SECURITIES MARKETS, INVESTMENT SECURITIES AND ECONOMIC FACTORS OVERVIEW LEARNING OBJECTIVES. Securities Markets 1.

Chapter One SECURITIES MARKETS, INVESTMENT SECURITIES AND ECONOMIC FACTORS OVERVIEW This chapter will provide an overview of the securities trading markets, the primary market and the registration of securities with the SEC. A variety of terms and definitions will also be included in this chapter. Investment securities will be explained in great detail, since these are necessary to understand more testable items in future chapters. Finally, a basic overview of the economic factors which includes defining inflation, deflation, fiscal policy and monetary policy. LEARNING OBJECTIVES 1. Identify the four securities exchange markets 2. Explain the role of an Investment Banker 3. Describe the process of registering a security with the SEC 4. Describe the difference between equity and debt 5. Compare and contrast common and preferred stock 6. Define the basic bond terms 7. Discuss the bond pricing and interest rate relationship 8. Identify 3 types of secured corporate bonds 9. List the types of Marketable Government Securities 10. Explain the tax implications of a Municipal Bond 11. Identify 5 Money Market Instruments 12. List the 4 phases of the economic business cycle Securities Markets 1.1 Exchange Markets Nature of Auction Markets Stock exchanges, such as the New York Stock Exchange (NYSE), are auction markets where buyers and sellers meet. In other words, participants trade at a physical location on the floor of the exchange. However, the majority of the trading activity is completed quickly and efficiently, and at significantly lower cost, through electronic trading systems. The core function of an exchange is to promote fair and orderly trading, as well as accurate dissemination of price information for all securities listed on the exchange. Exchanges give companies and others who meet the criteria for listing securities on the exchange a platform for investors to acquire those securities. Exchanges are located around the world, but the most well-known exchanges include: New York Stock Exchange London Stock Exchange Tokyo Stock Exchange 1 Series 6

Based on the total market capitalization of its listed securities, the New York Stock Exchange is the largest equities-based exchange in the world. A Designated Market Maker (DMM) is a member of an exchange who acts to facilitate the trading of a given stock (think of them as auctioneers), and whose duties include: Holding inventory of the specified stock Posting the bid (buy) and ask (sell) prices at which it is willing to trade Managing orders Executing trades A DMM s responsibility is to manage large movement by trading out of its own inventory. If there is a large shift in demand on the buy or sell side, the DMM will step in, selling from its own inventory to meet the demand until the gap has been narrowed. The DMM s optimal responsibility is to find a fair price for each stock at the beginning of every trading day. The fair price is based on the current demand and supply of the stock. There is only one DMM per stock which is ready to step in and buy or sell as many shares as needed to ensure a fair and orderly market in that security. When acting as a DMM, the firm assumes the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security. Once an order is received, the market marker immediately sells from its own inventory or seeks an offsetting order. Electronically, this process can be completed in mere seconds. A DMM is employed by a NYSE member. Exchanges (the First Market ) Stock exchanges are places for buyers and sellers to come together and trade securities registered for public trading. The exchange provides price discovery in an auction environment designed to produce the fairest price for all parties. The price of a given stock is determined according to the principle of supply and demand, which states: If there is a greater demand than supply for a specific stock, the price of that stock will increase until there is no investor support for the increased price. If there is a greater supply than demand for a specific stock, the price of that stock will decrease until the stock once again becomes attractive to investors. Securities must meet specific criteria to be listed on the Exchanges. Each exchange has specific listing requirements before any company s stock may be listed. Some exchanges have more rigid requirements than others. A basic requirement for a company to be listed on the exchange includes regular financial reports, independently audited annual financial reports, and a minimum per share price. Penny stocks (any stock trading below $5 per share) cannot be listed, and companies whose stock has fallen in value to penny stock price range are in jeopardy of being delisted." Only member firms may transact business on the floor of the exchange. Exchange members interested in buying and selling a particular stock on behalf of investors gather around the appropriate post where a DMM is located. 1.2 Over-The-Counter known as a Negotiated Market (the Second Market) Nature of Negotiated Market The second market consists primarily of securities that are not listed or traded on an organized exchange. There is no physical location, and trading is conducted electronically. Series 6 2

A Principal is a broker-dealer who is buying or selling securities for the broker-dealer s own account and, therefore, is assuming the risk of owning the security. This is referred to as a principal trade. An Agent is a broker-dealer who executes a trade order for a customer s account. Because an agent does not buy or sell securities from its own broker-dealer account, an agent does not assume the risk of owning the security. A commission is typically charged to transact the sale. NASDAQ The National Association of Securities Dealers Automated Quotation system is the largest electronic securities trading market in the United States. It is how most over-the-counter (OTC) stocks are traded (though NASDAQ is now technically an electronic exchange, it is still part of the OTC market). NASDAQ is characterized by the following features: There is no physical trading floor. Trading relies on market makers to facilitate buying and selling of securities. Market makers effectively set the bid and the ask price, earning a profit on the spread between the two prices. It is entirely an electronic communications network. NASDAQ Capital Market consists of the stocks of smaller companies with less capitalization than required for the NASDAQ Global Market, but which meet the minimum financial requirements for listing (and must continue to meet those standards). NASDAQ Global Market consists of OTC stocks of companies from around the world that meet one of three sets of initial listing standards, and must continue to maintain those standards. The NASDAQ Global Select Market lists securities of companies who can meet, and continue to maintain, the most rigorous initial listing standards for specific financial and liquidity requirements. Market Makers are registered with FINRA and place their names on a list of buyers and sellers, which is then distributed by NASDAQ. In a split second, the order is given to thousands of agents over the network. If you wish to buy a stock trading on NASDAQ, your broker will either call up a market maker with the information of your trade or enter your order into a NASDAQ-sponsored online execution system. A Market maker is a broker-dealer who maintains an established bid and ask price in a security, and stands ready to buy or sell at those quoted prices. NASDAQ quotes are available at 3 levels: Level 1 Shows the highest bid and lowest asking price (or ask), called the inside quote." Level 2 Shows all public quotes of market makers including the quote size, which is the number of shares available to buy and/or sell each bid and ask price, together with information of market makers wishing to sell or buy stock. Level 3 Is used by the market makers and allows them to enter quotes (bid and ask) and execute orders. These are firm quotes of at least 100 shares. Some OTC stocks aren t listed on the NASDAQ. Pink Sheets include quotations for these stocks. Quotations are entered by broker-dealers acting as Market Makers in the individual securities. These non-nasdaq-listed securities are issued by SEC-reporting companies and trade on the OTC Bulletin Board (OTCBB). The Third Market The Third Market involves OTC trading of exchange-listed securities among institutional investors and broker-dealers who are not members of an exchange. Stock exchange members or non-members can trade large blocks of stock off the floor to avoid the transactions unsettling effect on the market. However, these trades must still be reported within 90 seconds of execution. NASDAQ uses a proprietary linkage system to interact with the various national securities exchanges, which makes it a direct competitor with the NYSE as a trading platform. 3 Series 6

The Fourth Market The Fourth Market consists of direct trading of large blocks of securities between institutional investors through a computer network that is referred to as Electronic Communications Network (ECN). INSTINET is an ECN that allows institutional buyers and sellers to display tentative bid and ask quotes and execute trades. 1.3 New Issue Market/ Primary Market Primary Offering A corporation is a legal entity with liability. Losses of the business do not pass through to the owners, who are called shareholders. Shareholders can receive profit shares of the Corporation in the form of a dividend when declared by the board of directors. Shareholders have limited liability, because the amount each of them pays to acquire the stock of the Corporation is the maximum amount they can lose. Forming a corporation usually includes creating a board of directors. The board or company principals file an Articles of Incorporation document with the Secretary of State in the state of domicile. When approved, a certificate or charter is issued by the State where the Articles of Incorporation document was filed. The primary market is divided into two segments, depending on whether the company has previously issued stock or not: The first sale of stock by a private company to the public is referred to as the Initial Public Offering (IPO). When the Corporation desires to raise additional capital through the sale of additional stock, an additional primary offering will take place. Therefore, a corporation will only go public once through its IPO, and may have additional primary offerings in the future, as necessary. All proceeds of the sale of securities in the primary market go to the corporation. The corporation offering its shares for sale is known as the issuer. All corporations must issue common stock, which is the first type of stock the corporation issues. The common unit of trading is 100 shares, which is referred to as a round lot. The corporation may raise capital initially by selling equity and/or issuing debt (bonds, notes, debentures). This is called Capitalization of a Corporation. Over time, a profitable corporation will increase its capitalization through retained earnings (held as cash savings or investments). A corporation can raise additional capital in the future by selling additional stock (new primary offering) or by borrowing money through the sale of new bonds (debt securities). Equity represents stock ownership, while debt is issued through bond ownership. Example: CAPITALIZATION Equity Market (Stock) + Debt Market (Bonds) CORPORATION: $40 million stock + $30 million bond $70 million total capitalization Role of the Investment Banker The issuer enters into a contract with an Investment Banker (also known as an Underwriter) to sell its shares to the public. An Underwriter can assume the risk of bringing the new securities issue to the market. Series 6 4

An Underwriter is a broker-dealer involved in all IPOs and new primary issues. An underwriter who enlists other underwriters to assist in the offering is called the lead underwriter. Two or more underwriters may serve as co-lead underwriters, reducing the risk a single underwriter might assume. The underwriter helps the issuer determine: What type of security to issue: Common Stock Preferred Stock Debt Securities The best offering price The time to bring the initial public offering or new primary issue to the market Price of New Issue and Underwriter s Compensation If the underwriter wants to spread the risk of purchasing the issue, the underwriter will form a syndicate that is an underwriting group consisting of a group of investment firms. When a syndicate underwrites the transaction, each member takes on a portion of the risk involved in distributing the securities. The selling price of a new issue is usually based on, but not limited to, the following factors: Price of similar issues Market conditions and the state of the economy Estimated public interest in the issue Amount of compensation for the selling group The underwriter is compensated by the spread (difference) between the amount that is paid to the issuer according to the selling contract and the capital raised by the sale of the securities. There are typically 3 types of fees built in: Manager s fee Underwriter s fee Selling concession paid to broker-dealers, which must be FINRA members Types of Underwriting The underwriter s risk and compensation is determined by the type of underwriting arrangement agreed upon. The sale (that is, the allocation and pricing) of shares in the IPO may take several forms. The common methods include: Firm Commitment In a firm commitment, the underwriter guarantees the sale of all securities in the offering, assuring the corporation that it will obtain the full amount of capital it was seeking. The underwriter effectively purchases all the shares and will have a gain or loss on the spread between the public offering price and market value when all shares are eventually sold. Unsold securities remaining after the close of the IPO will be held in the underwriter s inventory until they can be sold in the secondary market. NOTE: A fi rm commitment is also known as Standby Underwriting or a backstopped deal. Best Efforts An investment bank, acting as the agent of the issuer, agrees to do its best to sell an issue to the public, but does not make an outright purchase of the securities. If the underwriter is unable to sell all available securities, any unsold inventory is returned to the issuer. The issuer risks not receiving all the capital expected. 5 Series 6

All or None All or None is an agreement in which the underwriter has the authority to cancel the IPO if the timing or price is unfavorable, which could make it impossible to sell all the shares. Registration of the Securities with the SEC Registration Statement The underwriter files a registration statement with the SEC, including all financial information regarding the corporation. 20-day Cooling Off Period The minimum period of time between when the registration statement is filed and the effective date of the security s registration. Preliminary Prospectus (a Red Herring ) The initial offering document provided by an issuer; used to determine indications of interest. This helps to identify the public s interest in the security and to set the initial public offering price. No shares are actually available for purchase. Tombstone Advertisement An advertisement providing basic information about the security being offered: The underwriter or underwriting syndicate. The type and number of securities being offered. The expected offering price and expected date of offering. It is NOT an offer to sell. Investors are invited to call or write for a prospectus. Tombstone ads are also used by mutual fund families to create interest in various funds. The ads reveal information about one or more funds, but do not provide sufficient information for an investor to make a purchase of any fund. Due Diligence A meeting between the investment banker, any other underwriters in the syndicate, and the corporation s officers will take place prior to the offering of the new issue. The purpose of this meeting is to: Discuss and review detailed information in the registration statement. Determine that all material facts relating to the issue have been disclosed. Prepare a final prospectus for approval by the SEC and which must be provided to investors prior to or at the time of sale. Negotiate a formal underwriting agreement, except for the public offering price of the issue. SEC Disclaimer The SEC registers a security and releases it for sale. However, the SEC does not approve a security, or determine the adequacy or accuracy of a security offering. 1.4 Secondary Market The purchaser of either the IPO shares or newly issued shares subsequently sells the security to another investor. All trading of securities after the IPO has concluded is done in the secondary market. Proceeds of securities traded in the secondary market benefit only the investors, not the corporation. Series 6 6

1.5 Market Terms The following terms apply to most investment securities. Although these terms apply to mutual fund transactions, there are differences in the application. Trade Date The date the security transaction initially was placed between the buyer and the seller; the investor assumes all investment risk in the security on this date, and the seller is relieved of all future risk. Settlement Date The date specified for delivery of securities, and the date on which ownership changes between the buyer and the seller; this is the date an investor becomes the shareholder of record on the corporation s books. Regular Way Settlement 3 business days after the execution of the order. Regular Way = Trade date + 3 or T+3. This does not apply to government debt issues. Cash Settlement Same day settlement. The trade date = the settlement date. Purchases of newly issued government securities must be settled the day following the initial sale at auction (T+1). Secondary trades involving government securities also settle T+1. DVP/RVP Settlement Institutional investors, including investment companies, broker-dealers and custodian banks frequently use DVP (delivery versus payment) or RVP (receipt versus payment) trade clearing procedures for their securities transactions. These trades are also sometimes known as COD (collect on delivery) transactions. DVP/RVP trades are cleared through the Depository Trust Corporation (DTC). At the time of, or before a broker-dealer agrees to a DVP/RVP transaction, the broker-dealer must obtain the name and address of the agent representing the other institutional party in the transaction and that party s institution and account numbers. The broker-dealer must send a trade confirmation to that contraparty no later than the close of the next business day. Upon receipt of the trade confirmation, the contraparty must promptly give delivery instructions through its clearing agent to the broker-dealer. DVP/RVP orders must settle in a maximum of 35 days. Good Delivery Good delivery applies to transactions between broker-dealers. Good delivery requirements refer to the security being traded having: The right signatures Correct denomination Good physical condition A security must be in good condition for delivery when it is sold and delivered to the buyer. However, most securities transactions no longer involve the physical transfer of share or bond certificates. Property Receipt and Delivery of Securities It is the customer s obligation to deliver securities represented by actual certificates that have been sold by their broker-dealer in a timely manner. 7 Series 6

Confirmation The confirmation is written documentation of a trade. It includes the trade date and the settlement date, and must be provided to the customer on or before the settlement date. The confirmation also must include: Identity of the security Price at which the trade was executed Quantity of securities traded Amount of commission paid to the broker-dealer Identity of the selling agent, if any Any other regulatory fees or taxes applicable to the transaction 1.6 Pricing Terms The following terms apply to stocks or bonds being sold in a negotiated market and generally are applicable to securities being offered in the auction market: Bid An offer made by an investor, a trader, or a broker-dealer to buy a security; a bid will stipulate both the price at which the buyer is willing to purchase the security and the quantity to be purchased. A bid also is the stated price at which a market maker is willing to buy a security. Example: If a bid is 1,000 @ $23.53, it means a market marker is willing to purchase 1,000 shares at a price of $23.53 per share. If someone is willing to sell that amount of the security at that price, the transaction will be executed. If someone has a lesser number of shares or bonds for sale, they may be purchased at that price, but the buyer does not have to accept an offer of a lesser number of securities. Ask The minimum price a seller is willing to accept for a security, also known as the offer; along with the price, the ask usually stipulates the maximum number of shares of the security to be sold at that price. The ask will always be higher than the bid. A market maker will always display an ask, and the number of shares or bonds it is willing or has available to sell. Example: If an ask for a stock is 1,000 @ $10, it means that someone is offering to sell 1,000 shares at a price of $10 per share. The term bid and ask are used in nearly every financial market in the world covering stocks, bonds, and derivatives. Spread The difference between the purchase price and the selling price; it may also be referred to as the markup (ask) or mark-down (bid). A market maker sets the price it will buy securities from (bid) and sell securities to (ask) investors (or other market makers). Example: If the bid is $20 and the ask is $21, the spread is $1; it is the market maker s profi t. The size of the spread from one security to another will differ as the result of investor interest, number of shares/bonds available, and the relative liquidity of each asset. Securities in great demand will command a lower spread and, conversely, securities showing little interest will have the greatest spread, due to the ease or difficulty in executing transactions. Series 6 8

Liquidity of a particular security also affects the spread. Example: A Treasury bill is considered a highly liquid asset and would almost always have a very narrow spread. A less liquid asset, such as small-cap stock, will have wide spreads due to lack of liquidity. Best Execution and Interpositioning Securities trade in various markets and on various electronic platforms. The broker-dealer must make a reasonable effort to determine the best market in which to execute a customer order so that the customer receives the best possible price. This obligation is known as Best Execution. The following factors are considered in determining if a member used reasonable diligence in directing a customer transaction to the best market: Security s characteristics, such as liquidity, volatility, available information, price, etc. Size and type of the transaction Number of markets the broker-dealer investigated before entering the customer order Accessibility of a quotation Terms and conditions of the order (i.e., market order, limit order, etc.) Interpositioning is when a broker-dealer introduces a third party between the broker-dealer and the customer. Interpositioning is not allowed unless it results in a better price to the customer than the broker-dealer itself could obtain. The burden of proof is on the broker-dealer to demonstrate why the third party was necessary to obtain the best price to the customer. This applies to transactions done on both an agency and on a principal basis. Investment Securities 1.7 Corporate Securities Equity Securities Definitions and Features One way for a corporation to raise capital is to sell equity securities. Equity represents ownership in a corporation. Stock is considered an equity security. Stock or shareholders represent ownership in a corporation. While a corporation has an unlimited liability and can be sued, the investors can only lose what they invested and therefore have a limited liability. Shareholders share in the profit and loss of a corporation. Profits are paid through dividends and must be declared by the Board of Directors. Types of Equity Securities Common Stock (most junior security) Common Stock is the first type of stock issued by all corporations and is a security that represents fractional ownership in the company. Stock ownership is referred to as having an equity position in the corporation. The shareholders exercise a measure of control over the company by: Electing the board of directors Voting for or against changes in corporate policies Holding the board of directors accountable for the actions of company managers and executives In case of corporation liquidation, common shareholders are the last to have any claims on residual assets and earnings of the corporation. Common stock carries the greatest risk of loss of any securities issued by the corporation. 9 Series 6

Common stock goes through 4 phases: A stock is authorized; authorized shares are the maximum number of shares a corporation is legally permitted to issue as specified in the Articles of Incorporation. Stock is issued through the Initial Public Offering (IPO) and is sold to investors. Subsequent sales of shares to raise additional capital are called additional primary issues. After stock is in the possession of investors (shareholders), the shares are referred to as outstanding shares. Outstanding shares of stock that have been repurchased by the issuing corporation are referred to as treasury stock. Treasury stock: Does not receive dividends Has no voting rights Is not included in calculating the number of outstanding shares May be released as dividends, resold to raise capital for the corporation, or cancelled A corporation can repurchase its stock. This reduces the number of shares outstanding, thus increasing the price in the hopes of attracting or retaining investors. Owning stock is generally for the purpose of long-term capital appreciation ( buy low, sell high ). Dividend-paying stocks provide both income and an opportunity for capital appreciation. Common Stock Values Par Value This is an arbitrary dollar amount given to common stock under the Articles of Incorporation. All stock, because it represents an ownership interest in a company, must have intrinsic value, even if it s only worth $0.01 it is entirely unrelated to the IPO or secondary market selling price. Book Value A theoretical liquidation value of a share of stock that is used for accounting purposes; it does not determine selling price. This is what the stock would be worth after all assets are sold, all liabilities are extinguished, and any other obligations of the corporation are settled. It is the company s residual value divided by the number of shares outstanding. Market Value The market value, or current market value, is the price investors will pay for the stock in secondary trading (securities that are sold from one investor to another). It is based in part on principles of supply and demand, as well as on corporate profitability. An unprofitable company s stock price will probably decline, yet the price of a share of a profitable company might also decline if the company s profits fall short of investor expectations. Market value per share x Number of shares outstanding = Market capitalization Voting Rights Common stockholders have voting rights on certain matters affecting the corporation: Issuing new debt or equity securities Stock splits recommended by the board of directors Substantial changes in corporate operations Members of the board of directors If a stockholder isn t able to vote, a proxy is a certificate that enables someone other than the stockholder to vote. Series 6 10

Each share owned represents one vote. There are two common methods by which shareholders will vote: Statutory Voting Each shareholder has one vote per share. Example: An investor owns 100 shares and, therefore, has 100 votes. When voting for members of the board, the number of statutory votes is the maximum which may be voted for each available seat on the board. In all other matters, the number of statutory votes is the total number of votes which may be cast for, against, or withheld from the matter under consideration. Cumulative Voting Only applies to voting for members of the board of directors; each shareholder is entitled to one vote per share multiplied by the number of directors being elected. This is considered advantageous to individual investors owning fewer shares because they may cast all of their votes for one board member. Example: A Corporation has four vacancies on the board of directors. A shareholder who owns 100 shares of common stock would be able to vote as follows: Statutory Voting: Up to 100 votes for each candidate, but only 100 votes on all other shareholder matters. Cumulative Voting: Shareholder has 400 votes for the board of directors and can choose how to use them, but only 100 votes in all other shareholder matters: All 400 votes can be cast for one candidate or distribution of votes in any manner between the candidates up to the combined total of 400 votes. Open Director Positions Statutory Voting Cumulative Voting 1 100 400 2 100 Or 3 100 200 4 100 200 Preferred Stock (Senior Stock) Each year, preferred stock shareholders must be paid stated dividends before dividends are payable to common shareholders. There is no guarantee dividends will be paid to any class of shareholder, including preferred. This class of ownership in a corporation has a higher claim to assets than common shareholders in case of liquidation. Therefore, this is considered a senior security in the case of a liquidation of the corporation. Preferred stock usually offers investors a higher dividend rate than is paid on the same company s common stock. Typically, preferred stock has a fixed yield based on a percentage of the par value of the stock. Preferred shareholders own non-voting stock and are more interested in the income stream shares are expected to provide through quarterly dividends. Preferred stock is an equity position that more closely resembles that of bondholders of the corporation (but preferred stock ranks below all forms of debt upon liquidation). For the Series 6 exam, the par value of preferred stock is $100 per share. Types of Preferred Stock Straight (Stated or Noncumulative) Preferred Stock Stock pays a dividend ($ or % of par) as stated on the certificate. If a corporation chooses not to pay dividends in a given year, these shareholders do not have a right to receive unpaid dividends in future years. 11 Series 6

Cumulative Preferred Stock This class of stock provides that if any dividends have been suspended in the past, these stockholders must receive payment of dividends in arrears before any current preferred dividends are paid and before common stockholders are entitled to receive any dividends. Example: A corporation does not pay any dividends to any shareholders this year. Cumulative preferred shareholders must receive their missed dividends when dividends are next declared in the future, in advance of dividends payable to any other class of shareholder. Participating Preferred Stock The participating preferred shareholders have the right to receive dividends equal to the specified fixed rate preferred shareholders receive, as well as an additional dividend based on some predetermined condition. The additional dividend is generally structured to be paid only if the amount of dividend common shareholders receive exceeds a specified per-share amount. The participating preferred shares can include a clause that the extra dividends to be paid to participating stock will be triggered whenever the dividend for common shareholders exceeds that of the preferred shareholders. Example: Preferred shareholders fi xed quarterly dividend is $2.00 per share, and the board of directors declares a common shareholders quarterly dividend of $2.50 per share. The participating preferred shareholders will receive a total dividend of $2.00 + $.50 = $2.50. Thus, participating preferred shareholders will never receive a dividend less than that of common shareholders, but might receive more. Dividend Priority of Payout: 1. Dividends in arrears (cumulative preferred) 2. Stated (noncumulative preferred) 3. Participating preferred and common Features of Preferred Stock Convertible Preferred Stock This stock includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually on or after a predetermined date (a fixed point in time, not the duration of ownership of the stock by an investor). Convertible preferred stock is generally exchanged at the request of the shareholder. A provision may be included that allows the company ( issuer) to force conversion. The value of convertible preferred stock is more closely tied to the performance of common stock than other classes of preferred stock, which are considered interest sensitive securities. Callable Preferred Stock Includes a provision giving the issuer the right to force redemption and cancel the stock (at a certain price set by the board of directors, but never less than the par value). Advantages of Preferred Stock Owners have priority over common shareholders on equity and assets in the event of liquidation. A fixed dividend is paid before common shareholders receive a dividend. The dividend paid is generally greater than dividends common shareholders receive. The price of preferred stock does not fluctuate as much as the company s common shares. Preferred stock prices are driven mostly by fluctuations in interest rates in the economy. Series 6 12

Disadvantages of Preferred Stock No voting rights. Fixed dividend, similar to nominal interest on a bond (per share value will decline as interest rates rise, or rise as interest rates fall; dividends cannot be guaranteed). Less potential for appreciation than common stock. Rights to Earnings Earnings are not guaranteed. When dividends are distributed to shareholders, the dividend payout comes from retained corporate earnings. When a corporation s dividend is distributed, the corporation s earnings are reduced by the same dollar amount. Example: Corporation total earnings $10,000,000 Dividend distribution - $3,000,000 Earnings after dividends payout $7,000,000 The corporation pays income tax on net income after dividends; investors pay ordinary income tax on dividends received. Rights to Dividends A Dividend is a distribution of a portion of a company s earnings. Dividends are usually paid quarterly, but stated as an annual rate (A $0.10 quarterly dividend is the same as a $0.40 annual dividend). All dividends must be declared by the board of directors. The dividend is generally payable in terms of a dollar amount for each share owned. Dividends can be paid in the form of: Cash Stock Property Many larger and more stable companies offer dividends to attract and retain shareholders. Preferred shareholders receive a fixed dividend. The price per share of preferred stock might not significantly increase or decrease in value, but what preferred shareholders receive in the form of dividends helps to make up for low appreciation. Smaller, high-growth companies rarely offer dividends because profits typically are being reinvested to help sustain higher-than-average growth. Dividend Yield Dividend yield is a measure of the return on investment for a stock and is calculated as follows: Annual dividend per share Price per share Example ABC Company stock is trading at $20 and pays a $0.50 quarterly dividend. Annual dividend is: $0.50 x 4 = $2 Dividend yield is: $2 $20 = 10% Next year, ABC increased its quarterly dividend to $.75 per share, but the market price remains the same. Annual dividend is: $0.75 x 4 = $3 13 Series 6

Dividend yield is: $3 $20 = 15% (Yield increases) The following year the quarterly dividend is reduced to $.50 per share, but the market price has increased to $30. Dividend yield is: $2 $30 = 6.67% (Yield decreases) NOTE: A change occurs in the yield any time the stock price changes and/or dividend payout changes, so don t mistakenly equate a change in dividend yield with a change in the payout received. For the test, you must know how dividend yield changes in relation to stock price changes and/or dividend changes. Important Dividend Dates (DERP) Declaration Date The date on which the board of directors announces the company will pay a dividend to shareholders. Ex-Dividend Date On and after this date, the security trades without the value of the dividend. The ex-dividend date is two business days before the record date (R-2). This date is set by FINRA. Record Date The date on which an investor must own the stock to receive the dividend. This date is set by the board of directors. Only shareholders of record will receive a dividend. Payable Date The date on which the company actually pays the dividend to the shareholders of record. This date is set by the board of directors and usually is a week or more after the record date so the company has sufficient time to ensure all shareholders entitled to receive the payment are accurately paid. Why are these dates important? The Ex-Dividend date is intended to prevent last minute sales of stocks to investors solely to obtain dividends. Settlement of stocks is based on Regular Way Settlement (T + 3), and the ex-date is determined by this practice. Example: Ex-Dividend Date Record Date Monday Tuesday Wednesday Thursday Friday 1 2 3 4 5 If stock is purchased on the Ex-Dividend date (Tuesday), which is only 2 days before the record date, the trade will settle on Friday, and the dividend will not be received by the new owner. The investor s name will not appear in the company s record books until Friday. To receive the dividend, the trade must have been executed on Monday and settled on Thursday. NOTE: For mutual fund shares, the ex-dividend date is not determined by regular way settlement, so it's NOT R-2. Rather, the ex-date is set by the fund s board of directors, usually the day after the record date (R+1). Therefore, whereas the chronological order of the four dates for stocks is DERP, for mutual fund shares it is DREP. Selling Dividends Recommending an investor purchase a stock in order to receive the dividend. One should not buy stock just before the ex-dividend date for two reasons: The value of the shares will be reduced by the amount of the dividend, but the trade must be settled at the higher purchase price. The dividend will be taxable. In essence, an investor has bought the dividend. NOTE: Selling dividends is a trading violation for Registered Representatives. When a stock is trading with the dividend, the term cum dividend is used. Series 6 14

Stock Quotes Stocks are quoted in points; one point equals $1. Quotes can be found online and in most daily newspapers. Stock transactions usually occur in round lots (100 shares). A transaction that is not evenly divisible by 100 shares is referred to as an odd lot (i.e., less than 100 shares or between 100-200 shares). Rights or Preemptive Rights (also known as Subscription rights ) When a corporation decides to raise additional capital through the issuance of new shares, the new shares will dilute the equity stake existing shareholders have, making their shares less valuable. A preemptive right permits existing shareholders in a company to maintain the same percentage of ownership by subscribing to new stock offerings (additional primary issue) at a predetermined price on a particular date, and often without a sales charge or commission. It is a security that can be bought or sold by investors prior to the expiration date. Generally, existing shareholders are offered an opportunity to purchase stock at a price below the current market price. This encourages an investor to exercise the right. A right will not be exercised if the stock price falls below the offering price. The additional shares may be purchased in the secondary market at the lower price. The type of underwriting most often used in conjunction with a rights offering is standby underwriting. The underwriter agrees to purchase the portion of newly issued shares that were not purchased after the rights offering expires. Rights are issued only for a short period of time (typically 30 days to 6 weeks). The shareholder may: Exercise the right and buy the stock at the exercise price so the shareholder will retain proportional ownership share of the corporation. Immediate profit is not the deciding factor; maintaining a proportional interest in the corporation is. Sell the right to someone else in the secondary market place. Rights are transferable, so if a shareholder sells theirs to someone else, proportional share of ownership will be reduced when the additional shares are sold. Let the right expire. Example: A shareholder owns 1,000 shares, which represent 10% ownership in the corporation prior to a rights offering. The corporation is about to issue 100,000 new shares. To maintain 10% ownership, the shareholder must exercise all rights offered (purchase 10,000 of the newly issued shares). If the shareholder doesn t exercise all of the rights, the proportional ownership share is reduced. Warrants A warrant is a financial derivative that gives the holder the right, but not the obligation, to purchase an underlying stock in a specified quantity, at a certain price, and on a specified future date. Warrants may be traded separately from the underlying security and often are included in a new debt (bond) issue as a sweetener to entice investors to purchase bonds. Warrants are always issued with a distant redemption date (often 1 to 10 years into the future), and generally above the current market price. A warrant will be exercised if the market price on the redemption date is higher than the exercise price. It will expire unexercised if the market price is lower. Warrants trade in the secondary market. Options An option is a standardized derivative financial contract between two parties; the option writer and the option buyer or holder. An options contract gives the option holder the right to buy or sell (depending on the type of contract) an underlying index or security such as a stock. The 15 Series 6

option writer sells the option contract to the option holder and receives the selling price called the premium. There are options on stocks, indices, government bonds, currencies and other financial securities. Options trade in the secondary market. The largest options exchange is the Chicago Board Options Exchange (CBOE). Stock option contracts are for 100 shares of stock. There are two types of stock options; calls and puts. A call option gives the option holder the right (but not the obligation) to buy 100 shares of stock at specified price, called the strike price, up until the expiration date of the option contract. If a call holder exercises her right to buy stock then the call writer must sell the stock to the call holder at the strike price. Put options give the option holder the right (but not the obligation) to sell 100 shares of stock at the strike price up until the expiration date of the option contract. If a put holder exercises his right to sell stock then the put writer must buy the stock from the put holder at the strike price. An option holder is long the option (he owns the option) whether the option is a put or a call. The option writer is short the option (she initiated a short position) whether the option is a put or a call. Options Definitions: Writer Has obligation to buy or sell. Buyer Has option to buy or sell. Call Conveys the option to BUY a specific stock; the writer has an obligation to SELL the specific stock at the agreed (strike) price. Put Conveys the option to SELL a specific stock; the writer of the contract has an obligation to BUY a specific stock at the agreed (strike) price. Market Anticipation A speculator looks at the direction the market will take. Bullish Investor Takes a LONG position anticipating the market will go up Bearish Investor Takes a SHORT position anticipating the market will go down Long calls and short puts anticipate market increases, while short calls and long puts anticipate market declines. CALLS (Writer is obligated to Sell) PUTS (Writer is obligated to Buy) LONG Anticipate Increases Anticipate Declines SHORT Anticipate Declines Anticipate Increases The writer of a call option is exposed to unlimited loss, while the buyer of an option (put or call) is only exposed to the loss of the premium paid. Bulls buy long calls and write short puts. Buying a call Owning the option to buy at the strike price. Writing a put The obligation to buy at the strike price. Bears write calls and buy puts: Writing a call The obligation to sell at the strike price. Buying a put Owning the option to sell the strike price.. Series 6 16

CALL PUT BUY Option to buy (Bullish) Option to sell (Bearish) WRITE Obligation to sell (Bearish) Obligation to buy (Bullish) American Depositary Receipt (ADR) Characteristics Shares of foreign corporations created for and bought and sold (negotiable) in U.S. securities markets (via exchanges or OTC) like a stock, but not the same as owning the foreign stock itself. Bought and sold in U.S. dollars. Allows non-u.s. corporations to sell securities in U.S. more easily without registering. Foreign stocks do not trade in U.S. markets directly, but through ADRs. U.S. investors are allowed to purchase foreign securities through foreign exchanges. Receipts represent shares (usually 1-10) of stock in a non-u.s. Corporation. Market price is impacted by business risks of underlying company, but also currency exchange risk. Issued and registered with SEC by U.S. Banks. Dividends are paid in dollars. Any foreign taxes due are withheld prior to pay out. Rights of Ownership To trade receipts for underlying foreign securities; ADRs are returned to depository bank that delivers underlying security. Owners of receipts do not have preemptive or voting rights. REMEMBER: ADRs enable domestic investors to buy U.S. denominated securities of foreign corporations they are NOT domestic securities sold to foreign investors. Debt Securities (Bonds) Definitions and Features Bonds, notes, and debentures are debt securities (also referred to as debt instruments) representing a loan made by an investor (bondholder) to the legal entity issuing the bond (issuer). Bonds are used to finance a variety of projects and activities, and are issued by: U.S. corporations U.S. municipalities States U.S. government Foreign governments Foreign municipalities Foreign corporations A legal entity (issuer) is the one responsible for developing, registering, and selling the bond for the purpose of financing its operation. An issuer is legally responsible for the obligations of the issue and for reporting the financial condition, material developments, and any other operational activities as required by the regulations of its jurisdiction. The issuer borrows funds for a specific period of time at a fixed or variable (or floating) interest rate. Bonds typically are long-term investments with maturities ranging from 10-30 years from date of issue. The longer the term of the bond, the higher the interest rate will be. 17 Series 6

The issuer also uses funds borrowed from investors as leverage to finance its operations, though it must be paid back eventually. Example: ABC Company wants to purchase some equipment with a lifespan of 20 years that will cost $25 million. A corporation issues 10-year bonds (equipment trust or collateral trust bonds would offer a measure of security to the bondholders, since the equipment could be sold to retire the bond issue). The principal needs to be repaid to the creditors (bondholders) in 10 years. During this period of time, the company will need to pay interest to investors who purchased the bonds. Bonds are generally referred to as fixed income securities and are one of the three main asset classes, along with stocks and cash equivalents. A bond is a security since an investor can: Obtain a profit Suffer a financial loss, or Break even. NOTE: Bonds can be actively traded (bought and sold) after their issue date and before they mature, and general interest rates in the economy affect bond prices (after they are fi rst sold). The creditworthiness of the issuer will affect the liquidity/marketability of the bonds. The main categories of bonds are: Corporate Bonds Municipal Bonds U.S. Treasury Bonds Bond Registration Coupon (Bearer) Bonds The owner is the person in possession. Bonds are not registered, and no proof of ownership required. Interest coupons are detached and submitted to paying agent in order to receive interest payments. No longer being issued in the U.S. Registered Bonds Bondholder s name is registered and appears on the certificate. Fully Registered Registered as to principal and interest. Interest automatically is mailed to bondholder; most corporate bonds are issued this way. Registered as to Principal Only Owner s name is registered but interest coupons are in bearer form. Book-Entry Bonds Bond owners do not receive certificates, and a Transfer Agent keeps record of all owners. Most U.S. Government and municipal bonds are issued this way. Liquidation Preference (Priority of Payment upon Dissolution or Bankruptcy of a Corporation) Employees, federal and state governments, creditors, and investors have a claim to corporate assets upon the dissolution or bankruptcy of a corporation. The creditors and investors have subordinate priorities when it comes to receiving their share of the assets according to the stipulated order or priority of payout: Wages Taxes Secured debt (mortgage bonds and equipment trust or collateral trust bonds) Unsecured bondholders (debentures) and general creditors Subordinated debentures Cumulative Preferred shareholders Straight Preferred shareholders Participating Preferred shareholders Common shareholders Series 6 18