturing on December 1, Trish paid a premium of $1,5991 calculated as ($11,599- $10,000), to purchase the bond, as its cost was greater than its face value. Paul paid $9,839 to purchase a $10,000 Ontario Hydro bond with a coupon rate of 5.60%, maturing on June 2, Paul bought the bond at a discount of $161, calculated as ($10,000 - $9,839), because its cost was less than its face value IFSE Institute

11 Interest Payments and Principal Repayment In summary, bonds result in a stream of regular interest payments, called coupons, plus a repayment of the face amount at maturity. The final interest payment is usually paid at the same time as the principal repayment, as illustrated by the following example. Shafik bought a 3-year, 7.5%, $5,000 bond, priced at 94.5, paying interest semi-annually. He paid $4,725, calculated as (( ) x $5,000). If he holds the bond until maturity, he will receive the following stream of payments: Time Interest Payments at 0.5 years $ at 1.0 years $ at 1.5 years $ at 2.0 years $ at 2.5 years $ at 3.0 years $5, The Trust Indenture The terms and conditions of each bond issue are set out in a trust deed or trust indenture. This is a legal document that specifies the coupon rate and date of maturity, as well as any other conditions that the issuer must meet to ensure the security of the bondholder. For example, the trust indenture could do the following: specify limits on any new debt that may be issued by the issuing corporation place conditions on future mergers with other corporations identify property that has been pledged as security for the bond issue place restrictions on the dividends that the corporation may pay to its shareholders If the issuer fails to meet any of the terms or conditions set out in the trust indenture, the issuer will be said to be in default. If the issuer is in default, the bondholders have the right to demand immediate repayment of their principal and accumulated interest. Furthermore, most trust indentures specify that if the issuer defaults on any one-bond issue, then all outstanding bond issues are also considered to be in default. Thus, if a corporation has four outstanding bond issues and defaults on the terms specified in the trust indenture for just one of the issues, all four issues are deemed to be in default. The trustee for an issue is usually a trust company, with the responsibility to act on behalf of bondholders. Exercise: Bond Terminology Government Bonds and Debentures This section focuses on longer-term marketable government debt securities, issued by federal, provincial, and municipal governments or their agencies, which actively trade after they are issued. For this part, we are not concerned with T-bills and Canada Savings Bonds (CSBs). Although they are government debt securities, they operate differently than normal bonds and debentures. T-bills are sold at a discount and mature at par; they do not pay a specific rate of interest. CSBs are redeemable on demand at face value and do pay a set interest amount, but they do not trade on the secondary market after they are issued IFSE Institute 11

12 Why Governments Issue Bonds and Debentures Governments issue bonds or debentures to raise cash for expenditures that could not otherwise be met through current tax revenues. These debt securities are often issued to raise money for longterm capital projects such as: road infrastructure schools community centres government buildings hospitals airports power plants Sometimes government bonds are issued to refund prior debt. New bonds are issued to pay for past borrowing. Government of Canada Bonds The federal government is the primary issuer of debt securities in the Canadian bond market. Government of Canada bonds (or Canadas, for short) are long-term debt issued by the federal government that provide semi-annual interest payments. They can be bought and sold any time prior to maturity. They typically mature within one to 30 years after the date of issue. Risk and return The federal government has the highest credit rating of any Canadian bond issuer, due to its ability to collect taxes and print money. Consequently, Government of Canada bonds are essentially default risk-free. Because of their longer terms to maturity, Canadas typically offer a higher rate of return than Canada Savings Bonds or T-bills, while still offering low credit risk. Like all other bonds, the value of Canadas will fluctuate with changing interest rates. When interest rates increase, the value of Canadas decreases; when interest rates fall, the value of Canadas rises. Therefore, if an investor sells prior to maturity, the proceeds of the sale will depend on current market conditions and not the face value of the bond. New Issues Whereas the federal government issues T-bills bi-weekly and Canada Savings Bonds annually, Canadas are only issued when funds are needed. When governments have eliminated federal deficits and are successfully paying down federal debt, the need for new borrowing is reduced. Over the last few years, the number and amount of new Canadas being issued has decreased dramatically. Government of Canada bonds are issued in multiples of $1,000 usually with medium to long terms. When the government requires additional funds, it usually announces a new issue, with a new coupon and maturity date, or simply sells more bonds of an existing issue. In addition to issuing debt in its own name, the federal government also guarantees the debts of several of its crown corporations and agencies. Real Return Bonds One of the problems with almost any investment is that the return can be significantly eroded by inflation. If a bond provides a yield to maturity of 4%, but inflation over that same period averages 3%, then the investor in fact gains only 1% before tax IFSE Institute

13 The Government of Canada addressed this problem by issuing its first real return bond in The return from a real return bond is indexed for inflation by adjusting the face value of the bond to reflect a corresponding change in the Consumer Price Index (change in CPI). The coupon, or stated interest rate, stays the same but because the face value changes, the amount of the interest payments also adjusts. It is for this reason that a real return bond is sometimes called an indexed bond. Eric purchased a real return bond for $1,000 with a coupon rate of 4%. With no inflation, his semi-annual interest payments will be based on a face value of $1,000. However, if inflation was 3%, then the face value of the bond would be adjusted by 3% to $1,030 or ($1,000 x 1.03). The coupon rate would still be 4% but his interest payments would be based on a new face value of $1,030. Therefore his initial investment and his interest payments are protected from inflation. Exercise: Government of Canada Bonds Provincial Bonds Provinces issue bonds for the same reasons as the federal government - they need money to finance public works. In some cases, the money may also be used to finance social welfare expenses. However, each province has strict regulations governing the types of expenditures that can be financed by issuing debt securities. Normally, the funds are used to finance projects that will last for a number of years. Risk and return Although not quite as secure as Government of Canada bonds, provincial bonds are still considered to be good investment grade debts. Provinces do not have the ability to print money but they do have taxation powers. Because they have a lower credit rating than Canadas, provincials usually offer a slightly higher return. Some provinces also guarantee the bond issues of provincial agencies and commissions, and in some cases the issues of municipalities and school boards. British Columbia Hydro bonds are guaranteed by the province of British Columbia and Ontario Power Generation bond issues are backed by the Ontario government. In some cases, the province may even guarantee a bond issued by a corporation in an effort to keep an industry in the province. Municipal Debentures Municipalities also raise funds for capital projects by issuing debentures. However, most provinces strictly regulate a municipality's ability to issue debentures. The municipality's council must approve debentures before they can be issued. Although individual villages, towns, and cities historically offered municipal debentures, regional governments have recently co-operated to raise funds through the issue of joint municipal debentures. Risk and return Municipal bonds are not automatically guaranteed by the province in which they operate. Because of this, their credit rating often varies depending on the municipality's power of taxation and the creditworthiness of the debt. The creditworthiness of the municipality is linked to the size, strength and growth prospects of its tax base. Municipal debentures usually have significantly higher returns than provincial bonds IFSE Institute 13

14 Types of Bonds These are the major types of bonds: Interest-bearing bond: Interest-bearing or coupon-bearing bonds are the most conventional types of bonds. During the life of these bonds, holders receive coupon payments according to the stated interest rate and at maturity receive the face value. Strip bond (zero coupon bond): These bonds carry no coupon or interest rate. This means that the entire return from the investment comes in the form of price appreciation of the bond. These bonds are sold at a discount and mature at the face value. The difference is considered interest for tax purposes. Callable or redeemable bond: With a callable bond, the issuer (borrower) reserves the right to buy back or call the bond from the bondholder within a specified time period and at a specified price, usually at a premium to face value. This makes sense if interest rates drop and the borrower can issue bonds at a lower interest rate. Investors demand a higher rate of interest on callable bonds because they may have to sell the bond back at a disadvantageous time. Extendible bond: If a bond has an extendible feature it allows the investor to extend the term of the bond within specified limits. This would be an attractive feature if the bond was close to maturity, and was paying higher interest than current rates. Investors would accept a lower rate of interest to obtain this feature. Retractable bond: These bonds allow the bondholder to redeem a bond at par before the maturity date. A bondholder may choose to redeem early if the coupon rate is lower than current interest rates and invest the proceeds elsewhere. Convertible bond: Convertible bonds allow the investor to exchange the bond for a stated amount of common stock of the issuing company within a stated time period. This is desirable when the market value of the common stock is higher than the value of the bond. Investors will accept less interest on the bond to obtain this feature. Floating rate bond: With floating rate bonds the interest paid is adjusted periodically to reflect interest rate movements. These bonds protect against inflation. Income bond: Income bonds pay interest only when the issuing company makes money. In this case, if a company performs poorly and does not pay interest to its bondholders, it is not considered to be in default of its obligation. They are an exception to the rule that missing an interest payment puts the company in default. Investors require a premium in interest paid to assume the added risk that they may not be receiving any interest. Mortgage bond: These bonds are backed by real property. If a corporation cannot fulfil its obligation to pay principal and interest, property can be sold and the proceeds used to pay bondholders. Corporations can issue first or second mortgage bonds. Junk bond: A so-called junk bond is a bond whose quality is deemed below investment grade by bond rating agencies. As some of these bonds may be of very low quality, all below-investmentgrade bonds have been informally called junk. Because of their relatively low quality, some of these bonds may pay very high interest rates, often in excess of 20%, because the investors are then assuming a high risk. In such cases, they could lose not only the interest owing but also some or part of the invested capital. Foreign-pay bond: These bonds are issued by Canadian governments and businesses in foreign currency to attract international investors. Payments of principal and interest are made in the foreign currency IFSE Institute

15 Debentures: Debentures are bonds that are not collateralized with specific assets but are issued against the general credit of the issuer. They are promises by the issuing company to pay. A debenture pays more interest than a secured bond due to the increased uncertainty of payment. Sinking fund: Corporations that issue sinking fund bonds set aside a certain amount each year in a sinking fund to fulfil its debt obligation at maturity. Perpetual Bonds Whereas regular bonds have a maturity date, perpetual bonds never mature. The holder of a perpetual bond will never receive the face amount, but will receive regular interest payments indefinitely. The issuer is never obligated to repay the principal, but must make interest payments in perpetuity. Although perpetual bonds are uncommon and have not been issued for quite some time, some issues still exist. Valuing Regular Bonds Bonds are priced at a par value of $100 and their returns are expressed as yield to maturity. When a bond is issued at par, the bond's yield to maturity is equal to the coupon rate. On July 1, 2007, ASA Breed Inc. issued senior debentures with a coupon rate of 9.40% and term to July 1, 2012 at par value. The yield to maturity at issue was 9.40%. Bonds are not always issued at par. The issue price can be greater than or less than par. If it is issued at greater than par it is sold at a premium. If it is sold at less than par, it is sold at a discount. In September of 2007, the Province of Ontario 5.00% bonds due March 8, 2014 were sold at a price of $ to yield 4.44%. Although the bond paid a coupon rate of 5.00% annually, the premium of $3.119 per $100, calculated as (price - par value) or ($ $100), will result in a capital loss if held to maturity. If you purchase a 10-year, 6%, $10,000 bond at par, you will pay $10,000 and earn interest of $300, calculated as ((face value annual interest rate) number of payments per year) or (($10,000 6%) 2), twice each year for ten years. At the end of the ten years, you will also receive your initial investment of $10,000. If, at the time of the initial investment, 6% was a reasonable return for comparable 10-year investments, then the price of $10,000 was reasonable. However, if after two years, you want to sell your bond because you need the cash, you are selling what is in effect an 8-year bond. It will make semi-annual interest payments of $300 and will provide a lump sum of $10,000 at maturity. If interest rates for a comparable 8-year investment are 6%, then it would be reasonable to assume that you could get $10,000 for the bond. However, if other 8-year investments are paying a higher level of interest, say 8%, then no one will want to buy your bond at par value. You will have to lower the price below par to entice potential investors to accept the lower annual interest amount and still provide an 8% return. Bond Prices Bond prices are affected by fluctuations in interest rates. In fact, there is an inverse relationship between bond prices and interest rates. When interest rates rise, bond prices generally decrease. When interest rates fall, bond prices generally increase. This inverse relationship applies to all fixed income instruments, such as treasury bills, mortgages and bonds IFSE Institute 15

16 Once bonds are issued, they may be resold on the secondary market to other investors before they mature. Just as a market exists for stocks, there is a market for the trading of bonds. Claire purchases a 10-year bond with a face value of $1,000 and an interest rate of 8%. This means that Claire will be receiving $80 annually for 10 years. After two years, Claire decides to sell her bond. Let's look at the potential scenarios. Calculating Bond Yields In order to measure the return on a bond, you would calculate the yield. The yield is the rate of return from an investment, calculated on its par value. There are two types of yield calculations: current yield and yield to maturity. Calculating current yield Since bonds often trade at a price different from their par value, current yields are used to determine the rate of return an investor would realize if he or she purchased a security at its market price. To calculate current yield: Current yield = Return ($) Market price ($) A 6% bond with a par value of $1,000, due to mature in one year, might trade at $980. The return is $60 (6% x $1,000) and the market price is $980, therefore: Current yield = $60 = or 6.12% $980 A bond purchased at a discount (a price below par value) will have a current yield that is higher than the coupon rate. A bond purchased at a premium (a price above par value) will have a current yield that is lower than the coupon rate. Calculating yield to maturity Yield to maturity is the rate of return an investor would receive if the bond were held until maturity. It takes into account the purchase price, the interest payments, time remaining to maturity, maturity value, and the time between interest payments. Yield to maturity considers interest-on-interest; however, it assumes that the interest payments are reinvested at an interest rate equal to the yield to maturity. The calculation is complex, so bond tables, calculators, and computer programs have been developed to determine the yield to maturity for a given bond. For this course, you are not required to calculate yield to maturity. Yield to maturity is the most frequently used comparison of bond returns. Exercise: Calculating Bond Yields The Yield Curve A yield curve is a graph that shows the relationship between yield to maturity of bonds in the same class and their different maturity dates. Bonds within the same class are those that have the same default risk, or credit quality. The bonds found along the yield curve are all within the same class because they have the same credit quality. The same term, coupon, or yield is not required IFSE Institute

17 Whereas the coupon of a bond is fixed, the yield to maturity is dictated by the price of the bond, which in turn reflects the present value of the face amount, the coupon, and the term to maturity. Normal Yield Curves The yield curve demonstrates the relationship between yield and term to maturity. A normal yield curve will slope upwards and to the right. This indicates that the yield increases as the term to maturity gets longer. The normal curve is also referred to as a positive yield curve. This means that short-term interest rates are less than long-term interest rates. So among bonds with the same credit quality, short-term bonds are characterized by lower yields than long-term bonds. Liquidity preference theory The liquidity preference theory states that investors perceive long-term bonds to be riskier than short-term bonds and so long-term bonds must pay a higher rate of return to encourage investors to make the longer investment. This may explain the shape of the normal yield curve. The movement of interest rates, which affects the yield of bonds, is easier to predict in the short term than far in the future. The same is true for an issuer's ability to make its regular payments and repay the principal at maturity. However, with a normal yield curve, the additional yield you achieve by taking on extra risk gets less and less as you move along the curve. On the graph, you can see how the upward sloping line flattens as the term to maturity increases. Inverted Yield Curves An inverted yield curve indicates a situation where short-term yields are higher than long-term yields. This is represented by a yield curve that slopes downwards and to the right. Inverted yield curves are also referred to as negative yield curves. Inverted yield curves are relatively rare but can occur when investors believe that the economy will decline in the future. Investors in long-term bonds are willing to take lower yields today if they think that in the future yields will be worse. It can also mean that investors think that future inflation will be low. They will accept lower yields if they believe those yields are not likely to be eroded by inflation in the future. An inverted yield curve could also occur if governments raise short-term interest rates during an economic or currency crisis to prevent a potential flight of foreign capital. Using a Yield Curve to Select Term to Maturity Yield curves show the relationship of yield versus term to maturity at one particular point in time. They cannot be used to predict what might happen in the future. However, yield curves can be used to help the investor choose a term to maturity by showing the incremental difference in yield that is obtained by increasing the term. There will usually come a point where the investor is not comfortable with the added risk that comes with a small increase in yield. Normal yield curves flatten as you move along the curve. This means that the amount of the increased yield you achieve by investing in a bond lessens as the maturity date lengthens IFSE Institute 17

18 Justin wants to choose between two bonds with the same credit quality. He decides that the increase in yield gained by switching from a 1-year to a 5-year bond is worth it to him, but that the difference in yield achieved by switching from 5-year to a 10-year bond is not worth the added risk. He would gain a small amount of yield but only with a degree of risk with which he is not comfortable. Monitoring Changes in the Yield Curve Yield curves change over time due to changing economic conditions. There may be opportunities to maintain the same yield but shorten the maturity of a portfolio. A shorter maturity would imply less risk and more liquidity. Consider the changing yield curves shown in this graph. Suppose you purchase a bond at time 1 represented by the lower (blue) yield curve in this graph, resulting in a yield to maturity of Y% for a specified term, Term 1. Now suppose that the yield curve changed into the upper (red) curve of the graph. You could realize the same yield to maturity, Y%, with a lower term to maturity. You could switch to a bond with a shorter term to maturity, without sacrificing the yield to maturity. However, in order to take advantage of this decreased risk, you would likely have to realize a loss on the sale of the original bond because the yield on new bonds with that term will have increased, as shown by the upper curve. Also, you would have to consider any cost to switch the investment. You would have to evaluate carefully both the positive and negative aspects of switching before making a decision. Using Yield Curves to Compare Bonds Yield curves for bonds of different classes can be used to help you decide which type of bond you want. Consider the yield curves shown in this graph, for government and corporate bonds. You may be attracted to the relatively high yield, Y%, provided by a corporate bond with a term T c. However, you may not be comfortable with the risk associated with some corporate debt securities. By comparing the yield curves of the corporate and government bonds, you might find a government bond with less risk that provides the same yield, Y, albeit with a longer term to maturity, T g. Exercise: Yield Curves IFSE Institute

19 Time Value of Money The time value of money is the concept that the value of a dollar today is not equal to the value of a dollar tomorrow. Since a dollar today can be invested and earn interest, it is more valuable than a dollar received at a later date. Compounding is where interest is earned on interest. The magic of compounding refers to the phenomenal growth that reinvested income can generate. For example, if you invest $1,000 at 10%, after one year, you will earn $100 in interest. If this $100 is reinvested along with the original $1,000, after the second year, you will earn $110 in interest. If you elect not to reinvest your income, you would only earn interest on your original investment. This is known as simple return. When discussing compounding, present value refers to your initial deposit and future value refers to the lump sum you will receive at a future date. The following formula is used to calculate the future value of a single sum with annual compounding: Lesson 4: Common Shares Welcome to the Common Shares lesson. In this lesson, you will learn about the characteristics of common shares, including the benefits and rights of ownership, and the different types of returns that can be provided by common shares. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: explain the characteristics of a common share, including the benefits and rights of ownership describe and calculate the different types of returns that can be provided by common shares, including capital gains and dividends General Characteristics A common share, also called common stock, represents an ownership interest in the equity of a public or private corporation. When you purchase a common share, you gain voting rights and the ability to benefit or suffer from the financial successes or failures of that company. A public corporation is a company that has one or more classes of shares listed on a prescribed stock exchange or a company that has at least 150 shareholders, each of whom holds at least $500 worth of shares IFSE Institute 19

20 Suppose Elektron Ltd. is a major telecommunications company and a large Canadian public corporation. Elektron issues both common shares and preferred shares. Elektron's shareholders are: those who own only a few hundred shares and are only interested in the investment prospects of buying and selling shares to make a profit those who own shares through their employment with Elektron and their participation in its profit sharing plan. It is possible that eventually, these employees may own a large number of the company's shares. those who own large blocks of Elektron shares with the goal of controlling the company Together, all of these shareholders own Elektron and they share in its financial success or failure. The number of common shares that can be issued by a company may be limited by its articles of incorporation. This limit on shares issued is called authorized capital. A corporation can issue several classes of common shares, each with different characteristics. The shares that have been issued are referred to as outstanding, or 'the float'. The following is the authorized capital structure of common shares for Elektron. Rights of Shareholders Elektron Capital Stock Common Shares Capital Stock Authorized Outstanding Shares Shares Common Unlimited Series A 110,000,000 Series B 40,000 Shareholders have a part ownership in a company but are not responsible for running it. They benefit from the company's success in the form of share appreciation and any dividends received. However, if the company's fortunes decline, they could lose most, if not all, of their investment. Shareholders are not liable for the debts incurred by a company, nor are they personally liable for any actions undertaken by the corporation. As a shareholder, you have certain rights, but it depends on the voting rights attached to the class of shares you own. Both the series A and B common shares of Elektron Ltd. are voting shares. Both series rank equally in all respects, except that dividends on B shares are payable in shares or cash. Holders of voting shares elect the directors of the company and often have the right to vote on major issues, such as: the sale or purchase of significant portions of the business mergers and acquisitions adoption of a stock option plan liquidation any other fundamental changes affecting the company Voting is done at shareholders' meetings. An annual shareholders' meeting is held to elect directors, and to discuss the corporation's financial statements and the auditor's report for the year. Often, IFSE Institute

21 shareholders learn the future prospects of their investments by taking an active interest and attending shareholders' meetings. All shareholders are sent information regarding the date and place of the shareholders' meetings and an outline of the issues to be voted on at the meeting. This information package includes a proxy form, which allows shareholders to send representatives to vote in their place if they are unable or do not wish to attend. A minimum number of shareholders or their proxies must be present at the shareholders' meeting before a vote can be taken. Director Responsibilities After the Board of Directors is elected, their role is to supervise the management of the company. Shareholders elect them and if they are not satisfied with the Board's performance, may remove them or deny their re-election at shareholders' meetings. Some of the directors' responsibilities include: approving financial statements authorizing major capital expenditures hiring executives and determining their compensation, assessment, and succession authorizing the issuance of any new shares, subject to the company's articles of incorporation declaring any dividends to be paid adopting bylaws to govern the day-to-day affairs of the company calling meetings of the shareholders at least annually Shareholders may be employed by the corporation and the directors and officers of a corporation can be shareholders, but neither is required to be. If directors and officers do hold shares, they must avoid insider trading, which is trading shares of the corporation while making use of information that is material to the corporation, but which is not public knowledge. Exercise: Roles and Responsibilities Returns from Investments in Common Shares Shareholders profit from their investment in common shares in two ways: capital gains dividends Capital gains If the share price increases over time, they can sell their investment for a profit and receive the capital gains. Dividends A company may also pay dividends from its retained earnings. Retained earnings are the cumulative after-tax profits of the corporation that have not yet been paid as dividends. Dividends are usually paid out if the company makes a profit, but are often also paid out even in years where the company incurs a loss if there are sufficient retained earnings IFSE Institute 21

22 The directors of a company make the decision to distribute dividends to shareholders. If there is more than one class of shares, the directors declare the amount of dividends for each class of shares. The total amount paid is divided among the shareholders in a class of shares in proportion to the number of shares owned. Elektron Ltd. pays dividends on the series A common shares in cash, whereas dividends declared on series B common shares can either be paid in series B common shares or cash. Regular vs. Extra Dividends Regular dividends Regular dividends are those dividends that a company usually pays, either on a quarterly, semiannual, or annual basis. Armand owns 100 common shares in VanHelden Inc. The company has paid a regular dividend for the last twenty years. For the year-ending December 31, VanHelden paid a regular cash dividend in the amount of $1.50 per common share. Therefore, Armand received a dividend payment of $150, calculated as (regular dividend x number of shares held) or ($ shares). Companies are not required by law to pay dividends to shareholders. There is no guarantee that a company will continue to pay dividends in the future if it has in the past. However, once a history of dividend payments has been established, a company will usually try to continue them to uphold investor confidence in its stock. This is why it will try to pay its regular dividend even in years where it incurs a loss. Extra dividends To avoid distorting shareholders' expectations, some companies will designate unusual dividends as special or extra dividends. These are dividends that are not expected to reoccur (for example, those resulting from the sale of a property or a division of the business). VanHelden Inc. sold some valuable downtown real estate last year and accumulated an unusual amount of cash on its balance sheet. Instead of leaving the gain in retained earnings, VanHelden declared a special dividend of $0.65 per common share. The special dividend was paid in addition to the regular dividend of $1.50 per common share. VanHelden does not expect to repeat the extra dividend in subsequent years. Therefore, Armand will receive both a regular dividend of $1.50 per share and a special dividend of $0.65 per share for a total dividend payment of $2.15 per share, calculated as (regular dividend + special dividend) or ($ $0.65). Stock Dividends Stock dividends include dividends that are paid by a corporation in the form of additional stock in that corporation, accompanied by an increase in the paid-up capital of the corporation. Paid-up capital means the total amount that has been invested by all of the company's shareholders. A dividend that is paid in the form of shares in another corporation is a dividend in kind, not a stock dividend. Stock dividends are often paid by rapidly growing companies that prefer to capitalize their retained earnings to finance future growth or by companies that have not realized sufficient cash flow to pay cash dividends. Stock dividends are included in the income in the year they are received and taxed as normal dividends IFSE Institute

23 Stock Splits A stock split occurs when a company decides to lower its market price by increasing the number of shares outstanding. The split does not affect the total value of the investor's holdings. If, for example, a company decides to double the amount of shares in the market, the price of those shares will fall by half. Hugo was holding 600 shares in the SMD Corporation, which were valued at $48 per share before SMD initiated a 3:1 split. After the split, Hugo held 1,800 shares, calculated as (600 3), and the stock price was $16 or ($48 3). The total value of his stock was $28,800, calculated as (new price new number of shares) or ($16 1,800). This is identical to his total holdings before the split of $28,800, calculated as (old price old number shares) or (600 $48). A company may decide to initiate a stock split when the market price of a share is very high. The price of a board lot becomes excessive for some investors. This limits the liquidity of the shares because less people are able to afford the shares. By initiating a stock split, a company makes its shares more affordable to the average investor. This in turn leads to a broader shareholder base with more frequent trading and improved liquidity of the corporation's shares. A stock split may also signal the corporation's intention to raise new capital with a new stock issue at a more marketable price. Unlike with a stock dividend, there is no addition made to the total paid-up capital. The total amount of paid-up capital remains the same, although the paid-up capital per share declines because there are now more shares issued. Dividend Reinvestment Plans Some corporations offer dividend reinvestment plans (DRIPs), which allow shareholders to automatically reinvest their dividends in the company. They receive more shares in return. Clik Co. has ten shareholders, each holding 100 shares, so they each hold 10% of the shares. The current market price of the shares is $25. Five of the shareholders participate in the dividend reinvestment plan and five do not. Clik Co. declares a dividend of $1 per share. It will distribute a total of $1,000, calculated as ($1 x 100 shares x 10 shareholders). The five who do not participate in the reinvestment plan each receive a cash payment of $100, calculated as ($1 per share 100 shares), and they still hold their 100 shares. The five who do participate, will all reinvest their $100 received back into the company at the current market price of $25. This means a purchase of another 4 shares each, calculated as ($100 $25). Each of these shareholders now owns 104 shares, compared to the 100 shares owned by the nonparticipating individuals. A dividend reinvestment plan can be an effective savings plan, and for many investors, it solves the problem of investing small amounts of cash. The shareholders acquire a gradually increasing number of shares in the company, and because the purchases are made regularly, dollar-cost averaging can take effect IFSE Institute 23

24 The convenience of a DRIP often encourages the investor to invest more than if he or she received a cash dividend. Although no cash has been received because of the DRIP, the dividend is still taxable in the year it is received. Exercise: Types of Dividends How Dividends are Declared and Paid A company's board of directors decides whether to declare a dividend, and how much it will be per share, based on whether it thinks some of its after-tax profit should be kept in retained earnings or distributed to shareholders. The date on which the dividend is authorized and announced to the public is called the declaration date. Notice is hereby given that the Board of Directors of Riton Inc. has declared a dividend on outstanding Class A common shares in the amount of $0.55 per share. The dividend will be payable December 1 to shareholders of record at the close of business on November 15. By order of the Board H. Smithson, Edmonton, Alberta Secretary Dividends are declared to be payable on a specific payment or distribution date, with payments to be made to all investors who are shareholders on a specific date of record or record date. Everyone who owns shares at the end of the date of record will receive the dividend on the payment date, whether or not they own the shares on the payment date. Ex Dividend and Cum Dividend When a dividend declaration is made, it stipulates that all those who own shares on a certain date of record will receive the dividend. Ex dividend If you purchase shares after the date of record, those shares are said to be ex dividend. Those shares are not eligible for the declared dividend. The date of record is usually at lest two weeks prior to the payment date to allow time for processing the dividend payment. For trading on the Toronto Stock Exchange, to own stock by the end of the date of record, you must have initiated the purchase three trading days earlier for the transaction to be settled. The number of days for settlement may be different on other stock exchanges. The ex dividend date, the day on which the shares begin to trade without the right to the declared dividend, is two trading days prior to the date of record. Share prices should generally fall by an amount equal to the declared dividend on the ex dividend date. The payment date for the Riton Inc. dividend is December 1, the date of record is November 15 and the ex dividend date is November 13th. Ursula purchased shares in Riton Inc. on November 1. She is entitled to receive the dividend because she purchased the shares prior to the date of record. Uffie purchased shares in Riton Inc. on November 16. She purchased her shares ex dividend and is not entitled to receive the dividend IFSE Institute

25 Bobby purchased shares in Riton Inc. on November 14. He purchased his shares ex dividend because although the date of record is November 15, he purchased his shares after the ex dividend date. By the time the trade settles (when he will actually own the shares), it will be past the date of record. Cum dividend Shares that are purchased after the dividend is declared, but before the ex dividend date, are purchased cum dividend, meaning with dividend and the purchaser is entitled to receive the declared dividend. After reading about the Riton dividend payment in the newspaper, Sebastien decided to purchase shares in the company on November 12. He has purchased his shares cum dividend and is entitled to receive the dividend. Retained Earnings Corporations are not legally obligated to distribute dividends. To distribute cash dividends, a corporation needs cash. Profits are not necessarily cash. For example, an increase in sales and profits may result in an increase in accounts receivable, not cash. On the other hand, dividends can only be paid to the extent the corporation has retained earnings. So, the payment of dividends requires both cash and profits. The directors must also ensure that the payment of a dividend does not prevent the corporation from meeting its financial obligations. The directors may decide to keep some or all of its cash in the company to finance future growth or facilitate a future loss. This would even allow them to declare a dividend where the company has incurred a loss, to keep investors happy. Profits that are not distributed to shareholders are called retained earnings. Diplo Inc. had a profit for the year-ending December 31, of $1.5 million. At the end of the year, the company had retained earnings of $5.2 million and $2.5 million dollars of cash. The Board of Directors considered the company's cash needs and profit outlook, and authorized a dividend of $0.6 million. The company could have paid a dividend of $2.5 million or more if it could obtain enough cash. However, if it paid a dividend of more than $5.2 million, this would have been more than its retained earnings. The excess would be considered a return of shareholders' capital and not a dividend. Exercise: Mechanics of Dividend 2010 IFSE Institute 25

26 Expected vs. Required Returns A stock can be considered an appropriate purchase if its expected return is greater than your required return. Required return Each potential investor must define his or her own required rate of return, as the return that will provide adequate compensation for making the investment. This required rate of return has two components: The return that you would otherwise earn on a risk-free investment, like a GIC, plus a premium for incurring the risk associated with making an investment in the stock market. The general risk associated with investing in the stock market is that the return from a particular stock will not match the performance of the market as a whole. The volatility of an individual stock compared to the market as a whole is defined as the beta factor (b). A beta factor of greater than 1.0 suggests that the stock is more volatile than the market as a whole, while a beta factor of less than 1.0 suggests that the stock is less volatile than the market as a whole. The research departments of some securities firms estimate the beta factors for stocks that they follow. The required rate of return (rr) for a particular stock can be defined as follows: Pierre wants to invest for the long term so this year he has decided to invest half of his savings in common shares instead of a guaranteed investment certificate. He knows that his GIC will earn a return of 4% and he believes that the stock market as a whole will experience a return of 13%. Pierre has selected a volatile stock with a beta factor of 1.2 Pierre's required rate of return is 14.8%, calculated as (4% + ((13% - 4%) 1.2)). Expected Total Annual Return The total annual return on a stock market investment consists of two possible components: dividends capital gains The expected total annual return (r) on an investment is calculated as follows: As a company increases its earnings, it should be able to increase its dividends. The market price increases to reflect the market's anticipation of increased dividends and greater assets retained by the company. The ratio, D P, is also referred to as the dividend yield. An investment is a reasonable one if the expected return is greater than the required return. However, your expected return on an investment is just an estimate because it involves predicting future dividends and future growth IFSE Institute

27 In the previous example, Pierre's required rate of return was determined to be 14.8%. The current market price of the stock is $25. Over the next year, Pierre expects the company to pay dividends of $1.75 per share and the price of the stock to increase by 5.0%. Pierre's expected return on this investment is 12.0%, calculated as (($1.75 $25) + 5.0%). Because this is less than his required return of 14.8%, he should not make the investment. Estimating the Present Value of Dividends Instead of comparing required and expected rates of return, some investors prefer to identify a potential stock by determining its "true" value and then compare that to the current market price. They try to determine if the stock is priced too cheaply, which would suggest that it is worth buying. The valuation of a stock involves determining the present value of anticipated future dividend payments at the required rate of return, similar to the way bonds are valued. The dividend-valuation growth model is an accepted method of determining the intrinsic value (V) of a stock (that is, what it is worth to the investor). If this intrinsic value is greater than the current price, then the stock would be considered undervalued and it would be a good buy. If the intrinsic value is less than the current market value, then the stock would be considered overpriced and it would not be a good buy. If the intrinsic value is.. Then the stock is.. The investor should.. greater than the current price undervalued buy the stock less than the current price overvalued not buy the stock Omar is thinking about investing in Rouse Inc., currently priced at $9 per share. He believes that Rouse will pay dividends of $0.60 per share next year and that this will increase by about 6% per year. Based on the current risk-free rate and the beta of Rouse, Omar's required rate of return is 12%. Based on this information, the intrinsic value of shares in Rouse Inc. is $10.60, calculated as (($0.60 (1 + 6%)) (12% - 6%)). Because its intrinsic value, what it is worth to him, is more than the current market price, Omar will consider the stock undervalued and will likely want to invest. Price-to-earnings (P/E) Ratios While the dividend growth model can be used to estimate the intrinsic value of shares in a company that issues dividends, the model cannot be used to value the stock of a company that does not pay dividends. An alternate method that may be used in these cases involves first estimating the company's price-to-earnings ratio. The price-to-earnings ratio (P/E ratio) is simply the ratio of a stock's current market price divided by its net earnings per share IFSE Institute 27

28 At the end of its last fiscal year, the Gramme Corporation recorded net earnings of $2 million and had 800,000 outstanding shares, when its market price was $24 per share. The net earnings per share were $2.50, calculated as (net earnings number of shares outstanding) or ($2,000, ,000). The P/E ratio for Gramme Corporation is therefore 9.6, calculated as (current market price net earnings per share) or ($24 $2.50). Once the P/E ratio has been determined, you can estimate the value of the stock by multiplying the P/E ratio by the company's predicted future earnings. Assume research analysts have predicted that Gramme will experience net earnings of $3.25 per share in the coming year. The value of the stock can therefore be estimated at $31.20, calculated as (P/E ratio net earnings per share) or (9.6 $3.25). Because this is higher than the current price of $24, the stock can be considered a good investment. Note: The P/E ratio alone does not indicate whether the stock is a good investment. In fact, the P/E ratio varies significantly between different industries. Stable industries, such as banks and utilities, tend to have relatively low P/E ratios. High-technology industries tend to have a high P/E ratio (often around 50 and sometimes as high as 300 or more). A high P/E ratio suggests that investors are not basing their value on past earnings, but rather they believe that the company has the potential to realize phenomenal earnings in the future, perhaps because of some innovative product development. Case Study: Felix Leforet Lesson 5: Preferred Shares Welcome to the Preferred Shares lesson. In this lesson, you will learn about the features, types, and taxation of preferred shares. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: explain the nature of preferred shares, as compared to common shares and bonds calculate taxation of preferred shares Introduction to Preferred Shares A preferred share is a type of a company's stock that pays a fixed dividend. It is "preferred" because its shareholders get preferential claim to the company's profits and assets over common shareholders. The fixed dividend amount is usually a percentage of the par value of the share. Unlike common shares, with preferred shares, there is no real opportunity to share in the company's good fortunes in the way of capital appreciation. There may be some movement in the price of the share, but this is in response to interest rates. In this way, preferred shares are a fixed income product with some of the characteristics of a bond. The fixed dividend payments are similar to a bond's interest payments. When interest rates rise, preferred share prices go down and vice versa. The return on preferred shares is called a dividend yield. You calculate it by finding the dividends per year as a percentage of the price you paid for the shares. Celeste paid $25 for a preferred that pays $1.65 in dividends per year. Her dividend yield is 6.6%, calculated as ($1.65 $25 per share x 100). A new issue of preferred shares is introduced in the primary market, similar to common shares. Most preferred shares are issued at a par value of $25 and trade in the $20 to $30 range in the secondary market, either on a stock exchange or in the over-the-counter market (OTC) IFSE Institute

29 Like common shares, preferred shares pay dividends. Like bonds, they have a fixed payment amount, their price moves in the opposite direction to interest rates, and they are usually issued with a fixed term of at least five years. They are called hybrid securities because they combine features of both equity and fixed income. Example: IPSCO Inc. Click the icon below to view page a from the prospectus of Ipsco Inc. 5.50% Cumulative Redeemable First Preferred Shares, Series 1, and the Summary of the Offering. Features of Preferred Shares Preferred shares have some special preferences over common shares such as preference as to assets and preference as to dividends. Preference as to assets If a company goes bankrupt the bondholders and creditors have a first claim on the company's assets. Next in line come preferred shareholders. They are ranked senior to common shareholders even though common shares are a form of ownership of the company. Similar to a bond's interest payments, preferred shareholders receive a fixed dividend that does not increase if the company becomes more successful. In contrast, common shareholders can benefit from the success of the company in the form of capital appreciation. Their share price goes up. A preferred shareholder's senior claim over the company's assets is some compensation. If it wanted, an issuer could increase the dividend on existing preferred shares. Preference as to dividends As with dividends to common shareholders, the dividend payments from preferred shares are not guaranteed. The payment of a dividend is at the discretion of the board of directors of the company. Because preferred shareholders rank senior to common shares, the company must pay the fixed dividends to preferred shareholders before any dividends can be paid to common shareholders. The company does not have a legal obligation to pay the preferred dividends on an annual basis. If a company misses or decides not to make a dividend payment on its preferred shares, the dividend is lost to the shareholder unless the shares include a cumulative feature. This means that a company must pay all the dividends it missed, referred to as "in arrears", to preferred shareholders before it can pay a dividend to the common shareholders. Preferred shares with this feature are called cumulative preferred shares. Most preferred shares in Canada are cumulative. Trumbo Ltd. has an outstanding issue of cumulative preferred shares with a par value of $25 and a 7% dividend yield. The dividends in arrears amount to $2.35 per share. Trumbo must pay the dividends in arrears of $2.35 to the preferred shareholders before the common shareholders receive anything. Voting Rights Preferred shareholders do not have the same voting privileges that common shareholders enjoy. If the fixed dividends are paid, preferred shareholders do not have voting rights. However, if those dividends are not paid, preferred shareholders are granted voting rights. In general, preferred shares acquire voting rights once six or more quarterly dividend payments are in arrears. "Holders of BSO Co. 5.75% Cumulative Redeemable First Preferred Shares, Series 1 shares are entitled to cast one vote per Series 1 Preferred Share if the corporation fails to declare and pay eight quarterly dividends, consecutive or otherwise on those shares IFSE Institute 29

30 Exercise: Features of Preferred Shares Types of Preferred Shares Preferred shares come with different features and conditions attached to them that can affect the value of each share. The types of preferred shares are as follows: straight preferreds variable rate preferreds convertible preferreds participating preferreds redeemable preferreds retractable preferreds Straight and Variable Rate Preferreds There are two main types of dividend payment method for preferred shares: Straight preferreds Straight preferreds pay a fixed dividend rate. When interest rates change, the dividend rate remains unchanged and the price of the share fluctuates in the secondary market, changing its yield. Its market price moves in the opposite direction of interest rates, similar to a bond. Variable rate preferreds Variable rate preferreds pay a dividend that fluctuates with interest rates. As interest rates rise, the dividend payment on the preferred shares increases, and vice versa. The floating rate is usually expressed as a percentage of the average prime rate. Dunwood Financial has an outstanding issue of cumulative and redeemable preferred shares that pay a fixed $1.85 per share dividend to December 31, this year. Beginning January 1, next year, the dividend will float at a rate of 80% of the average prime rate. Corporations provide protection for both shareholders and themselves in the event of a dramatic drop or severe rise in interest rates by stipulating a range for the dividend rate. Variable rate preferreds provide some stability to the market for preferred shares. Holders of CanNational Bank Floating Rate First Preferred Series D shares are entitled to an annual dividend payable monthly. The annual dividend rate applicable for each month will not be less than 50% or greater than 85% of the average prime rate for that month. Convertible and Participating Preferreds Convertible preferreds Convertible preferreds allow you to convert the preferred shares into some other class of shares, usually the company's common shares at a fixed price within a specified period. Convertible preferreds are similar to convertible bonds. The convertibility feature offers you some flexibility. You get the fixed return from the dividends but also the potential to participate in the capital appreciation of the common shares. RAX Industries Cumulative Series A preferred shares are convertible into 1.2 common shares. If you held 100 preferred shares, you could convert them to 120 common shares, calculated as (100 x 1.2) IFSE Institute

31 Participating preferreds A participating preferred share has rights to a certain share of a company's net profits over and above the specified dividend rate. This entitlement ranks above any dividends to common shareholders. Prins Ltd. participating preferred shares pay a non-cumulative dividend of 6% of the par value, plus 15% of the net profits of the corporation. Redeemable & Retractable Preferreds Redeemable preferreds Redeemable preferred shares have a call feature that allows the issuing company to redeem the shares within a specified period of time. When the shares are called for redemption, the holder of the preferred shares receives a small premium over the shares' par value. Most Canadian preferred shares are redeemable. Any call provision is exercised at the option of the issuer. The company might exercise the call option on an outstanding series of preferreds if the dividend payment on those shares was more than what the market was offering. The redeemable feature gives the company a degree of control over their preferred shares. It gives a successful or growing company an opportunity to terminate the costs involved in paying a regular fixed dividend to the preferred shareholders. Attias Systems had a 10% preferred share issue with a par value of $25. The shares were redeemable at $27.50 per share until April 1, 2009, thereafter declining to $27.00 per share until April 1, 2012, to $26.50 per share until April 1, 2015, and at par from that date onward. Guillaume purchased 100 preferred shares in Attias at the par value of $25 in If the company decided to redeem all of the outstanding preferred shares in May 2009, the premium on Guillaume's shares is $2.00 per share, calculated as ($ $25.00). Retractable preferreds Retractable preferreds give the shareholder the option to sell the preferred shares back to the issuing company at a specified price and within a specified time. Retractable preferreds convert back to straight preferreds if they are not exercised within the specified period. Tanzmann Industries issued a retractable preferred share with a dividend of $1.75 and a par value of $25 per share. The share issue is retractable from June 1, 2010 to June 1, 2014, at a price of $25 per share, plus dividends in arrears. Exercise: Types of Preferred Shares Tax Considerations The dividend on a preferred share represents the main source of gain available to the preferred shareholder. Dividends are paid to investors by corporations out of their after-tax profits. However, dividends received by investors are taxable income. So, they are being taxed at the corporate level and then again at the individual level. To avoid this double taxation, dividends from taxable Canadian corporations on common or preferred shares are eligible for the gross-up and tax credit scheme, which results in a higher after-tax yield than if the same amount of interest income were earned. Dividend gross-up and tax credit scheme The dividend tax credit depends on the kind of corporation paying the dividend IFSE Institute 31

32 Canadian-controlled private corporation (CCPC) Dividends received from a Canadian-controlled private corporation (CCPC), are generally treated differently than dividends received from large public corporations. An individual who receives a dividend from a CCPC must include 125% of that dividend in taxable income for the year. This is referred to as the dividend gross-up. A taxpayer can then claim a federal dividend tax credit equal to 131/3% of the grossed-up dividend. The tax credit is intended to offset the tax the corporation is presumed to have paid. The taxpayer can also claim a provincial dividend tax credit. Enhanced dividend tax credit With the enhanced dividend tax credit, the gross-up and resulting tax credit depends on the year in which it is received. Federal Dividend Tax Credit (DTC) Gross-up 44% 41% 38% DTC as % of grossed-up dividends 17.97% 16.44% 15.02% Dividends received from large public corporations resident in Canada qualify for the enhanced dividend tax credit. These are for Canadian companies that are not privately owned, but trade on a major stock exchange. Other private corporations resident in Canada but not Canadian-controlled also qualify for the enhanced dividend tax credit. With the enhanced dividend tax credit, 144% of the dividend received will be included in income. The result is a federal tax credit of 17.97% of the taxable (grossed-up) dividend. Quentin purchased 1,000 Harris Inc. cumulative preferred shares at a par value of $25. Harris is a public corporation that trades on the TSX. The shares included a fixed dividend of $1.65 or 6.6% per share. Quentin has a federal marginal tax rate of 29%, 11.16% provincial marginal tax rate, and a provincial enhanced dividend tax credit of 6.40%. In 2010, his after-tax return on the preferred shares is as follows: Dividend income ($1.65 1,000) $1, Dividend gross-up ($1,650 44%) Taxable income $2, Federal tax ($2,376 29%) $ Federal dividend tax credit ($2, %) (426.97) Federal tax $ Provincial tax ($2, %) $ Provincial dividend tax credit ($2, %) ($152.06) Provincial tax $ Total tax $ After-tax income ($1,650 - $375.17) $1, After-tax yield ($1, ($25 1,000)) 5.10% Two years later, the Harris shares were trading at a price of $29 per share. Quentin decided to sell all 1,000 of his preferred shares at this price. His adjusted cost base (ACB) at the time of the sale was $25,000, calculated as (purchase price number of shares) or ($25 1,000). He received $29,000 from the disposition of the shares, calculated as (sale price number of shares) or ($ IFSE Institute

33 1,000). Quentin has a capital gain for the year in the amount of $4,000, calculated as (sale price number of shares) or ($29,000 - $25,000). Exercise: Preferred Shares and Taxation Risks of Preferred Shares Redeemable The main risk of investing in preferred shares is that they typically are redeemable. The issuer may exercise its right to call the preferred share. In a low interest rate environment, existing preferreds might be paying a higher yield than the market. This is good for the investor, but expensive for the dividend-paying company. Most would prefer to pay the expense of calling in the shares, rather than pay a high fixed dividend yield on them. In the fall of 1997, the Bank of Nova Scotia had an outstanding issue of preferred shares that were callable on October 29, 1997, at their par value of $25 per share. Just prior to the call date the shares were trading at $26.85, a $1.85 per share premium to their par value, calculated as (FMV - par value) or ($ $25.00). At the time, the prime rate in Canada was 6.25%. From the Bank of Nova Scotia's perspective, letting the preferred shares remain outstanding and paying the fixed dividend of 9.25% for any longer than necessary would not have made good business sense. Consequently, the company redeemed the shares on the October 29th call date. The Bank of Nova Scotia preferreds were trading at $26.85 on October 29th. The $1.85 premium on the shares disappeared once the shares were called. Interest rate risk If interest rates rise, the price of the preferreds will go down. You might incur a loss if rates rise after you make your purchase and for some reason you need to sell. Business risk There is the risk that the company will miss dividend payments if it is performing badly. Most preferred shares in Canada are cumulative, so that when dividend payments resume you will receive dividends in arrears, but in the meantime you are without the regular flow of dividend income. There is also the risk that the company will go out of business. If that happens, to recoup your loss there is some consolation that preferred shareholders rank senior to common shareholders as to the company's assets. Exercise: Preferred and Common Shares Lesson 6: Derivatives Welcome to the Derivatives lesson. In this lesson, you will learn about the different types of derivative securities that may be used in a mutual fund portfolio. To fully understand how a mutual fund works, you must first understand the underlying financial instruments. This lesson takes 30 minutes to complete. At the end of this lesson, you will be able to do the following: understand how option contracts work understand how futures contracts work explain why a mutual fund would hold derivatives in its portfolio describe the different characteristics of futures on foreign currencies, interest rates, and stock indices 2010 IFSE Institute 33

34 Derivatives Derivative products are investments whose value and returns depend on the value of an underlying security, commodity, or financial instrument. These instruments are called derivatives because their values derive from, or are dependent upon, the value of the underlying assets. Almost all derivatives have a limited lifespan or term. At some point the investor must actualize the value of the derivative by buying or selling, or allow the derivative to expire. Some of the most familiar derivatives are the following: rights warrants options futures Rights and Warrants Rights Often, when a company needs to raise additional capital, it will issue rights to existing shareholders. These give you the right, but not the obligation, to purchase additional stock in the company, usually below market value. One right is usually issued for every share you hold but it usually costs more than one right to purchase additional stock. Hinko Ltd. declared a rights issue that allowed its shareholders to purchase one additional share with four rights. Guy owns 100 shares so he receives 100 rights. If he wants, he may purchase 25, or (100 4) additional shares in Hinko. Rights usually expire after only a short time, usually four to six weeks. Warrants Similar to rights, warrants are certificates that allow you to buy shares of the underlying common stock at a stated price. However, warrants are usually issued at the same time as a new issue of bonds, and/or preferred shares. Both rights and warrants have a stated life or term, but warrants have a much longer lifespan, usually from one to seven years. Since both rights and warrants have value, i.e they give you an opportunity to purchase a stock at a set price, they trade independently of the underlying stock in the secondary market. Options Options give an investor the right to buy or sell a pre-determined amount of an underlying security at a set price for a set period of time. Most options trade on options exchanges, similar to stock exchanges. They have standardized terms for expiry dates and exercise (or strike) prices. There are two parties involved in an option transaction: the buyer and the seller. The option buyer, also known as the holder, has the right to buy or sell the underlying security. The option seller, also known as the writer, has the obligation to buy or sell the underlying security if the buyer decides to exercise the option IFSE Institute

35 There are options on many different securities, such as stocks, bonds, and indexes, but the most common are stock options. There are two kinds of options: Call options give the investor the right to buy a set amount of the underlying security at a set price for a set time period. You would buy a call option if you expected the underlying security to increase in price. Put options entitle the investor to sell a set amount of the underlying security at a set price for a set period of time. You would buy a put option if you expected the price of the underlying security to decline. Type of option contract Call Put A holder or buyer has the right to A writer or seller has the obligation to Buy the underlying security Sell the underlying security Sell the underlying security Buy the underlying security Call Options Call Option Example On July 1, Nancy thinks that ABC Inc., which is currently valued at $50, has good growth prospects over the next six months. She buys a December 50 call option for $3. This means that any time before the end of December, Nancy can exercise her option and buy a share of ABC Inc. for $50, which is known as the strike price. For this right she has paid the call writer a premium of $3. Scenario One Call Buyer - Exercise call option In December, ABC Inc. shares are selling for $75. In this case, Nancy would exercise her option. The option seller would be obligated to sell Nancy a share of ABC Inc. for $50, as per the terms of the option contract. Nancy could then sell that share on the market for $75, making a profit of $22 calculated as ($75 - $50 - the premium paid of $3). Call Seller - Obligated to sell stock The call seller has a very different risk profile. In Scenario One, the call writer is obligated under the terms of the option contract to sell a share of ABC Inc. to Nancy for $50 when it is actually trading at $75. If the call writer already owned the share, he or she could deliver the share to Nancy and would not be directly out of pocket. In this case, the call writer is called a covered writer since he or she could cover the delivery of stock. If the writer did not own the stock, he or she would have to buy a share of ABC Inc. on the open market for $75 and then sell it to Nancy for $50. In this case, the call writer would lose $22 calculated as ($50 - $75 + $3 premium). The writer is called a naked call writer because he or she had no protection. Being a naked call writer is one of the most aggressive and riskiest strategies, 2010 IFSE Institute 35

36 because the investor runs the risk that the underlying security could increase appreciably in price. In theory, the risk is unlimited. Scenario Two Call buyer - Does not exercise call option In December, ABC Inc. shares are selling for $45. In this case, Nancy would not exercise her call because it would not make sense to pay $50 for a share that is selling for $45 on the market. In other words, the call option will expire worthless. Nancy will have lost her premium of $3 but that is all. By purchasing this option, Nancy acquired the opportunity to make a substantial gain, but limited her risk to the amount of the premium, in this case $3. Call seller - Not obligated to sell stock In Scenario Two, the call writer would make a profit of $3 since Nancy, the call buyer, would not exercise the option. In and Out of the Money As illustrated in the table, a call option contract on a stock whose current market price is above the strike price is referred to as 'in the money'. If the market price equals the strike price, it is 'at the money'. If the market price is below the strike price, it is 'out of the money'. Put Options Put Option Example On July 1, Dan expects the price of XYZ securities, currently trading at $50, to decline over the next few months. He purchases a December 50 put option for $2. This means that between July and December, Dan can exercise his option and sell a share of XYZ at the strike price of $50 to the put seller. Scenario One Put Buyer - Exercises put option In December XYZ is trading at $35 per share. Dan could purchase a share of XYZ on the open market and then exercise his put option and sell it to the put writer for $50. Dan would realize a profit of $13 calculated as ($50 - $35 - $2 premium) IFSE Institute

37 Put Writer - Obligated to buy stock The put writer experiences a loss of $13. Under the terms of the option contract the put writer is obligated to purchase a share of XYZ at the discretion of the put buyer. Therefore he or she must buy a share of XYZ for $50 when the stock is worth $35 in the open market. If he or she had to sell that share he or she would lose $13 calculated as ($35 - $50 + the $2 premium received). Scenario Two Put Buyer - Does not exercise put option In December XYZ is trading at $55 per share. Dan would do nothing, since it would not make sense to sell a share of XYZ to the put writer for $50 when the shares are trading at $55 in the open market. The option expires worthless and Dan loses his $2 premium. Put Writer - Not obligated to buy stock Because Dan has not exercised the option contract, the writer keeps the $2 premium. As we can see, the risk to the put writer is much greater than the risk to the put buyer. The most a put buyer can lose is the amount of the premium paid, whereas the put writer can lose a substantial amount if the price of the underlying security drops. In and Out of the Money As illustrated in this table, a put option contract on a stock whose current market price is below the strike price is referred to as 'in the money'. If the market price equals the strike price, it is 'at the money'. If the market price is above the strike price, it is 'out of the money'. Analyzing an Option Problem If you anticipate an increase in the price of the underlying stock, you would buy a call option. If the market price rises above the strike price, you will be able to purchase the stock at the lower price, while everyone else will have to purchase it at the market price. Alternatively, you could sell a put to someone who feels the price of the stock will go down. If you are correct and the stock rises, the put option will never be exercised, will expire worthless, and you will have benefited from the premium received when you sold the put option. If you anticipate a fall in the price of the underlying stock, you would buy a put option. If the market price falls below the strike price, you will be able to sell the stock at the higher price, while everyone else will have to sell it at the market price. Alternatively, you could sell a call option to someone who feels the price of the stock will rise. If you are correct and the stock falls, the call option will never be exercised, will expire worthless, and you will have benefited from the premium received when you sold the call option. If you anticipate Then Buy a call An increase in the price of the underlying security Sell a put Buy a put A decrease in the price of the underlying security Sell a call 2010 IFSE Institute 37

38 Introduction to Futures Futures are also derivative instruments, but they differ from options in certain respects. With an option you obtain the right to purchase or sell the underlying security. With a future you agree to buy or sell a set amount of the underlying security for delivery at a specified point in the future, at a specified price. Historically, futures were developed on agricultural commodities, such as wheat, cattle, and soybeans, but futures can now be found on a wide range of underlying products, including metals, stock indices, and bonds. There are two main parties in the futures market: hedgers and speculators. Hedgers are trying to protect themselves from adverse movements in the underlying investments, while speculators are trying to make a profit through price movements. Hedging It is April and wheat is selling on the open market for $5 per bushel. Jim, a wheat farmer, will bring his crop to market in September. Jim does not know what the price will be for his wheat in September so he sells a futures contract on his wheat. The price of the futures contract is $5 per bushel. In other words, Jim has contracted to sell his wheat for $5 in six months time. Scenario One In September, wheat is selling for $3 per bushel. Jim sells his wheat as per the futures contract for $5 per bushel, despite the fact that it is currently selling for $3. Scenario Two In September, wheat is selling for $8 per bushel. Jim will have to sell his wheat for $5 as per his futures contract. In both scenarios, Jim sells his wheat for $5 per bushel. Although he has protected himself from a drop in price, he must also forego the potential profit if prices increase. Speculating Jim could have sold the futures contract to a speculator. The speculator would have no interest in buying wheat but wants to make a profit by selling the futures contract. Scenario One If wheat were selling for $3 a bushel in September, then the speculator would lose money since he has contracted to purchase a commodity for $5 when it is actually selling for $3 in the open market. The speculator would sell his or her contract for $3 and lose $2 per bushel. Scenario Two If wheat were selling for $8 a bushel in September the speculator would be able to sell his or her contract for $8. The speculator would realize a $3 profit since he or she had contracted to pay only $5 per bushel. Financial Futures Although there are futures contracts for many different types of commodities, as a mutual fund representative, you will be more concerned with financial futures. A financial futures contract or financial future is an agreement reached between two parties for the delivery of a financial instrument at a specified later date at a specified price. Financial futures are based upon currencies, debt instruments, and stock indices. The specified later date is referred to as the settlement date, the date on which the seller has to deliver the underlying financial instrument and the purchaser of the future has to purchase the financial instrument. The following are some common types of futures. Click the name to view a description IFSE Institute

39 Foreign currency futures These are futures calling for delivery of a specific amount of a foreign currency at a specified future date in return for a payment of a specified amount of domestic currency or another foreign currency. Foreign currency futures are not often used by individual investors, unless they need to hedge a very large foreign currency exposure. They are more often used by speculators to bet on the direction of changes in currency values. Interest rate futures These are futures calling for the delivery of a specific amount of a debt instrument, such as a treasury bill, at a specified future date in return for a payment of a specified amount. While interest rate futures call for the delivery of a debt instrument, the real purpose is to make an interest rate play. The value of the debt instrument changes inversely with the change in interest rates. So, by purchasing an interest rate future, an investor or speculator is locking in an interest rate today, even though he or she is not required to take delivery of the debt until the expiry date. Stock index futures These are futures calling for the delivery of an amount of cash, based upon the change in value of an underlying stock index, such as the S&P 500 Index, at a specified date. Rather than attempt to deliver a basket of the shares underlying the index, index futures are settled in cash. However, the profit or loss to the parties would be the same if they were settled with the stocks underlying the index. These are used by individual investors through the purchase of certain mutual funds that use stock index futures as an alternative to actually purchasing the stocks in the index. Basic Mechanics of a Futures Market Futures exchanges define a standardized contract for each type of future to be traded. The standardized contract specifies all the conditions of the agreement, except the price. In particular, it specifies the settlement date, and the exact nature and quantity of the financial instrument. Once the contract has been created between the two parties, the buyer and seller are disassociated from each other by the exchange, so that the futures can trade as securities. Futures Exchange The market in which the underlying assets trade, and are sold for cash and immediate delivery, whether currencies, bonds or stocks, is referred to as the cash market. The cash price or spot price is the current price for immediate delivery of the financial instrument. Futures contracts trade on a futures exchange. The exchange accepts bids and asks from the member traders, and reports the quotes, so investors and speculators can follow the market. When either a buyer accepts an ask price, or a seller accepts a bid, a futures contract is created. A contract is never created without a buyer and a seller. The seller of the future has the obligation to deliver the underlying financial instrument at the settlement date of the contract. The buyer of the future has the obligation to purchase the underlying financial instrument at the settlement date. The exchange guarantees that the buyer will receive the financial instrument as outlined in the contract and eliminates any default risk. As well, the exchange will guarantee that the seller will receive the agreed amount of money according to the contract. Thus the default risk of the seller is also eliminated IFSE Institute 39

40 Effectively, it eliminates the principle of privity of contract and the future effectively becomes a security that can be readily sold on the exchange. The default risk to the buyer and the seller is eliminated because the exchange assumes all of the default risk. Futures contracts listed by the exchanges are accessible to anyone in the world. With this exposure, futures are marketable and liquid. In North America, most futures are traded through the CME Group (formerly Chicago Mercantile Exchange, Chicago Board of Trade, and New York Mercantile Exchange) or ICE Futures US (formerly New York Board of Trade). In Canada some futures trade through ICE Futures Canada (formerly Winnipeg Commodity Exchange) and the Montreal Exchange (M-X), part of the TMX Group. Exercise: Introduction to Futures Structure of the Futures Market To trade futures, investors hold accounts with their respective member traders (their broker). Member traders are large institutional trading companies that have substantial assets and credit ratings. Their size allows them to cover all potential trading losses, which ensures that a default will not occur. Only member traders may trade futures with the exchange. This limits the exchange's exposure to default risk. As illustrated in this graph, amounts from margin accounts and proceeds from futures trades flow between the investor and the member trader. Futures orders and futures contracts flow between the member trader and the exchange. Why a Mutual Fund Holds Derivatives Most mutual fund managers engage in either buying or selling derivatives for hedging purposes. Hedging is the act of protecting your investment against adverse price movements by making an offsetting investment. It is a type of insurance against losses IFSE Institute