SECTION I The Canadian Investment Marketplace

Chapter 1 The Capital Market

• Investment Capital • Investment capital is available and investable wealth (e.g., real estate, stocks, bonds and

money) that is used to enhance the economic growth prospects of an economy. • In direct investment, an individual or company invests directly in an item (e.g., house,

new plant or new road); indirect investment occurs when an individual buys a security and the issuer invests the proceeds.

• Characteristics of Capital: mobile, sensitive to its environment and scarce. The decision as where capital will flow is guided by country risk evaluation, which analyzes such things as: the political environment, economic trends, fiscal policy, monetary policy, investment opportunities, and labour force.

• Sources and Users of Capital • The only sources of capital is savings. • Sources of Capital:

• Retail investors: individual investors who buy and sell securities for their own personal accounts, and not for another company or organization.

• Institutional investors: organizations that trade large volumes of securities and typically have a steady flow of money to invest.

• Foreign investors • Users of Capital:

• Individuals: individuals use capital to finance major purchases or for consumption. • Business: business use capital to finance day-to-day operations, to renew and

maintain plant and equipment, and to expand and diversify activities. • Governments: government use capital when expenditures exceed revenue and to

finance large projects.

• The Financial Instruments • Financial Instruments

• Debt Instruments (bonds, debentures, mortgages): the issuer promises to repay a loan at maturity and in the interim makes payments of interest or interest and principle at predetermined times. the term to maturity of a debt instrument can be either short (less than five years) or long (more than ten years).

• Equity Instruments (stocks): the investors buys a share that represents a stake in the company. Preferred share & common share.

• Investment funds (mutual funds, segregated funds): a company or trust that manages investments for its clients.

• Derivatives (options, futures, rights): products derived from an underlying instrument such as stock, financial instrument, commodity or index.

• Other investment products (linked notes, exchange-traded funds): investments that are relatively new and do not fit into any of the standard categories.

• Private Equity • Private equity is the financing of firms unwilling or unable to find capital using

public means — for example, via stock or bond markets. It complements publicly

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traded equity by allowing businesses to obtain financing when issuing equity in the public markets may prove difficult or impossible.

• Long term returns on private equity typically exceed most other asset class, while it also exposes investors to far higher risks.

• Public and private pension plans, endowments, foundations, and wealthy individuals are the main investors in the private equity market.

• The Financial Markets • The financial markets facilitate the transfer of capital between investors and users

through the exchange of securities. • The exchange do not deal in physical movement of securities; they are simply the

venue for agreeing to transfer ownership. • In the primary market new securities are sold by companies and governments to

investors for the first time. When a company issues stocks for the very first time in the primary market, the sale is known as an initial public offering (IPO).

• In the secondary market investors trade securities that have already been issued by companies and governments.

• In an auction markets, buyers enter bids and sellers enter offers for a stock. • the bid is the highest price a buyer is willing to pay for the security being quoted. • the ask (offer) is the lowest price a seller will accept. • the spread is the difference between the bid and ask prices. • the last price is the price at which the last trade on the stock took place.

• Dealer markets are network of dealers that trade with each other directly on a negotiated market with market makers. Most bonds and debentures trade on these markets.

Chapter 2 The Canadian Securities Industry

• Overview of the Canadian Securities Industry • Canadian capital markets are among the most sophisticated and efficient in the world. These

qualities are measured in terms of the variety and size of new issues brought to the markets and the depth and liquidity of secondary market trading.

• Financial Intermediaries • Types of Firms in the Canadian Securities Industry

• Integrated firms offer products and services that cover all aspects of the industry. • Institutional firms primarily handle the trading activity of large clients such as pension

funds and mutual funds. • Retail firms include full-service firms and discount brokers. Full-services retail firms

offer a wide variety of products and services for the retail investors. Discount brokers execute trade for the clients at reduced rates but do not provide advice.

• Main Functions of Investment Dealers • Main role of an investment dealer is to bring new issues of securities to the primary

markets and facilitate trading in the secondary markets. • The dealer can act as a principal or and agent in either market.

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• When acting as a principal, the dealer owns securities as part of its inventory when conducting transactions with clients and inventors. Profit is made on the spread between the original cost of the securities and what they eventually sell for.

• When acting as an agent, the dealer acts on behalf of a buyer or seller but does not itself own title to the securities at any time during the transaction. Profit is earned on the commission charged for each transaction.

• Chartered Banks in the capital markets • The Canadian chartered banks are the largest financial intermediaries in the country.

• Most Canadian-owned banks are designated as Schedule I banks. They are the dominant competitors in the industry both in term s of the wide-ranging services offered and their overall asset base.

• Schedule II banks are incorporated and operate in Canada as federally regulated foreign bank subsidiaries. These banks can engage in all the types of business that are permitted to schedule I.

• Schedule III banks are federally regulated foreign bank branches of foreign institutions. Most operate as full-service branches able to accept deposits, though some are merely leading branches.

• Trust Companies, Credit Unions and Insurance Companies in the Capital Markets • These financial intermediaries offer a broad range of financial services that in many cases

overlap with the services provided by chartered banks, including deposit-taking and lending, debit and credit cards, mortgage and mutual funds.

• The insurance company has two main business: life insurance and property and casualty insurance.

• Investment Funds, Saving Banks, Loan Companies and Pension Plans in the Capital Markets • Investment funds sell their shares to the public, most often in the form of closed or

opened funds, and invest the proceeds in a diverse portfolio of securities. • Loan companies make direct cash loans to consumers who typically use them to repay

principal and interest on instalment loans. These intermediaries also purchase instalment sales contracts from retailers on such items as new automobiles, appliances, or home improvements that are purchased on instalment.

• Pension plans represents a type of institutionalized savings. These plans are offered to the employees of many companies, institutions and other organizations.

Chapter 3 The Canadian Regulatory Environment

• The Regulators • Federal Regulators

• The Office of the the Superintendent of Financial Institutions (OSFI) provides regulatory oversight for all federally regulated financial institutions, including banks and insurance, trust, loan and investment companies licensed or regulated by the federal government. OSFI does not regulate the Canadian securities industry.

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• The Canadian Deposit Insurance Corporation (CDIC) is a federal Crown Corporation that provides deposit insurance and contributes to the stability of Canada’s financial system. CDIC insures eligible deposits up to $100,000 per depositor in each member institution.

• The Provincial Regulators • Each province is responsible for creating the legislation and regulation under which

the securities industry must operate. This regulatory authority is usually delegated by the province to its own provincial securities commission or administrator.

• The 13 securities regulators of Canada’s provinces and territories joined together to form the Canada Securities Administrators (CSA), a forum to co-ordinate and harmonize regulation of the Canadian capital markets.

• The Self-Regulatory Organizations • SROs are responsible for enforcing member conformity with securities legislation and

they have the power to prescribe their own rules of conduct and financial requirements for their members.

• Canadian SROs include the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association (MFDA). SRO regulation is divided between securities markets and mutual funds distribution side. • IIROC deals with all investment dealers and trading activity regulation on debt

and equity marketplace in Canada. • MFDA deals with the distribution side of the mutual fund industry.

• Investor Protection Funds • CIPF protects clients of IIROC dealer members against losses caused by the

insolvency of an IIROC dealer member. CIPF also oversees the self-regulatory system.

• MFDA IPC protects clients of MFDA member firms against losses caused by the insolvency of an MFDA member firm.

• The Principles of Securities Legislation • Provincial securities acts are designed to regulate the underwriting, distribution and sale of

securities, and to protect buyers and sellers of securities. Generally, the acts use three basic methods to protect investors: • Registration of securities dealers and advisors: The National Registration Database

(NRD). • Disclosure of facts necessary to make reasoned investment decisions: full, true and

plain disclosure. • Enforcement of the laws and policies.

• The industry also relies on the SROs for their members’ compliance to legislation.

• The Ethics of Trading • Ethical trading is of paramount importance to both the investing public and the users of the

capital markets, the listing corporations. • Unethical conduct may be defined as any omission, conduct, manner of doing business or

negotiation, which in the opinion of the disciplinary body is not in the public interest nor in the interest of the exchange.

• Public Company Disclosures & Investors Rights • Public Company Disclosures:

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• Once distributing securities, the issuer must comply with the timely and continuous public disclosure requirements of the acts.

• The primary disclosure requirements include issuing a press release and filing a material change report with the administrators if a material change occurs.

• Issuers also must file with the administrators annual and interim financial statements meeting prescribed standards of disclosure.

• Statutory Rights for Investors • The right of withdrawal: the purchasers have the right to withdraw from an

agreement to purchase securities within two business days after the deemed receipt of the company’s prospectus.

• The right of rescission: the purchasers have the right to cancel the purchase of securities if the prospectus contains a misrepresentation. The purchasers have 180 days after the purchase to take advantage of this right.

• The right of action damages: if it is deemed that a prospectus contains a misrepresentation, the issuer, the directors of the issuer, the seller of the security, the underwriter, and any other person who signs off on the prospectus may be liable for the damage.

• Takeover Bids & Insider Trading • A takeover bid is an offer to the shareholders of a company to purchase the shares of the

company that, with the offeror’s already owned securities, will in total exceed 20% of the outstanding voting securities of the company.

• The reporting of trading activity by insiders of a reporting issuer is based on the principle that shareholders and other interested persons should be regularly informed of the market activity of insiders

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SECTION II The Economy

Chapter 4 Economic Principles

• Economics • Economics is fundamentally about understanding the choices individuals make and how

the sum of those choices determines what happens in our market economy. • Microeconomics analyzes the market behaviour of individual consumers and

firms. • Macroeconomics focuses on the performance of the economy as a whole.

• The decision makers • Consumers set out to maximize their satisfaction or well-being. • Firms set out to maximize profits. • Governments set out to maximize the public good.

• Demand & Supply • The interaction that takes place between buyers and sellers in the market

ultimately determines an equilibrium price for that product.

• Gross Domestic Product (GDP) • GDP is the market value of all finished goods and services produced within a country

in a given time period, usually a year or a quarter. • Mesure GDP

• Expenditure approach: measuring GDP as the sum of personal consumption, investment, government spending, and net exports of goods and services.

• Income approach: measuring GDP as the total income earned producing those goods and services.

• c.f. real GDP & nominal GDP • Growth in GDP

• increase in population over time • increase in the capital stock • improvements in technology

• Business Cycle • Phases of Business Cycle

• Expansion: real GDP is rising during an expansion. • Peak: the top of the cycle. • Contraction: when an economy passes its peak, it enters a contraction. If the

downturn lasts longer than two consecutive quarters, then the economy has typically entered a recession.

• Trough: the growth cycle reaches its lowest point. • Recovery: GDP returns to its previous peak.

• Economic Indicators • Leading indicators tend to peak and trough before the overall economy. e.g.,

housing starts, manufacturers’ new orders, commodity prices, average hours worked per week, stock prices, the money supply.

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• Coincident indicators are those which change at approximately the same time and in the same direction as the whole economy. e.g., personal income, GDP, industrial production, retail sales.

• Lagging indicators are those which change after the economy as whole changes. e.g., unemployment, private sector plant and equipment spending, business loans and interest on such borrowing, labour costs, the inflation rate.

• Improvement in long-term economic growth are attributed to improvements in productivity. Productivity growth has major implications for the overall wealth of an economy.

• Labour Market • The Key Labour Market Indicators

• The participation rate represents the share of the share of the working-age population that is in the labour force.

• The unemployment rate represents the share of the labour force that is unemployed and actively looking for work.

• Main Types of Unemployment • Cyclical unemployment is the result of fluctuations in the business cycle. • Frictional unemployment is the result of normal labour turnover. • Structural unemployment occurs when working workers are unable to find work

or fill available jobs because they lack the necessary skills, do not live where jobs are available, or decide not to work at the wage rate offered by the market.

• Interest Rate • factors Influencing Interest Rates

• demand for and supply of capital • default risk • central bank credibility • foreign interest rates and the exchange rate • inflation

• Interest Rates Affecting the Economy • Higher interest rate raises the cost of capital for consumers and business. This

discourage consumers from spending and borrowing money to purchase. Thus higher rates lead to slower economic growth.

• Lower interest rate has an expansionary effect on the economy.

• Inflation • Inflation is a generalized, sustained trend of rising prices measured on an economy-

wide basis. • current CPI - previous CPI previous CPI • Inflation erodes the standard of living for those on a fixed income, it reduces the real

value of investments because the loans are paid back in dollars that buy less, and it distorts the signal that prices send to participants in the market. Rising inflation rates typically brings about rising interest rates and slower economic growth.

• Disinflation is a decline in the rate at which prices rise, meaning a decrease in the rate of inflation.

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* 100 = inflation

• Deflation is a sustained fall in prices where the annual change in the CPI is negative year after year. A sustained fall in prices can have negative implications for corporate profits and the economy.

• International Economics Impacting the Economy • The Balance of Payments: a detailed statement of a country’s economic transactions

with the rest of world for a given period — typically over a quarter or a year. • The current account records the exchanges of goods and services between

Canadians and foreigners, the earnings from investment income, and net transfers. • The capital and financial account records financial flows between Canadians and

foreigners related to investments by foreigners in Canada and investments by Canadians abroad.

• The Exchange Rate: the price of one currency in another. • The key determinants of the exchange rate include commodity prices, inflation

differentials, interest rate differentials, current account, economic performance, public debts and deficits, political stability.

Chapter 5 Economic Policy

• Economic Theories • The rational expectations theory suggests that firms and workers are rational thinkers

and can evaluate all the consequences of a government policy decision, thereby neutralizing its intended impact.

• Keynesian economics advocates the use of direct government intervention to achieve economic growth and stability. Keynesians believe the use of active fiscal policy, using government spending and taxation, is necessary to stabilize the business cycle.

• Monetarist theory suggests that the economy is inherently stable, with its own self-adjusting mechanism that automatically moves the economy to a stable path of growth. Monetarists believe the central bank should simply expand the money supply at a rate equal to the economy’s long-term growth rate.

• Supply-side economics suggests that to foster an environment of prosperity, the market should be left alone and government intervention should be minimal, only occurring through changes in tax rates.

• Fiscal Policy • Fiscal policy is the use of the government’s spending and taxation powers to pursue

such economic goals as full employment and sustained long-term growth. They do this by spending more and taxing less when the economy is weak, and by spending less and taxing more when the economy is strong.

• The federal budget: budget surplus, budget deficit, balanced budget.

• Monetary Policy • The goal of monetary policy is to improve the performance of the economy by

regulating growth in the money supply and credit. • The Bank of Canada

• The role of the Bank of Canada is to monitor, regulate and control short-term interest rates and the external value of the Canadian dollars.

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• The major functions of the Bank of Canada include: • The issue and removal of bank notes. • Acting as fiscal agent and financial advisor for the Federal Government. • The implementation of monetary policy.

• Inflation Control • In Canada, monetary policy involves following specific inflation-control targets

that establish a range within which to contain annual inflation. Currently, the target range is 1％ to 3%.

• The Bank of Canada achieve this through its influence over short-term interest rates. id inflation approaches the top of the target range, this needs to be controlled through an increase in short-term interest rates; while when inflation fall towards the bottom, the Bank decreases interest rates.

• Implementing Monetary Policy • The overnight rate is the interest rate set in the overnight market. The Bank

uses the target for the overnight rate to implement changes in the direction of monetary policy.

• The bank rate is the minimum rate at which the Bank of Canada will lend money on a short-term basis to the chartered banks and other members of CPA.

• Open Market Operations • Special Purchase and Resale Agreements (SPRAs) are used to relieve undesired

upward pressure on the overnight rate. If overnight money trade above the target of the operating band, the Bank intervenes and offers to lend at the upper limit of the band. This action effectively reinforces the upper limit of the overnight target.

• Sale and Repurchase Agreements (SRAs) are used to offset undesired downward pressure on the overnight rate. If overnight money is trading below the target of the operating band, the Bank intervenes and offers to borrow at the lower limit of the band. This action effectively reinforces the lower limit of the overnight target.

• Cash Management Operations • The Bank established the Large Value Transfer System (LVTS) to facilitate its

cash management operations. This system allows participating financial institutions to conduct large transactions with each other through an electronic wire system.

• A drawdown is the transfer of deposits to the Bank from the chartered banks, effectively draining the supply of available cash balances from the banking system. This cause a contraction in the availability of loans to consumers and business, which places upward pressure on interest rates.

• A deposit is the transfer of funds from the Bank to the chartered banks, effectively increasing deposits and reserves and the availability of funds in the banking system, which places downward pressure on interest rates.

• The Challenges of Government Policy • The economy may be slow to react to policy changes. • The economy makes its way quickly to its natural equilibrium, and that no need for

policy other than to constrain policy. • Fiscal and monetary policies are often unsynchronized, increasing the cost to the

economy.

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SECTION III Investment Products

Chapter 6 Fixed-Income Securities: Features & Types

• Fixed-Income Marketplace • Fixed-income securities represent debt of the issuing entity. • The Rationale for Issuing Fixed-Income Securities:

• To finance operations or growth. • To take advantage of operating leverage.

• The Basic Terminology • A bond is a long-term, fixed-obligation debt security that is secured by physical assets.

The details of a bond issue are outlined in a trust deed and written into a bond contract.

• A debenture is secured by something other than a physical asset. The asset secured may be a general claim on residual assets or the issuer’s credit rating.

• Face or par value is the amount the bond issuer contracts to pay at maturity. • The coupon is the regular interest income that the bond pays. • Bonds that trade in the secondary market have a price and a quoted yield. • The remaining life of a bond is called its terms to maturity. • The maturity date is the date at which the bond matures and the principal is repaid.

• Describing Bond Features. • Interest on Bonds: while most bonds pay a fixed coupon rate, bonds with variable

coupon rates are typically referred to as floating-rate securities. • Denomination: the most commonly used denomination are $1,000 or $10,000. • Bond Pricing

• A bond trading at a quoted price of 100 is said to be trading at face value, or par. • A bond trading below par is said to be trading at a discount. • A bond trading above par is said to be trading at a premium.

• Categorizing bonds (based on term to maturity) • Money market: up to one year term or less. • Short-term bonds: from one year to 5 years remaining to maturity. • Medium-term bonds: from 5 years to 10 years remaining to maturity. • Long-term bonds: greater than 10 years remaining to maturity.

• Liquid bonds, negotiable bonds & marketable bonds • Liquid bonds are bonds that trade in significant volumes and for which it is

possible to make medium and large trade quickly without making a significant sacrifice on the price.

• Negotiable bonds are bonds that can be transferred because they are in deliverable form.

• Marketable bonds are bonds for which there is a ready market. • A strip bond is created when a dealer acquires a block of high-quality bonds and separates

the individual future-dated interest coupons from the rest of the bond. The bonds are then sold at significant discounts to their face value. Holders of strip bonds receive no interest payments; instead, the income earned is considered interest rather than a capital gain.

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• A callable bond gives the issuer the right, but nor the obligation, to pay off the bond before maturity, either to take advantage of lower interest rates or to reduce debt when excess cash is available. • For callable bonds, the period before the first possible call date is known as the call

protection period. • Most corporate bonds are issued with a Canada yield call that requires the issuer to

call the bond at a price based on the greater of par or the price based on the yield pf an equivalent term Government of Canada bond plus a yield spread.

• Extendible & Retractable Bonds • Extendible bonds and debentures are usually issued with a short maturity term, but

with an option for the investor to exchange the debt for an identical amount of long-term debt at the same or slightly higher rate of interest by the extension date.

• Retractable bonds are issued with a long maturity term, but give investors the right to turn in the bond for redemption at par several years sooner by the retraction date.

• With both extendible and retractable bonds, the decision to exercise the maturity option must be made during a time period called election period.

• Convertible bonds and debentures combine certain advantage of a bond with the option of exchanging the bond for common shares of the issuing company. A convertible bond allows an investors to lock in a specific price (the conversion price) for the common shares.

• Sinking Funds & Purchase Fund • Sinking funds are sums of money taken out of earnings each year to provide for the

repayment of all or part of debt issue by maturity. Sinking fund provisions are as binding on the issuer as any mortgage provision.

• A purchase fund arrangement establishes a fund to retire a specified amount of the outstanding bonds or debentures through purchases in the market if these purchases can be made at or below a stipulated.

• Protective Provisions fo Corporate Bonds • Corporate bonds typically include protective covenants that secure the bond and make it

more likely that investors receive their principal at maturity. These protective provision are essentially safeguards in the bond contract to guard against any weakening in the security holder’s position.

• Government of Canada Securities • Marketable bonds have a specific maturity date and a specified interest rate, and are

transferable, which means they can be traded in the market. The Government of Canada issues marketable bonds in its own name.

• Treasury bills are short-term government obligations with original terms to maturity of three months, six months and one year. They are offered in denominations from $1,000 up to $1 million.

• Canada Savings Bonds (CSBs) can be purchased only through the Payroll Savings Program from early October to November 1st of each year but are cashable at any time at their full par value plus any accrued interest earned for each full month elapsed since the issue date.

• Canada Premium Bonds (CPBs) are very similar to CSBs but offer a higher interest rate when they are issued. Investors can purchase CPBs through most financial institutions from early October to December 1st and are cashable at any time at their full par value plus any accrued interest paid up to the last anniversary date of the issue.

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• Real return bonds (RRB) resemble a conventional bond because it pays interest throughout the life of the bond and repays the original principal amount on maturity. However, unlike conventional bonds, the coupon payments and principal repayment are adjusted for inflation.

• Provincial government and Municipal Debentures • Provincial bonds are actually debentures because they are promises to pay and no provincial

assets are pledged as security. The value of the bonds depends on the province’s ability to pay interest and repay principal. Provincial bonds are second in quality only to Government of Canada bonds.

• Municipalities typically raise capital from market sources through instalment debentures or serial bonds (part of the bond matures in each year during the term of the bond). Part of the bond matures in each year during the term of the bond. Broadly speaking, a municipality;s credit rating depends on its taxation resources. All else being equal, a municipality with many different types of industry is a better investment risk than a municipality built around one major industry.

• Corporate Bonds • Mortgage bonds are the senior securities of a company because they constitute a first charge

on the company’s assets, earnings and undertakings before unsecured current liabilities are paid.

• Collateral trust bonds are secured, not by a pledge of real properties, as in a mortgage bond, but by a pledge of securities or collateral.

• An equipment trust certificate pledge equipment as security instead of real property. These certificates are usually issued in a serial form, with a set amount that matures each year.

• Subordinated debentures are junior to other securities issued by the company and other debts assumed by the company.

• Floating-rate bonds automatically adjust to changing interest rates. They can be issued with longer terms than more conventional issues.

• A corporate note is an unsecured promise made by a borrower to pay interest and repay the funds borrowed at a specific date or dates. Corporate notes rank behind all other fixed securities of the borrower.

• Foreign bonds are issued outside of the issuer’s country and denominated in the currency of the foreign country where issued, allowing the issuer access to sources of capital in many other countries.

• Eurobonds are issued in a foreign market and are denominated in a currency other than that of the market in which the bonds are issued.

• Other Fixed-Income Securities • A bankers’ acceptance is a short term debt guaranteed by the borrower’s bank that is sold

at a discount and matures at face value. • Commercial paper is a one-year or less unsecured promissory note issued by a corporation

and backed by financial assets, sold at a discount and matures at face value. • Term deposits offer a guaranteed rate for a short-term deposit (usually up to one year).

There are generally penalties for withdrawing funds before a certain period. • Guaranteed investment certificate (GIC) offer fixed rates of interest for a specific term (longer

than with a term deposit). Both principal and interest payments are guaranteed, and they can be redeemable or non-redeemable. Non-redeemable GICs cannot be cashed before maturity except in the event of the depositor’s death or extreme financial hardship.

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Chapter 7 Fixed-Income Securities: Pricing & Trading

• Price and Yield of a Bond • Present value is the value today of an amount of money to be received in the future

and is the most accurate method of determining appropriate price for a bond. • The discount rate is the interest rate used to calculate present value. In general it

represents the minimum interest rate an investment should provide after factoring in risk.

• The fair price for a bond is the sum of the present value of its coupons and the present value of its principal.

•• Treasury bills are very short-term securities that trade at a discount and mature at par.

The difference between the purchase value and the maturity value represents the return on the security. The yield on a treasury bill is calculated as

• The current yield of any investment, whether it is a bond or stock, is the income yield on that security relative to its current market price. The current yield is calculated as:

• A bond’s yield to maturity incorporates both interest income and any capital gain or loss resulting from holding the bond to maturity. YTM is calculated based on the assumption that all interest received from coupon bonds is reinvested (or compounded) at the YTM prevailing at the time the bond was purchased. The risk that the coupons cannot be reinvested at that rate is called reinvested risk. A financial calculator simplifies the YTM calculation. The approximate YTM on a bond is calculated as:

• The Term Structure of Interest Rates • The Real Rate of Return: nominal rate = real rate +inflation rate. • The yield curve is a graphical depiction of interest rates by term to maturity and

shows how interest rates on debt securities differ depending on the term to maturity. • The expectations theory states that the shape of the yield curve is a reflection of

market consensus expectations for future interest rates. For example, an upward sloping curve reflects the expectation that interest rates will rise in the future.

• According to the liquidity theory, investors must be compensated for assuming the risk of holding longer-term debt securities, and this compensation is in the form of a yield or liquidity premium.

• According to the market segmentation theory, investors concentrate their debt holdings in a particular term to maturity. For example, an institutional investor may focus its

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holdings on bonds with terms of two or five years, while another investors may have a preference for long-term bonds.

• The Fundamental Bond Pricing Properties • The Relationship Between Bond Prices and Interest Rates: the value of a bond changes

in the opposite direction to interest rates (or bond yields): as interest rates rise,, bond prices fall, very versa.

• The impact of maturity: for two bonds with the same coupon rate and same yield, the price of the bond with the longer term to maturity is more volatile than the price of the bond with the shorter term to maturity.

• The impact of the coupon: for two bonds with the same term to maturity and the same yield, the price of the bond with the higher coupon rate is less volatile than the price of the bond with the lower coupon rate.

• The impact of yield changes: the relative yield change is more important than the absolute yield change.

• Duration is a measure of the sensitivity of a bond’s price to change in interest rates. It is defined as the approximate percentage change in the price or value of a bond for a 1% change in interest rates. The higher the duration of the bond, the more it will react to change in interest rates.

• The Rules and Regulations of Bond Delivery and Settlement • Fixed-income trading activities

• The sell side of fixed-income trading is the investment dealer side. Sell-side services include everything related to creating, producing, distributing, researching, marketing and trading fixed-income products. (investment banker, trader, sales representative)

• The Buy-side focuses on asset management on behalf of institutional clients. (portfolio manager, trader)

• Buying bonds through an investment dealer • Trading in forms with a large institutional dealing desk allows for automatic

execution in most cases. All non-electronic trades carried out between the investment advisor and the trader are consummated over the phone.

• Trading without a large internal institutional inventory to draw on, the retail trading desk must build its own inventory and source products it does not own from other dealer.

• Inter-dealer brokers are participants in the wholesale bond market (the bond market between the institutional buy side and sell side). They act solely as agents bringing together institutional buyers and sellers in matching traders.

• Mechanics of the trade • The trade ticket is an electronic confirmation that contains the specifics of the

counterparties, identification of the bond, the CUSIP (Committee on Uniform Security Identification Procedure) or other electronic settlement ID number, the nominal, par, or face amount of the transaction, the price and yield, the settlement date, the custodian’s name, and the settlement amount.

• Bond Settlement Periods • GoC treasury bills settle on the same day as the transaction. • GoC bonds with a term on maturity of three years or less settle on the second

clearing day after the transaction takes place.

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• GoC bonds with a term on maturity of more than three years and all other bonds. debentures, or other certificates of indebtedness settle on the third clearing day after the transaction takes place.

• Accrued Interest • Accrued interest is the amount of interest built up during the previous holding

period. • The client that buys a bond pays the previous holder the purchase price plus the

interest that has accrued since the last interest date. • accrued interest = par amount * coupon rate * time period

• Bond Indexes • An index measures the relative value and performance of a group of securities over

time. • Bond indexes are generally used as a guide to the performance of the overall bond

market or a segment of that market, and as a performance measurement tool to access bond portfolio managers. Bond indexes are also used to construct bond index funds.

Chapter 8 Equity Securities: Common & Preferred Shares

• Common Share • Common Share Ownership

• Common shares are evidence of ownership: shares are most often registered in street certificate form, meaning they are registered in the name of the securities firm rather than the beneficial owner. This increase the negotiability of the shares, making them more readily transferable to a new owner.

• Benefits if common share ownership • Potential for capital appreciation: common shares may increase in value as

retained earnings increase the size of shareholder’s equity, making the stock more attractive to investors. Increasing profits and increasing dividend payments can also lead to the stock’s capital appreciation.

• The right to receive any common share dividends paid by the company • Voting privileges, including the right to elect directors, to approve financial

statements and auditor’s report, and vote on other important issues. • Favourable tac treatment in Canada of dividend income and capital gains. • Marketability - shareholdings can easily be increased, decreased or sold, for

most public companies. • The right to receive copies of the annual and quarterly reports, and other

mandatory information pertaining to the company’s affairs. • The right to examine certain company documents such as the by-laws and

register of shareholders at a specified times. • The right to question management at shareholders’ meetings. • Limited liability.

• Dividends • Regular & extra dividends

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• some companies paying common share dividends designate a specified amount that will be paid each year as a regular dividend.

• some companies may also pay an extra dividend on the common shares, usually at the end of the company’s fiscal year.

• Declaring & claiming dividends: the Board of Directors decides whether to pay a dividend, the amount and the payment date. An announcement is made in advance of the payment date.

• Ex-dividend & Cum dividend • individuals that have legal ownership of the shares before the ex-dividend

date will receive the dividend; these individuals are the shareholders of record.

• The last day of a stock trades cum dividend (meaning with dividend) is the third day before the dividend record date (the first ex-dividend date).

• Dividend reinvestment plans: the company diverts the shareholders to the purchase of additional shares of the company.

• Stock dividends • the dividend in form of additional stock rather than cash. • the advantage to the company is that the cash is conserved for expansion

purposes while shareholders receive additional shares, which can be sold if they require the cash.

• Voting privileges • through the right to vote at the annual meeting and at special or general

meetings, shareholders exercise their rights as owners to control the destiny of the corporation.

• Restricted shares • Non-voting: shares which have no right to vote, except perhaps in certain

limited circumstances; • Subordinate voting: shares which carry a right to vote, where there is

another class of shares outstanding that carry a greater voting right on a per share basis;

• Restricted voting: share which carry a right to vote, subject to a limit or restriction on the number or percentage of shares that may be voted by a person, company or group.

• Tax Treatment • A dividend tax credit is available that makes the purchase of dividend-paying

shares of taxable Canadian companies relatively attractive compared to interest paying securities.

• The current exemption from tax of 50% of capital gains provides investors with a tax inducement to buy shares.

• Stock savings plans entitle residents of some provinces to deduct up to specified annual amounts from (or obtain a tax credit for) the cost of certain stocks purchased in their respective provinces during the year.

• Dividends paid on foreign equities are also subject to taxation but receive no favourable tax treatment.

• Stock Splits & Stock Consolidations • A stock split increase the number of shares outstanding, while a consolidation

reduces the number of shares outstanding.

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• The market price of the underlying stock is adjusted to reflect the split or consolidation on the day it occurs.

• Preferred Shares • The Preferred’s Position

• Preferred shareholders are usually entitled to a fixed dividend payment subject to the discretion of the Board of Directors. They occupy a position between the company’s creditors (including bondholders) and the company’s common shareholders, if any.

• Preference as to assets: preferred shares are usually given a prior claim to assets ahead of the common shares in the event of bankruptcy or dissolution of a company.

• Preference as to dividends: preferred shares are usually entitled to a fixed dividend expressed either as a percentage of the par or stated value, or as a stated amount of dollars and cents. • Since most preferred shares can be considered fixed-income securities, they

do not offer, from an investment standpoint, the sam e potential for capital appreciation that common shares provide.

• Preferred Issue • Preferred shares are usually more expensive for a company than issuing debt

because dividends paid are not a tax-deductible expense. • Preferred shares are typically issued instead of debt securities when it is not

practical or feasible to issue new debt, market conditions are temporarily unreceptive to new debt issues, the company’s current debt-to-equity ratio is high, the company does not want to assume legal obligations related to debt, or low apparent tax rate makes it cost effective to pay dividends from after-tax profits.

• Preferred Share Feature • Holders of cumulative preferred shares have the right to accumulate unpaid

dividends in arrears and to have all accumulated dividends paid before dividends are paid on common shares or before the preferred shares or redeemed.

• Holders of non-cumulative preferred shares are entitled to payment of a specified dividends in any year but only when declared.

• Issuers of callable preferred shares have the right to call or redeem preferred issues at a stated time and at a stated price.

• Non-callable preferred shares cannot be called or redeemed as long as the issuing company is in existence.

• Preferred shares are usually non-voting as long as preferred dividends are paid on schedule; however, once a stated number of preferred dividends have been omitted, it is common practice to assign voting privileges to the preferred shareholders.

• A purchase or sinking fund will attempt to buy preferred shares in the market if the price of the shares declines to or below a stipulated price.

• Straight preferred shares have normal preferences as to asset an dividend entitlement, pay a fixed dividend rate, and trade in the market on a yield basis.

• Convertible preferred shares enable the holder to convert the preferred shares into some other class of shares (usually common) at a predetermined price and for a stated period of time.

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• A retracted preferred shareholders can force the company to buy back the retractable preferred shares on specific date(s) and at a specified price(s).

• Floating- or variable- rate preferred shares pay dividends in amounts that fluctuate to reflect changes in interest rates.

• Foreign-pay preferred shares pay dividends in a foreign currency or in relation to a foreign currency.

• Participating preferred shares have certain rights to a portion of company earnings over and above their specified dividend rate.

• Deferred preferred shares do not pay out regular dividend. Shares mature at a preset future date with the return based on the difference between the purchase price and the redemption value paid out at maturity.

• Stock Indexes & Averages • A stock index is a time series of numbers used to calculate a percentage change in

the series over any period of time. Most stock indexes are value-weighted and are derived by using the market capitalization of all stocks used in the index relative to a base period.

• A stock average is the arithmetic average of the current prices of a group of stocks designed to represent the overall market or some part of it.

• Canadian Market Indexes: the S&P/TSX Composite Index, the S&P/TSX 60 Index, the S&P/TSX Venture Composite Index.

• U.S. Market Indexes: Dow Jones Industrial Average, the S&P 500, the New York Stock Exchange Indexes, the Amex Market Value Index, the NASDAQ Composite, the Value Line Composite.

• International Market IndexesL Nikkei Stock Average (225) Price Index, United Kingdom FTSE 100 Index, German DAX, France CAC 40 Share Price Index, the Swiss Market Index.

Chapter 9 Equity Securities: Equity Transactions

• Cash Accounts & Margin Accounts • Cash Accounts: clients with regular cash accounts are expected to make full payment

for purchase of full delivery for sales on or before the settlement date, which is prescribed by industry rules and specified in the contract.

• Margin Accounts: for clients who wish to buy and/or sell securities on credit and initially pay only part of the full price of the transaction. In such cases, the dealer member lends the remainder of the transaction price to the client, charging interest on the loan.

• Free credit balances are uninvested funds held in client accounts that the dealer member may use as a financing source for its business.

• Long Position & Short Position • A long position represents actual ownership in a securities. • A short position is created when an investor sells a security that he or she does not

own. To close the short position, the investor would buy back the stock from the market, and return the stock to the broker.

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• A long margin position allows the investors to partially finance the purchase of securities by borrowing money from the dealer. An investor enters a long position with the expectation that the underlying stock price will rise.

• A short margin position allows the investors to sell securities short by arranging for the dealer to borrow securities to cover the short position.

• When a long position is established on margin, sufficient funds (or securities with excess loan value) must be in the account to cover the purchase.

• Margin is the amount put up by the client (not the amount borrowed or loaned), and the minimum margin required equals the initial cost of the transaction minus loan.

• The loan value of securities in an account is strictly regulated an depends on the loan value status of the individual securities.

• No loan is made to the client in a short sale. The client must maintain a margin amount that is more than the value of the short sale, although the proceeds of the short sale can be used as part of the margin amount if not withdrawn from the account.

• Short Selling • Short selling is defined as the sale of securities that the seller does not own. Profits

are made whenever the initial sale price exceeds the subsequent purchase cost. • Steps of Short Selling

• You call broker and instruct him to sell ABC short. • Your broker lends you the ABC shares and you immediately sell ABC into the

market. • The proceeds from the short sale are deposited in your account. • The required margin is then deposited into your account. • The share price of ABC falls and you want to close your position. You buy

ABC back at the lower price and return the stock to your broker. • There is no limit on how long a short sale position can be maintained, provided the

stock does not become de-listed or worthless. • The risks associated with short-selling

• Difficulties in borrowing or continuing to borrow the securities sold short. • Maintaining adequate margin if the price of the shorted security fluctuates. • Liability for dividends or other benefits paid while the security is sold short. • Potential volatility in the price if a large number of short sellers cover their

position. • The potential for unlimited loss if the price of the security rises rather than falls.

• The Trading & Settlement Procedures for Equity Transactions • Once a buy order and sell order are matched and trade is completed on an exchange,

the exchanges’s data transmission system reports the trade over the ticker and provides the buying firm with trade details.

• A confirmation with details about the settlement (i.e. date, amount, location) is sent to the buyer and seller once the transaction has occurred.

• Cross trades occur when a dealer matches buy and sell orders internally instead of on an exchange.

• Principal transaction (i.e. new issuer or orders filled out of a dealer’s inventory) are done outside of an exchange.

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• In all cases, the buyer provides payment and the seller delivers the security by the settlement date. The mechanism and time frame for settlement depend on the type of securities traded.

• Buy & Sell Orders • A market order is an order to buy or sell a specified number of securities at the

prevailing market price. • A limit order is an order to buy or sell securities at a specified price or better. • A day order is an order to buy or sell that expires if it is not exceed on the day it

entered. • A good till cancelled (GTC) order is an order to buy or sell that remains in effect

until it is either executed or cancelled. • An all or non (AON) order must be filled for the entire number of shares specified.

No smaller amount will be accepted, nor will a succession of trades adding to the total amount specified.

• An any part order can be filled by any combination of odd lot or standard trading units up to the full amount of the order (opposite of AON order).

• A good through order is an order to buy or sell that is good for a specified number of days and then automatically cancelled if it has not been filled by the end of the trading session on the date specified.

• A stop loss order is an order to buy or sell a security when the price of one standard trading unit of the security declines to or falls below a certain price (the stop price), and it becomes a market order when the stop price is reached.

• A stop buy order is an order to buy a security only after it has reached a certain price (the stop price), and it becomes a market order when the stop price is reached.

• Professional (pro) orders are orders for the accounts of partners, directors, officers, shareholders, investment advisors and, in some cases, specified employees.

Chapter 10 Derivatives

• Derivative • A derivative is a financial contract between two parties whose value is derived from,

or dependent upon the value of some other asset. The other asset, known as the derivative’s underlying asset or underlying interest or security, can be a financial asset, and also can be a real asset or commodity. • Options: the buyer of option has the right, but not the obligation, to buy or sell

a specified quantity of the underlying asset in the future at a price agreed upon today.

• Forwards: both buyer and seller obligate themselves to trade the underlying asset in the future at a price agreed upon today.

• Features Common to All Derivatives • All derivatives are contractual agreements between two parties, know as

counterparties. • All derivatives have an expiration date. Both parties must fulfill their obligation

or exercise their rights under the contract on or before the expiration date.

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• When a derivative contract is drawn up, it includes a price or formula for determining the price of an asset to be bought and sold on or before the expiration date. • With options, the buyer makes a payment to the seller when the contract is

drawn up, known as a premium. • With forward, no up-front payment is required. Sometimes one or both

parties make a performance bond or good-faith deposit. • Derivative Market

• Over-The-Counter (OTC) Derivatives market is an active and vibrant market that consists of a loosely connected and lightly regulated network of brokers and dealers who negotiate transactions directly with one another primarily over the telephone and/or computer terminals.

• Exchange-Traded Derivatives: a derivative exchange is a legal corporate entity organized for the trading of derivate contracts. The exchange provides the facilities for trading, either a trading floor or an electronic trading system or both. • the Montreal Exchange • ICE Futures Canada

• OTC Derivatives vs. Exchange-Traded • Standardization & Flexibility: in the OTC market, the terms and conditions

of a contract can be tailored to the specific needs of their users. For exchange-traded derivatives, each contract has standardized terms and other specifications.

• Privacy: in an OTC derivative transaction, neither the general public nor others (competitors) know about the transaction. On exchange, all transactions are recorded and known to the general public.

• Liquidity & Offsetting: because they are private and custom designed, OTC derivatives cannot be easily terminated or transferred to other parties in a secondary market. By contract, the standardized and public nature of exchange-traded derivatives means that they can be terminated easily by taking an offsetting position in the contract.

• Default Risk: the risk that one of the parties to a derivative contract cannot meet its obligations to the other party. OTC derivatives have greater default or credit risk.

• Regulation: OTC contracts are private and exchange-traded contracts are public.

• Underlying Assets • Commodities that underlie derivative contracts include grains and oilseeds;

livestock and meat; forest, fibre, and food; precious and industrial metals; and energy products.

• Financials that underlie derivative contracts include equities and equity indexes, interest rates and interest-rate sensitive securities, and currencies.

• Users of Derivative Trading • Individual Investors: for most part, individual investors are able to trade

exchange-traded derivatives only. • Institutional Investors (mutual fund managers, hedge fund manager, pension fund

managers, insurance companies, etc) use derivatives for both speculation (speculators) and risk management (hedgers).

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• Corporation & Business use derivatives primarily for hedging purpose. These users tend to focus on derivatives that help them hedge interest rate, currency and commodity price risk.

• Derivative Dealers are the intermediaries in the market, buying and selling to meet the demands of the end users.

• Options • Basic Option Positions

• Buyer long position & call option: PAYS premium to the writer; has the RIGHT to BUY the underlying asset at the predetermined price, expects the price of the underlying asset to RISE.

• Buyer long position & put option: PAYS premium to the writer, has the RIGHT to SELL the underlying asset at the predetermined price, expects the price of the underlying asset to FALL.

• Writer short position & call option: RECEIVES premium from the buyer, has the OBLIGATION to SELL the underlying asset at the predetermined price, if called upon to do so, expects the price of the underlying asset to REMAIN THE SAME or FALL. • Covered call writing: writers own the underlying stock, and will use this

position to meet their obligations if they are assigned. • Naked call writing: writers do not own the underlying stock. If a naked

call writer is assigned, the underlying stock must be purchased in the market before it can be sold to the call option buyer.

• Writer short position & put option: RECEIVE premium from the buyer, has the OBLIGATION to BUY the underlying asset at the predetermined price, if called upon to do so, expects the price of the underlying asset to REMAIN THE SAME or RISE. • Cash-secured put writing: writing a put and setting aside an amount of

cash equal to the strike price. • Naked put writing: writers have no position in the stock and have not

specifically earmarked an amount of cash to buy the stock. • Basic Terminology

• Strike price (exercise price): the price at which the underlying asset can be purchased or sold in the future.

• American-Style & European-Style: options that can be exercised at any time up to and including the expiration date are referred to as American-style options. If the option can be exercised only on the expiration date, it is referred to as a European-style option.

• Owners of options will exercise when an option is In-the-money: a call option is in-the-money when the price of the underlying asset is higher than the strike price; a put option is in-the-money when the price of the underlying asset is lower than the strike price.

• Owners of options will NOT exercise when an option is Out-of-the-money & at-the-money: a call option is out-of-the-money when the price of the underlying asset is lower than the strike price; a put option is out-of-the-money when the price of the underlying asset is higher than the strike price. Call and put options are at-the-money when price of the underlying asset equals the strike price.

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• Intrinsic value: the value of certainty; the in-the-money portion of a call or put option.

• Time value: the value of uncertainty; option price = intrinsic value + time value.

• Forwards & Futures • Future contract: forward is traded on an exchange. Futures contracts can be offset

through the exchange prior to the expiration. Daily gains and losses on futures are marked-to-market (calculated and settled) daily. • Financial futures: contracts that have a financial asset as the underlying asset. • Commodity future: contracts that have a commodity asset as the underlying asset.

• Forward agreement: forward is traded on OTC. • Investors buy futures wither to profit from an expected increase in the price of the

underlying asset or to lock in a purchase price for the asset on some future date. Investors sell futures either to profit from an expected decline in the price of the underlying asset or to lock in a sale price for the asset on some future date.

• Rights & Warrants • Rights and warrants are securities that give their owner the right, but not the

obligation, to buy a specific amount of stock at a specified price on or before the expiration date. they are usually issued by a company as a method of raising capital. Rights are usually very short term, with an expiration date often as little as four to six weeks after they are issued, while warrants tend to be issued with three to five years to expiration.

• A right is a privilege granted to an existing shareholder to acquire additional shares directly from the issuing company. • Theres is no cost for shareholders to acquire these rights. The exercise price of a

right, known as the subscription or offering price, is usually lower than the market price of the shares at the time of the right issue.

• Corporations issue rights when market conditions are not conductive to an ordinary common share issue, a company wants to give existing shareholders the opportunity to acquire additional shares before anyone else, or a company wants to allow existing shareholders to maintain their proportionate interest in the company.

• When a company decides to do a rights offering, they announce a record date to determine the list of shareholders who will receive the rights. For the two business day before the record date, the shares trade ex rights (anyone buying shares on or after the ex rights date is not entitled to receive the rights from the company). Between the announcement and ex rights date, the stock is said to be trading cum rights (anyone who buys the stock is entitled to receive the rights if they hold the stock until at least the record date).

• The intrinsic value of a right during the ex-rights period is calculated as:

• The intrinsic value of a right during the cum-rights period is calculated as:

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• A warrant is a security, often issued as part of a package that also contains a new debt or preferred share issue, that gives its holder the right to buy shares in a company from the issuer at a set price until expiration.

• Warrants can be sold either immediately or after a certain holding period.

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SECTION IV The Corporation

Chapter 11 Financing and Listing Securities

• Business Structure • Sole proprietorship involves one person running his or her own business, and the

individual is taxed on earning at their personal income tax rate. He or she is also personally liable for all debts, losses and obligations arising from the business activity beyond the assets held in the business.

• Partnership involves two or more persons contributing to the business, whether it be capital or expertise required to run the business. • General Partnership involves in the day-to-day operations and are personally

liable for all debts and obligations incurred in the course of business. • Limited Partnership: a limited partner cannot participate in the daily business

activity and liability is limited to the partner’s investment. • A corporation is an incorporated business that is a distinct legal entity separate from

the people who own its shares. Property acquired by the corporation does not belong to the shareholders of the corporation, but the corporation itself. The shareholders have no liability for debts of the corporation and there can be no additional levy on shareholders if the debts of a bankrupt corporation exceed the value of its realizable assets. The corporation can raise funds by issuing debt or equity. • Private corporation, which have in their charters a restriction on the right of

shareholders to transfer shares, a limitation on the number of shareholders to not more than 50, and a prohibition on inviting members of the public to subscribe for their securities.

• Public corporation, which are companies whose shares are listed on a stock exchange or traded over the counter.

• Corporation are created through incorporation, which requires filing of jurisdiction dependent documents with the relevant provincial or federal authorities. • Advantage of incorporation: limited liability of shareholders, continuity of

interest, ability to transfer ownership of shares, certain tax benefits, feasibility of capital growth, status as a separate legal entity and professional management.

• Disadvantage of incorporation: loss of flexibility, double taxation, additional expenses, and restrictions on withdrawal of capital.

• Government Finance • For government, this financing is often accomplished through an auction process and

occasionally through a fiscal agency. • Auction bids can be submitted on a competitive or non competitive tender (the bid is

accepted in full and bonds are awarded at the auction average). Competitive bids are filled from highest price to lowest price, until all bonds not allocated to the amount of the non-competitive tender are distributed.

• New issues of provincial direct and guaranteed bonds offered in Canada are usually sold at a negotiable price through a fiscal agent.

• Corporation Finance

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• For companies, financing takes the form of a private offering, an initial public offering (IPO), or a secondary offering.

• Share Capital • Authorized shares are the maximum number of shares the company can issue

according to its corporate charter • Issued shares refers to all shares issued. • Outstanding shares are the issued shares that have not been redeemed or

repurchased by the company. (interchangeable with issued shares) • Public float: issued shares that are outstanding and available for trading by the

public and not held by company officers, directors or institutions that hold a controlling interest in corporation.

• Market capitalization: the total dollar value of the company based on the current market price of its issued and outstanding shares.

• Corporations may also raise capital by issuing debt securities (e.g. bonds, debentures, medium-term notes, callable bonds, convertible bonds) or by borrowing from lending institutions (e.g. bank loan).

• Corporate Financing Process • A corporation issuer choose a dealer to act as principal or agent in a new security

issue. The dealer prepares analyses of market conditions and other factors and suggests the terms and types of the issue, including debt or equity (due diligence report). • Advice on the security to be issue: the lead dealer designs the new issue and

advises the corporation on the best approach in the market. • Advice on protective provisions: the dealer offers advice about security’s specific

attributes, which may include for bonds the rate of interest, redemption and refunding provisions, and protective clauses called Protective Provisions, Trust Deed Restrictions or Covenants.

• The Method of Offering • Private Placement: one or a few large institutional investors, such as banks,

mutual fund companies, insurance companies and pension funds, are solicited and the entire issue is sold to one or more of them. (No formal prospectus need be prepared)

• Public Offering • A primary offering of securities refers to a new issue of securities by an

issuer and generally takes place in the IPO market. • A second offering refers to the public sale of a company’s previously

issued securities made after its IPO. • P.s. Treasury shares: a company may repurchases some of its outstanding

shares currently trading in the market. treasury shares do not have voting rights or dividend entitlements.

• The Prospectus • The prospectus is the primary information document for a new securities issue

and is based on the premise of full, true and plain disclosure of all material facts relating to securities being offered.

• Most provinces require that issues file both a preliminary prospectus and a final prospectus.

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• The preliminary prospectus is a disclosure document required under provincial securities law; it is also used to determine the level of interest of potential buyers of the security.

• The applicable securities commission will issue a receipt after reviewing the preliminary prospectus, and the issuing company will have 90 days (waiting period) to prepare, submit and receive approval for the final prospectus.

• Companies that have previously made public distributions and that are subject to continuous disclosure requirements can use a short form prospectus.

• After-Market Stabilization • The Over-allotment Option permits underwriters to initially sell securities in

excess of the original amount offered by the issuer for sale to the public. • Penalty bid: the lead underwriter will penalize members of the selling group of

their customers sell shares in weeks issues in the after-market during the distribution or shortly after the offer closes

• Stabilizing bid: the dealer purchase shares at a price not exceeding the offer price if the distribution of shares is not complete.

• Other Methods of Distributing Securities • Junior Company Distribution: when a listed company decides it must raise new

capital through a distribution of treasury shares to the public, it must find a dealer member to act either as an underwriter for the offering or as the issuing company’s agent with respect to the offering.

• Options of Treasury Shares & Escrowed Shares • Capital Pool Company Program (CPC) as a vehicle to provide business with an

opportunity to obtain financing earlier in their development than might be possible with a regular IPO.

• NEX is a separate board of the TSX Venture Exchange that provides a trading forum for companies that have fallen below the Venture Exchange’s listing standards.

• The Listing Process • Companies must apply and be approved by the exchange(s) prior to listing. • Advantages of listing shares for trading on an exchange: prestige and goodwill,

establishment of market value, increased market visibility, wider distribution of company information, easier valuation for tax purposes and increased investor following.

• Disadvantages of listing shares for trading on an exchange: additional controls on management, additional costs, visibility of any market indifference, requirement for additional disclosure, and the requirement to provide information to a range of individuals and organizations on a regular basis.

• Exchange have the power to withdraw a listed security’s trading and/or listing privileges temporarily or permanently if necessary to protect investors.

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Chapter 12 Corporations & Financial Statements

• The Statement of Financial Position • The Statement of financial position (balance sheet) shows a company’s financial

position at a specific date. • Classification of Assets

• Non-Current Assets • Property, Plan & Equipment (PP&E) consists of land, buildings, machinery,

tools and equipment of all kinds, trucks, furnishings and so on used in the day-to-day operations of a business. • Depreciation, Amortization & Depletion: straight-line method: an equal

amount is charged to each period; declining-balance method: fixed percentage to the outstanding balance to determine the expense to be charged in each period.

• Capitalization: the recording of an expenditure as an asset rather than as an expense so that the expense can be spread over more than one accounting period.

• Goodwill & other intangible assets • Goodwill: the probability that a regular customer will continue to

return to do business. • Intangible assets: non-monetary assets that do not have physical

substance. • Investment in Associates: the degree of ownership a company has in

another company. • Current Assets: cash and other assets that will be realized, consumed, or sold, in

the normal course of business, normally within one year. • Inventories: consists of the goods and supplies that a company keeps in

stock. • Weighted average of all items in inventory • FIFO: items acquired earliest are assumed to ben used or sold first.

• Prepaid expense: payment made by the company for services to be received in the near future.

• Trade receivable: money owing to the company for goods or services it has sold.

• Cash & cash equivalent: cash on hand or in the company’s bank account(s) or in short-term, highly liquid investment that are readily convertible into known amounts of cash.

• Classification of Equity • Share capital: the money that is paid in by the shareholders • Retained earnings: the profits that have been earned over a period of years and

not paid out as dividends. • Non-controlling Interest

• Classification of Liabilities • Non-current Liabilities

• Long-Term Debt is usually due in annual instalments over a period of years or in a lump sum in a future year.

• Deferred Tax Liabilities represents income tax payable in future periods.

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• Current Liabilities are debts incurred by a company in the ordinary course of its business that have to be paid within a short time. • Current portion of long-term debt due in one year. • Taxes payable to the government in the near term. • Trade payable for unpaid bills for raw materials, supplies and the like. • Short-term borrowings from financial institutions.

• The Statement of Comprehensive Income • Revenue: the first source of income is from selling its main products or services; the

second source includes dividends and interest from investments, rents, and sometimes profits from the sale of PP&E.

• Cost of Sale includes costs of labour, raw materials, fuel and power, supplies and services and other kind of expense.

• Gross profit is deduction the cost of sales from the amount of revenue. • Genreal expenses

• Distribution costs includes such expenses as salaries and/or commissions to sales personnel and advertising.

• Administrative expense includes office salaries, accounting staff salaries and office supplies.

• Other expenses include expenses that are not directly related to the company’s normal operating activities.

• Finance costs result from debt holders receiving interest payments on their securities or loans to the company.

• Share of Profit of Associates • Income Tax Expense includes both current tax and deferred tax for the time period. • Profit (or loss)

• The Statement of Changes In Equity • Retained Earnings are profits earned over the years that have not been paid out to

shareholders as dividends. • The total comprehensive income attributable to the owners of the company represents

the total comprehensive income of the company minus the total comprehensive income attributable to the non-controlling interests.

• The Statement of Cash Flows • Operating Activities: it begins with profit, and added back to profit are all items not

involving cash such as depreciation and amortization. Share of profit associates is subtracted as it is not an actual cash transaction for the company. Change in net working capital items represents changes in the various asset an liabilities accounts that appear on the statement of financial position.

• Financing Activities • If the company has issued new shares capital or debt, cash flows into the

company; • If the company repays debt or pays dividends to the shareholders, cash flows out

of the company. • Investing Activities: it includes any investments that the company made in itself, such

as the purchase of new capital assets or disposal of such assets. • The Change in Cash Flow

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• Cash & Cash equivalent - Year End

• Annual Report • Notes to the financial statements • The auditor’s report

• Identifies the financial statements covered • Outlines the financial statement responsibilities of management • Outlines the auditor’s responsibilities and states how the audit was conducted • Gives the auditor’s opinion on the financial statements of the company being

audited

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SECTION V Investment Analysis

Chapter 13 Fundamental & Technical Analysis

• Methods of Analysis • Fundamental Analysis & Technical Analysis

• Fundamental Analysis involves assessing the short-, medium- and long-range prospects of different industries and companies to determine how the price of securities will change.

• Technical analysis looks at historical stock prices and stock market behaviour to identify recurring and predictable price patterns that can be used to predict future price movement.

• The main difference between technical and fundamental analysis is that technicians study the effects of supply and demand (price and volume), while fundamental analysts study the causes of price movement.

• Market Theories • The Efficient Market Hypothesis states that at any given time a stock’s price will

fully reflect all available information and thus represents the best estimate of a stock’s true value.

• The Random Walk Theory assumes that new information concerning a stock is disseminated randomly over time. Therefore, price changes are random and bear no relation to previous price changes.

• The Rational Expectations Hypothesis assumes that people are rational and make intelligent economic decisions after weighing all available information.

• Fundamental Analysis • Fundamental Macroeconomic Analysis

• The Fiscal Policy Impact: tax changes, government spending, government debt. • The Monetary Policy Impact

• When economic growth begins to accelerate bond yields tend to rise. If inflation begins to rise during an expansion the central bank will most often raise short-term interest rates to slow economic growth and contain inflationary pressures.

• When long-term bond yields fall while short-term rates rise, this is called an inverting or a tilting of the yield curve. It suggests a temporary reprieve from short-term interest rate pressure and less competition for equities from the level of bond yields.

• The Flow of Fund Impact • Net purchases of Canadian equity mutual funds influence the TSX. Since

falling interest rates tend to improve the value of stocks relative to bonds, equity mutual fund purchases should rise as interest rates fall.

• Non -resident net purchases tend to increase after a rise in the market and tend to persist even after it starts to fall.

• The Inflation Impact: the increase in inflation rates tend to result in higher interest rates, lower corporate profits, and lower price-earning multiples. Inflation

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also means higher inventory and labour costs for manufacturers, and further result in squeeze on corporate profits and lower common share prices.

• Fundamental Industry Analysis • Classifying Industries by Products or Services • Classifying Industries by Stage of Growth

• Emerging growth industries may not always be directly accessible to equity investors if privately owned companies dominate the industry, or if the new product or services is only one activity of a diversified corporation.

• Growth industries are consistently expanding at a faster rate than most other industries in terms of sales and earnings.

• Mature industries usually experience slower, more stable growth rates in sales and earnings.

• Declining industries produce products for which demand has declined because of changes in technology, an inability to compete on price, or changes in consumer tastes.

• Classifying Industries by Competitive Forces: Porter’s five forces • Classifying Industries by Stock Characteristics

• Cyclical industries are sensitive to global economic conditions, swings in the prices of international commodities markets, and changes in the level of the Canadian dollar.

• Defensive industries have relatively stable return on equity (ROE), and tend to do relatively well during recessions.

• Speculative industries usually have risk and uncertainty due to lack of definitive information.

• Fundamental Valuation Model • Dividend Discount Model (DDM)

• DDM is used to calculate and interpret the intrinsic value of a stock. • Through the model, the decision can be made on whether the company’s

stock price is under- or overvalued- relative to its current price. •

• Price-Earning Ratio (P/E ratio) offers investors a way of comparing the prospects of a company. Generally, it is assumed that when investor confidence is high, P/E ratio is also high, vice versa.

• Technical Analysis • Assumptions

• All influences on market action are automatically accounted for or discounted in price activity.

• Prices move in trends and those trends tend to persist for relatively long periods of time.

• The future repeats the past. • Commonly Used Tools in Technical Analysis

• Chart Analysis is the use of graphic representations of relevant data • A support level is the low of the trading range. • A resistance level is the high of the trading range.

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• Reversal patterns are formations on charts that usually precede a sizeable advance or decline in stock prices. (head-and-shoulders formation)

• Quantitative Analysis • A moving average is simply a device for smoothing out fluctuating values

in an individual stock or in the aggregate market as a whole. • Oscillators are indicators that are used when a stock’s chart is not showing

a definite trend in either direction. • The Moving average convergence-divergence (MACD) oscillator takes the

difference between two moving averages so that you can measure any shift in trend over a period of time (i.e. momentum).

• Sentiment Indicators focus on investor expectations. Contrarian investors use these indicators to determine what the majority of investors expect prices to do in the future, because contrarians move on the opposite direction from the majority.

• Cycle Analysis helps the analyst forecast when the market will start moving in a particular direction and when the ultimate peak or through will be achieved.

Chapter 14 Company Analysis

• Company Analysis • Statement of Comprehensive Income Analysis

• Revenue • Cost of Sales • Dividend record

• Statement of Financial Position Analysis • The capital structure: the analysis of company’s capital structure provides an

overall picture of a company’s financial soundness. It may indicate the need for future financing and the type of security that might be used.

• The effect of leverage: the earnings of a company are said to be leveraged if the capital structure contains debt and/or preferred shares. The presence of senior securities accelerates any cyclical rise or fall in earnings. The earnings of leveraged companies increase faster during an upswing in the business cycle than the earnings of companies without leverage, vice versa.

• Other Features of Company Analysis • Qualitative analysis is used to assess management effectiveness and other

intangibles that cannot be measured with concrete data. • Liquidity of common shares is a measure of how easy it is to sell or buy a

security on a stock exchange without causing significant movement in its price. • Continuous monitoring

• Financial Ratio Analysis • Trend analysis

• Ratios calculated from a company’s financial statement for only one year have limited value. They become more meaningful when compared with other ratios either internally with a series of similar ratios of the same company over a

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period, or externally with comparable ratios of similar companies or with industry averages.

• The trend ratio for subsequent years are easily calculated by dividing the EPS for the base year into the EPS for each subsequent year.

• Liquidity ratios are used to judge the company’s ability to meet its short-term commitments. • Working capital ratio (current ratio) determine the ability of a company to meet

its obligations, expand its volume of business, and take advantage of financial opportunities as they arise. • Working capital = current assets - current liabilities • Working capital ratio (current ratio) = current assets / current liabilities

• Quick ratio (the acid test) = (current assets - inventories) / current liabilities • Risk analysis ratios show how well the company can deal with its debt obligations.

• Asset coverage ratio shows a company’s ability to cover its debt obligations with its assets after all non=debt liabilities have been satisfied.

• Debt / equity ratio shows the proportion of borrowed funds used relative to the investments made by shareholders in the company. • debt / equity ratio = total debt outstanding / equity • If the ratio is too high, it may indicate that a company has borrowed

excessively, and this increase the financial risk of the company. • Cash flow / total debt outstanding ratio gauges a company’s ability to repay the

finds it has borrowed. A relatively high ratio is considered positive. • Interest coverage ratio reveals the ability of a company to pay the interest

charges on its debt and indicates how well these charges are covered, based upon profit available to pay them. • interest coverage ratio = profit before interest charges and taxes / interest

charges • Operating performance ratios illustrate how well management is making use of the

company;s resources. • Gross profit margin ratio is an indication of the efficiency of management in

turning over the company’s goods at a profit. • gross profit margin ratio = (revenue - cost of sales)/ revenue

• Net profit margin is an indicator of how efficiently the company is managed after taking both expenses and taxes into account • net profit margin = (profit - share of profit of associates)/ revenue

• Net Return on common equity (ROE) ratio shows the dollar amount of earnings that were produced for each dollar invested by the company’s common shareholders. This ratio reflects the profitability of the investors’ capital in the business. • ROE = profit / total equity

• Inventory turnover ratio measures the number of times a company’s inventory is turned over in a year. A high turnover ratio is considered good. • inventory turnover ratio = cost of sales / inventory

• Value ratios show the investor what the company’s shares are worth, or the return on owning them. • Dividend payout ratios indicate the amount or percentage of the company’s profit

that is paid out to shareholders in the form of dividends. • dividend payout ratio = common share dividends / profit

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• Earnings per share (EPS) ratio shows the earnings available to each common share and is an important element in judging an appropriate market price for buying or selling common stock. A rising trend in EPS has favourable implications for the price of a stock. • EPS = profit / weighted average number of common shares outstanding.

• Yield on common stock is the annual dividend rate expressed as a percentage of the current market price of the stock. • yield = indicated annual dividend per share / current market price.

• Price-earning ratio (P/E multiple) represents the ultimate evaluation of a company and its shares by the investing public. • P/E = current market price of common stock / LTM EPS • P/E ratio helps analysts determine a reasonable value for a common stock

at any time in a market cycle. • Equity Value (Book value) per common share measures the asset coverage for

each common share. • Equity value per common share = equity / number of common shares

outstanding

• Preferred Share Investment Quality • Investment Quality Assessment

• Preferred dividend coverage • Equity per preferred share • Record of continuous dividend payments • An independent credit assessment

• Selecting Preferred: when choosing any equity security, marketability, volume of trading and research coverage by investment firms should be investigated.

Chapter 15 Portfolio Analysis

• Return • The Expected Return of a Single Security

• Types of return • An investor who buys Government of Canada bonds expects to earn

interest (cash flow). • An investor in common shares expects to see the stock grow in value

(capital gain) and may also be rewarded with dividends (cash flow). • Expected return = cash flow + capital gain (or - capital loss)

• Rate of Return •

• Historical returns: the highest rates of return have been achieved by securities that had the greatest variability or risk as measured by standard deviation.

• Real return = nominal rate - annual rate of inflation • The risk-free rate of return: T-bills often represent the risk-free rate of return

as there is essentially zero risk associated with this type of investment. Since T-

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bills are considered essentially risk-free, all other securities must at least pay the T-bill rate plus a risk premium in order to entice clients into investing.

• Risk • Risk is defined as the likelihood that the actual return will be different from expected

return. The greater the variability or number of possible outcomes, the greater the risk. • Types of risks

• Inflation rate risk: inflation reduces future purchasing power and the return on investments.

• Business risk is associated with the variability of a company’s earnings due to such things as the possibility of a labour strike, introduction of new products, and the performance of competing firms, among others.

• Political risk is associated with unfavourable change in government policies. • Liquidity risk: the risk that an investor will not be able to buy or sell a security

at a fair price quickly enough due to limited buying or selling opportunities. • Foreign exchange risk: the risk of incurring losses resulting from an unfavourable

change in exchange rate. • Default risk: the risk associated with a company being unable to make timely

interest payments to repay the principal amount of a loan when due. • Systematic & Non-systematic Risk

• Systematic risk represents non-diversifiable risk, as it is always present and affects all assets within a certain class.

• Non-systematic risk is the risk that the price of a specific security or group of securities will change to a different degree or in a different direction from the market as a whole. Non-systematic risk can be reduced through diversification.

• Measuring Risk • Variance measures the extent to which the possible realized returns differ from

the expected return or the mean. The greater the variance, the greater the risk. • Standard deviation is the square root of the variance. Expressed as a percentage,

it gives an indication of the risk associated with an individual security or a portfolio. The greater the standard deviation, the greater the risk.

• Beta measures the degree to which equity securities or equity portfolios tend to move up and down with the market. The higher beta, the greater the risk.

• Relationship Between Risk & Return of a Portfolio • Asset allocation involves determining the optimal division of an investor’s portfolio

among the different asset classes of cash, fixed income and equities to maximize portfolio return and reduce overall risk.

• Measuring the risk and return of a portfolio • The return on a portfolio is calculated as the weighted average return on the

securities held in the portfolio. While future return are not controllable, risk can be managed to a certain extent by effective portfolio management.

• Correlation looks at how securities relate to each other when they are added to a portfolio and how the resulting combination affects the portfolio’s total risk and return.

• An equity portfolio with a beta of 1.0 is considered as risky as the market; a beta less greater than 1.0 is less risky than the market; and a beta greater than 1.0 is more risky than the market.

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• Alpha measures the degree to which an equity portfolio performs better than would be expected from beta.

• Portfolio Management Process • Determine investment objectives and constrains. • Design an investment policy statement. • Formulate an asset allocation strategy and select investment styles. • Implement the Asset Allocation. • Monitor the economy, the markets, the portfolio and the client. • Evaluate portfolio.

• Investment Objectives & Constraints • An advisor must determine what rate of return a client needs to attain his or her

goals, and what risk he or she is willing and able to take to achieve them. • Investment Objectives

• Primary investment objectives • safety of principal • income • growth of capital

• Secondary investment principal • liquidity (or marketability) • tax minimization

• Investment Constraints are essentially considerations that may hinder or prevent the investment manager from satisfying the client’s objectives. • Time horizon is the period of time from the present until the next major change

in the client’s circumstances. • Liquidity requirement: in portfolio management, liquidity means the amount of

cash and near-cash in the portfolio. • Tax requirement: an investor’s marginal tax rate will dictate the proportion of

income that should be received as dividends from Canadian corporations, which are eligible for a tax credit, versus interest income.

• Legal and regulation requirement • Unique circumstances

• Investment Policy Statement (IPS) • The IPS contains the operating rules, guidelines, investment objectives and asset mix

agreed on by the manager and the client. The policy statement forms the basis fro the agreement between the manager and the client.

• Most investment policy statements cover the objectives and constraints of a portfolio, provides a list of acceptable securities and a list of prohibited securities, and outline the method to be used for performance appraisal.

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Chapter 16 The Portfolio Management Process

• The Asset Mix • The Basic Asset Classes

• Cash includes currency, money market securities, Canada Savings Bonds, redeemable GICs, and bonds with a maturity of one year or less. Cash is primarily used for liquidity purpose in case of emergencies. Normal long term strategic asset allocation for cash are often within 5%-10% range.

• Fixed-income securities include bonds due in more than one year, mortgage-backed securities, fixed-income mutual funds, fixed-income exchange-traded funds, and other debt instruments, as well as preferred shares. The purpose of including fixed-income products is primarily to produce income as well as provide some safety of principal.

• Equities include common shares, rights and warrants, equity exchange-traded funds, equity mutual funds, convertible bonds, and convertible preferred. Its main purpose is to generate capital gains either through trading or long-term growth in value.

• Asset class timing is the practice of switching among industries and asset classes with a goal of maximizing returns and minimizing losses.

• The link between equity and economic cycles allows investors to attempt to maximize returns on equity investments by acquiring or divesting holdings based on the stage of the equity and/or economic cycle.

• The Portfolio Manager Styles • Investment Strategies

• Active Investment strategy: the goal of an active investment strategy is to outperform a benchmark portfolio on a risk adjusted basis. • Bottom-up analysis begins with a focus on individual stocks and builds

portfolios of the best stocks in terms of forecasted risk-return characteristics. • Top-down analysis begins with a study of broad macroeconomic factors

before it narrows the analysis to individual stocks. The classic approach to top-down analysis factors to evaluate a company’s operating environment, and finally using company-specific factors to assess the value of a firm’s common stock.

• Passive Investment strategy: managers using a passive investment strategy tend to replicate the performance of a specific market index without trying to beat it. • Buy-and-hold system • Indexing is a portfolio management style that involves buying and holding

a portfolio securities that matches the composition of a benchmark index. • Equity Manager Styles

• Equity growth manager use the bottom-up style of growth investing by focusing on current and future earnings of individual companies, with a key consideration being earnings per share (EPS).

• Equity value manager focus on specific stock selection, buying stocks that research indicates are undervalued.

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• Equity sector rotators apply a top-down investing approach, focusing on analyzing the prospects for the overall economy. Based on that assessment, managers invest in the industry sectors expected to outperform.

• Fixed-income managers make choices based on the term to maturity, credit quality, and their expectations of changes in interest rates and how this will affect the prices of fixed-income products.

• Asset Allocation • Strategic asset allocation is the long-term asset mix that will be adhered to by

monitoring and, when necessary, rebalancing a portfolio. It is the initial mix developed and is based on an evaluation of a client’s personal and financial circumstances.

• Ongoing asset allocation: once the asset mix is implemented, the asset classes will begin to change in value with fluctuations in the market. Dividends and interest income will flow into the cash component. As a result, the asset mix will begin to change. • Dynamic asset allocation involves adjusting the asset mix to systematically

rebalance the portfolio back to its long-term strategic asset mix. • Tactical asset allocation involves short-term, tactical deviations from the strategic

mix to capitalize on investment opportunities in one asset class before reverting back to the long-term strategic allocation.

• Integrated asset allocation is an all-encompassing strategy that takes into account changes in capital markets and client risk tolerance.

• Portfolio Monitoring • Monitoring the markets and the clients refers to evaluating portfolio decisions in light

of changes in the investor’s goals, financial position and preferences, relative to changing expectations for capital markets and individual securities.

• Monitoring the economy refers to evaluating the changes in the economy as a whole and revisiting portfolio decisions based on changes in the economy.

• Portfolio Performance Evaluation • The success of a portfolio manager is determined by comparing the total rate of return

of the portfolio being evaluated with the average total return of comparable portfolios. • Managers are often measured against a predetermined benchmark specified in the

investment policy statement. • One very simple method of computing total return is to divide the portfolio’s total

earnings (income plus capital gains or losses), or the increase in the market value of the portfolio, by the amount invested in the portfolio.

• The Sharp Ratio measures the portfolio’s risk adjusted rate of return using standard deviation as the measure of risk. Higher Sharp Ratios are preferred.

(Rp = return of the portfolio; Rf = risk-free rate)

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SECTION VII Analysis of Managed Products

Chapter 17 Fundamentals of Managed and Structured Products

• Managed & Structured Products • Managed Products

• A pool of capital gathered to buy securities according to a specific investment mandate; the pool seeds a fund; the fund is managed by an investment professional that is paid a management fee to carry out the mandate.

• e.g., mutual funds, hedge funds, segregated funds, exchange traded funds (ETFs), private equity funds, labour-sponsored venture capital corporations.

• Account structures • Pooled accounts: investors’ funds are gathered into a specific legal structure,

usually a trust or corporation; an investor’s claim to the pool’s return is proportional to the number of shares or units the investor owns; the pools are often open-ended, which means units are issued when there are net cash inflows to the fund, or units are redeemed when there are net cash outflows.

• Separately managed account: individual accounts are created for each investors.

• Structured Product • A passive investment vehicle that is financially engineered to provide a specific

risk and return characteristic. The value of a structured product product tracks the return of a reference security known as the underlying asset.

• Underlying assets can consist of a single security, a basket of securities, foreign currencies, commodities or an index.

• Investors buy a share of the total pool of underlying assets. The issuer of a structured product (e.g. a bank or a consumer finance firm) takes advantage of its economies of scale and market reach to package underlying assts that individuals could not cost effectively assemble on their own.

• Compared to the investment mandate of a structured product, the mandate of a managed product generally imposes more demands and restrictions on its fund manager.

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Chapter 18 Mutual Funds: Structure & Regulation

• Mutual Fund • A Mutual fund is an investment vehicle operated by an investment company that pools

contribution from investors and invests these proceeds into a variety of securities, including stocks, bonds and money market instrument. A professional money manager manages the fund and follows a particular investing style.

• Individuals that contribute money become unit holders in the fund and share in the income, gains, losses and expenses the fund incurs in proportion to the number of units that they own.

• Mutual fund unit are redeemable on demand at the fund’s current net asset value per share (NAVPS), which depends on the market value of the fund’s portfolio of securities.

• Advantage of mutual funds • low-cost professional management • diversification • variety of types of funds & transferability • variety of purchase and redemption plans • liquidity: mutual fund shareholders have a continuing right to redeem shares for

NAVPS. • ease of estate planning • loan collateral & margin eligibility: fund shares or units are usually accepted as

security for a bank loan and margin purposes, thus giving aggressive fund buyers both the benefits and risk of leverage in their financial planning.

• various special options • Disadvantage of mutual funds

• costs: the perceived steepness of sales and management costs. • unsuitable as a short-term investment or emergency reserve • professional investment management is not infallible • tax complications

• The Structure of Mutual Funds • Mutual Funds Trust Structure

• The most common structure for mutual fund is the incorporated open-end trust. • The trust structure enables the fund itself to avoid taxation. Any income flows

through to the unit holder to be taxed in the hands of the holder based on the type of income the fund generates.

• Mutual Funds Corporation Structure • Mutual funds may also be set up as federal or provincial corporations and can

be eligible for a special tax rate. This structure requires the holdings to be mainly a diversified portfolio of securities, and income must be derived primarily from capital gains, interest, and dividends generated by those securities.

• The corporation distributes income through dividends that are taxed in the hands of the unit holder, which allows the corporation to avoid paying taxes on income.

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• Mutual fund units are purchased directly from the fund company, usually through a distributor, and are sold back to the fund when redeemed.

• Pricing Mutual Funds Units or Shares • The offering price is the net asset value per share and is the price an investor

pays for a unit. This price is based on the NAVPS at he close of business on the day an order is placed.

• The NAVPS is calculated as

• NAVPS is the amount a funds’ unitholders would receive for each share if the fund were to sell its entire portfolio of investments at market value, collect all receivables, pay all liabilities, and distribute what is left to its unitholders.

• The redemption price is the price a shareholder receives when he or she redeems units, and is also based on the NAVPS.

• Charges Associated with Mutual Funds • A front-end load is a percentage of the purchase price paid to a distributor or

fund company at the time of purchase. • No-load funds are sold with low to no direct percentage selling charges; however,

an administration fee may be charged for purchaser and/or redemption. • Back-end load funds levy a fee at redemption, also referred to as a redemption

charge or deferred sales charge. The fee may be based on the original contribution to the fund or on the net asset value at the time of redemption, and it may decline the longer an investor holds a fund.

• Trailer fees (service fees): a mutual fund manager may pay to the distributor that sold the fund.

• Management fees. Management expense ratio (MER) represents the total of all management fees and other expenses charged to a fund, expressed as a percentage of the fund’s average net asset value for the year.

• Labour Sponsored Venture Capital Corporations (LSVCCs) • LSVCCs are investment funds sponsored by labour organizations to provide capital for

small to medium-sized and emerging companies. • LSVCCs can be divided into two broad categories: funds that invest in a diverse range

of industries and those that concentrate on specific sectors. • Advantages of LVCCs

• Generous federal and provincial tax credits • RRSP & RRIF eligibility

• Disadvantages of LVCCs • a high level of risk • complicate redemption rules • possible recapture of tax credits on early redemption • comparatively high management expense ratios • a reduction in performance in cases where managers need to maintain high levels

of cash to fund potential redemption.

• Mutual Funds Regulation • Mutual Fund Regulatory Organizations

• The Mutual Fund Dealers Association (MFDA) is the mutual fund industry’s SRO for the distribution side of the mutual fund industry. the MFDA does not

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regulate the funds themselves, but how the funds are sold. The MFDA is not responsible for regulating the activities of mutual fund dealers who are already members of another SRO.

• In Québec, the mutual fund industry is under the responsibility of the Autorité des marchés financiers and the Chamber de la sécurité financière.

• National Instruments 81-101 and 81-102 • Canadian funds fall under the jurisdiction of the securities act of each province. • National Instrument 81-101 (NI 81-101) deals with mutual fund prospectus and

fund facts disclosure. • National Instrument 81-102 (NI 81-102) and a companion policy contain

requirements and guidelines for the distribution and advertising of mutual fund. • General Mutual Fund Requirements: mutual fund disclosure documents include:

• A fund facts document: because mutual funds are in a continuous state of primary distribution, investors purchasing a mutual fund for the first time must be provided with fund facts document, which is a document designed to give investors key information about a mutual fund, in an easily understood format and described in plain language.

• A simplified prospectus is a shortened form of full prospectus that contains certain specific components. The simplified prospectus must be filed with the securities commission annually.

• The annual information form • The annual audited statements or interim unaudited financial statements • Other information required by the province or territory where the fund is

distributed, such as material change reports and information circulars. • Registration Requirements for the Mutual Fund Industry

• Mutual fund managers, distributors and sales personnel must be registered with the securities commissions in all province in which they operate (and with the Autorité des marchés financiers if they operate in Quebec.

• Mutual fund sales registration must be renewed annually. Registration is subject to employment status with a registered dealer and has the requirement of notification to the relevant administrator, within time limits, of any changes in specific information.

• Mutual Fund Restriction • The fund manager provides day-to-day supervision of the fund’s investment

portfolio and must observe a number of guidelines for securities trading as specified in the fund’s charter and simplified prospectus, and the constraints imposed by the securities commissions.

• Prohibited sales practices include, among others, quoting a future price, making an offer to repurchase, selling without a licence, advertising registration, promising a future price, selling from one province into another, and selling unqualified securities.

• The “Know Your Client” Rule • Know Your Client

• Securities regulation require that dealers and their dealing representatives know the objectives, investment knowledge, time horizon and risk tolerance of their clients by requiring the provision of “know your client” rule.

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• This information must obtained for all person who have trading authority for the account as well as other persons with a financial interest in the account.

• If the client refuse to provide know-your-client data, then the transaction cannot be processed.

• Suitability and Know Your Product • Suitability of investments held in the client account must be re-assessed whenever

the client transfers their account to the dealer, or whenever the dealer or mutual fund dealing representative becomes aware of a material change in the KYC information previously provided and/or anytime where has been a change in the mutual fund dealing representative responsible for the client account.

• The suitability requirement applies to recommendations that a dealing representative may make to a client and unsolicited orders (i.e. orders for mutual funds that have not been recommended by the dealing representative but instead come from the clients).

• KYC information requires an update where there has been a material change in the client information previously provided. Material changes include, but are by no means limited to the client’s risk tolerance, investment time horizon, investment objectives of the client or a material change in the client assets or income.

• The Role of KYC Information in Opening Account • Financial interest in an account • Change in circumstances: at least once a year the dealer must request, in writing,

that each client notify the dealer of any material change in his or her circumstances. • Anti-money laundering & anti-terrorist financing laws

• Relationship Disclosure Information • Relationship disclosure information is all the information that a reasonable client

would consider important about their relationship with the mutual fund dealer and the dealing representative.

• Specific information must be included in the relationship disclosure document, including a description of the nature or type of the account, a description of the products and services offered by the dealer and dealing representative, a description of the procedures at the dealer regarding the handling of cash and cheques, and a description of the dealer’s obligations to ensure that each order accepted or any recommendation made is suitable.

• There are specific rules that apply to the distribution of mutual funds by financial institutions (such as banks, trust companies, insurance companies and loan companies).

Chapter 18 Mutual Funds: Types & Features

• Types of Mutual Funds • Canadian Mutual Funds fall into six categories:

• Money Market Funds invest in cash and near-cash securities or money market instruments. They generally have a constant share or unit value. The net income of the fund is calculated daily and credited to unitholders, the paid out as cash or reinvested in additional shares on a regular basis.

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• Fixed-income Funds are designed to provide as a steady stream of income rather than capital appreciation. Interest rate volatility is the main risk associated with this type of fund. Interest income is the primary source of return.

• Equity Funds are invested primarily in the common shares of publicly traded companies with an investment objectives of long-term capital growth. Funds vary greatly in degree of risk and growth potential, and are all subject to market risk.

• Balanced Funds invest in both stocks and bonds to provide a mix of income and capital growth.

• Speciality Funds specialty funds seek capital gains and are willing to forgo broad market diversification in the hope of achieving above-average returns. Because of their narrower investment focus, these funds often carry substantial risk due to the concentration of their assets in just one area.

• Target-date Funds is a new type of balanced funds. These funds have a maturity date and the risk of the fund decreases as the maturity date approaches.

• An Index fund is a passive investment strategy designed to match the performance of a specific market index through direct investment in the securities that make up the specified index.

• Risk and return can be seen as a scale from the lowest risk/lowest return funds category to the highest risk/highest return funds category money market funds, fixed-income funds, balanced funds, and equity funds, specialty funds.

• Fund Management Styles • A passive investment strategy involves some form of indexing to a market or

customized benchmark. In contrast, most equity styles are active. Active managers try to outperform the market benchmarks. Overall, funds that follow a passive strategy generally report lower management expense ratios (MERs) while funds that pursue an active strategy typically report higher MERs.

• Indexing represents a passive style of investing that attempts to buy securities that constitute or closely replicate the performance of a market benchmark such as S&P/TSX Composite Index or the S&P 500 Composite Index.

• Closet indexing does not replicate the market exactly, but sticks fairly closely to the market weightings by industry sector, by country or region, or by average market capitalization.

• Mutual Funds Units or Shares Redemption • Mutual funds redeem their shares on request at a price that is equal to the fund’s

NAVPS. If there are no back-end load charges, the investor would receive the NAVPS. If there were back-end load charges or deferred sales charges, the investor would receive NAVPS less the sales commission.

• Tax Consequences • Annual distributions: when mutual funds are held outside a registered plan, the

unitholder of an unincorporated fund is sent a T3 form and a shareholder is sent a T5 form by the respective funds. This form reports the types of income distributed that year- foreign income and Canadian interest, dividends and capital gains, including dividends that have been reinvested.

• Capital gains: when a fund holder redeems the shares or units of the fund itself, the transaction is considered a disposition for tax purposes, possibly giving rise to

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either a capital gain or a capital loss. Only 50% of net capital gains is added to the investor’s income and taxed at their marginal rate.

• Systematic Withdrawal Plans • In a ratio withdrawal plan, the investor receive annual income from the fund by

redeeming a specified percentage of fund holdings on each withdrawal date. • In a fixed-dollar withdrawal plan, the investor receives a specified dollar amount

on each withdrawal date. • In a fixed-period withdrawal plan, a specified amount is withdrawn over a

predetermined period of time with the intent that all capital be exhausted when the plan ends.

• In a life expectancy-adjusted withdrawal plan, the goal is to deplete the entire investment by withdrawing amounts adjusted to reflect the portfolio;s current value and the changing life expectancy of the plan holder.

• Mutual Fund Performance • Performance measurement involves the calculation of the return realized by a portfolio

manager over a specified time interval (the evaluation period). • The most frequently used measure of mutual fund performance is to compare NAVPS

at the beginning and end of the period. • Gain = (ending NAVPS - beginning NAVPS)/beginning NAVPS • This calculation assumes that the investor made no additions to or withdrawals

from the portfolio during the measurement period, and reinvested all dividends. • A time-weighted rate of return (TWRR) is calculated by averaging the return for

each sub-period in which a cash flow occurs to create a return for the reporting period. TWRR better measures the actual rate of return earned by a portfolio manager because it minimizes the effect of contributions and withdrawal by investors. • Daily valuation method measures the incremental change in fund value from day

to day and this is expressed as an index from which the return can be calculated.

• Modified Dietz method reduces the extensive calculations of the daily valuation method by providing a good approximation. The Modified Dietz method weights each cash flow by the amount of time it is held in the portfolio. this method is a more accurate way to measure the return on a portfolio because it identifies and accounts for the timing of all interim cash flow while a simple geometric return does not.

• Canadian regulations require standardized performance data, including which return measures are to be calculated, how often they must be calculated, and the way they must be calculated.

• Quality of fund performance is determined by comparison against a relevant standard, which is either a fund’s benchmark index or the average return on the fund’s per group of funds.

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Chapter 20 Segregated Funds and Other Insurance Products

• Segregated Fund • Segregated funds is a type of pool investment that is similar to a mutual fund, but is

considered an insurance product. Because of their legal structure, segregated funds issue national units of the contract, instead of actual units or shares to investors.

• Segregated funds are regulated by provincial insurance regulators because they are insurance contracts - known as individual variable insurance contracts (IVICs), between a contact holder and an insurance company.

• Because of the insurance benefits they offer, segregated funds are more expensive than uninsured funds, particularly in the form of higher MERs.

• The contract holder is the person who bought the segregated fund contract. The annuitant is the person on whose life the insurance benefits are based. The beneficiary is the person or person who will receive the benefits payable under the contract on the death of the annuitant. In registered plans only, the contract holder and the annuitant must be the same person.

• Segregated Fund Features • Maturity Guarantees

• provincial regulations require that beneficiaries receive a guarantee of at least 75% to a maximum 100% of the return of the money invested over a contract term of at least a ten year holding period.

• Depending on the annuitant’s age, the contract may be renewable when the term expires. If renewed, the maturity guarantee on a ten-year contract would reset for another ten years.

• Death Benefits • The death benefits associated with segregated funds meet the needs of clients

who want exposure to long-term asset while ensuring that their investments are protected in the event of death.

• The amount of the death benefits is equal to the difference, if any, between the guaranteed amount and the net asset value of the fund at death.

• If a contract holder dies, the holding in the fund bypass probate and pass directly to the beneficiaries.

• Credit Protection • Credit protection is available because segregated funds are insurance policies. The

fund’s assets are owned by the insurance company rather than the contract holder, and insurance proceeds generally fall outside the provisions of bankruptcy legislation.

• To benefit creditor protection, the purchase must not be made with the intention of avoiding potential creditor action, and a beneficiary must be named.

• Segregated funds can help clients avoid the costly probate fees levied on assets held in investment funds.

• Similarities & Differences Between Segregated Funds & Mutual Funds

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Features Segregated Funds Mutual Funds

Legal Status Insurance Contract Security

Who owns assets of fund

Insurance Company Fund itself, which is a separate legal entity

Nature of fund units

Units have no legal status, and serve only to determine value of benefits payable

Units are legal property which carry voting rights and rights to receive distributions

Who regulates their sale

Provincial insurance regulators Provincial securities regulatiors

Who issues them Mainly insurance companies; also a small number of fraternal organizations

Mutual fund company

Main disclosure document for investor

Information folder Fund Facts Document (simplified prospectus available upon request)

How often valued Usually daily, and at least monthly Usually daily, and at least weekly

Redemption rights Right to redeem is based on contract terms

Redeemed upon request

Required financial statements

Audited annual financial statement Audited annual financial statement and semi-annual statement for which no audit required

Sellers’ qualifications

Licensed life insurance agents; BC, Saskatchewan and PEI also require successful completion of a recognized investment course, such as those offered by the CSI, IFIC or potentially by CAIFA

Licensed mutual funs representatives or registered brokers

Maturity guarantees

Minimum of 75% of deposits after 10 years. Companies may offer guarantees up to 100%

None

Government guarantees

None None

Protection against issuer insolvency

Assuris, a not-for-profit organization, provide up to $60,000 per policyholder per institution in compensation against any shortfalls in policy benefits resulting from the insolvency of a member firm

The Mutual Fund Dealer Association (MFDA) Investor Protection Corporation (IPC), a not-for-profit corporation, provides protection to $1,000,000 to eligible customers off MFDA members as a result of a member’s insolvency.

Death benefits Yes, may be subject to age or other restrictions

None

Features

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• Tax Consideration • Net income earned from a segregated fund is deemed to be the contract holder’s

income and is taxable in the current year. • The appropriate percentage of the income is allocated to the contract holder, generally

based on the number of units held and the proportion of the calendar year in which the units were held.

• The allocation are reported annually on a T3 slip, although they are made throughout the year.

• Payments from maturity guarantees are taxable. The amount taxed is the proceeds, less sales charges, minus the cost of the contract (which is the original amount deposited plus any allocation).

• The Regulation of Segregated Funds • All communications considered advertisements are governed by Canadian Life and

Health Insurance Association (CLHIA) guidelines. • The contracts are subject to the guidelines on guarantee provisions of The Office of

the Superintendent of Financial Institutions (OSFI). • In the case of insolvency of a fund, Assuris guarantee cover the death benefits and

maturity guarantee of the fund contract and will top up any payments made by a liquidator to fulfill these insurance obligations.

• Guaranteed Minimum Withdrawal Plans (GMWB) • Guaranteed minimum withdrawal plans are similar to variable annuities in that the

amount of the monthly payment varies according to the value of investments. The GMWB option gives the planholder the right to withdrawal a certain fixed percentage of the initial deposit every year until the entire principal is returned, no matter how the fund performs.

Chapter 21 Hedge Funds

• Hedge Funds • Hedge funds are lightly regulated pools of capital whose managers have great flexibility

in their investment strategies, including using derivatives for leverage and speculation, arbitrage, and investing in almost any situation in any market.

• Comparisons to mutual funds: mutual funds are far more regulated and restricted in terms of permitted investments, valuation and reporting practices.

Creditor protection Yes, under certain circumstances None

Probate bypass Yes, proceeds of contract held by deceased contract holder may be passed directly to beneficiaries, avoiding probate process

None

Segregated Funds Mutual FundsFeatures

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• Markets for Hedge Funds • Funds targeted toward high-net-worth and institutional investors.

• These hedge funds are usually structured as limited partnerships or trusts, and are issued by way of private placement. They issue an offering memorandum, which is a legal document stating the objectives, risks and terms of investment involved with a private placement.

• To invest in these funds, investors must be considered either sophisticated or accredited. Investors must meet certain minimum requirements for income. net worth, or investment knowledge.

• Funds and other hedge fund-related products targeted toward the broader individual investor, or “retail” market. • Commodity pools are a special type of mutual fund that can use leverage

and engage in short selling using derivatives. • Closed-end funds: the redemptions by the fund, if any, occur only once a

year or even less frequently • Principal-protected notes (PPNs) provide investors with exposure to the

returns of one or more hedge funds and a return of principal on maturity that is guaranteed by a bank or other highly rated issuer of debt securities.

• Hedge fund performance is tracked against market indexes, although findings exactly correlated indexes is problematic because of variance among funds and the lack of regulatory requirements for funds to publicly report performance figures.

• Benefits & Risks of Hedge Funds • Benefits

Mutual Funds Hedge Funds

Can take limited short positions when regulatory authority has been granted

No restrictions on short positions

Can use derivatives only in a limited way Can use derivatives in any way

Are usually liquid May have liquidity restrictions

Are sold by fund facts to the general public Are generally sold by offering memorandums to sophisticated or accredited investors only

Are subject ot considerable regulatory oversight As private offerings are subject to less regulation

Charge management fees but usually have no performance fees

Charge management fees and in most cases performance fees

“Relative” return objective; performance is usually measured against a particular benchmark

“Absolute” return objective; fund is expected to make a profit under all market conditions

Most are valued daily Most are valued mothly

Quarterly or annual disclosure to unitholders Annual disclosure to unitholders

Cannot take concentrated positions in the securities of a single issuer

Can take concentrated positions

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• Low correlation with traditional asset classes: hedge funds provide diversification benefits and help lower overall portfolio risk.

• Risk minimization • Absolute returns: hedge fund managers seek to achieve positive or absolute

returns in any market condition, not just returns that beat a market index, which is the goal of most mutual funds.

• Potentially lower volatility and higher returns: higher performance than other asset classes on a risk-adjusted basis.

• Risks • Light regulatory oversight: the lack of transparency may create a situation in

which hedge fund investors may not know how their money is being invested. • Manager and market risk • Investment strategies: complex investment strategies that may not be fully visible

to potential investors. • Liquidity constraints: hedge funds are typically not able to liquidate their

portfolios on short notice. A lockup refers to the time period that initial investments cannot be redeemed from a hedge fund.

• Incentive fees: in addition to management and administration fees, hedge fund managers often charge an incentive fee based on performance.

• Tax implications • Short selling and leverage • Business risk

• Due diligence: as most hedge funds provide investors with limited information, advisors recommending these funds as investments must perform through research to fulfill requirements of due diligence (an investigation of a business or person prior to signing a contract).

• Hedge Fund Strategies

Hedge Fund Category Objectives of the strategy Most exposure to the underlying market direction

Specific strategies

Relative Value Strategies

Attempt to profit by exploiting inefficiencies or arbitrage opportunities in the pricing of related stocks, bonds or derivatives

Low or no exposure

• Equity market neutral

• convertible arbitrage • fixed-income

arbitrage

Event-driven strategies Attempt to profit from unique events such as mergers, acquisitions, stock splits, and buyback

Medium exposure • Merger or risk arbitrage

• distressed securities • high-yield bond

Directional strategies Bet on anticipated movements in the market prices of equity securities, foreign currencies and commodities.

High exposure • Long/short equity • global macro • emerging markets • managed futures • dedicated short basis

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• Funds of Hedge Funds • A fund of hedge funds (FoHF) is a portfolio of hedge funds, overseen by manager

who determines which hedge funds to invest in and how much to invest in each. • Types of FoHF

• Single-strategy, multi-manager funds invest in several funds that employ a similar strategy, such as long.short equity funds or convertible arbitrage funds.

• Multi-strategy, multi manager funds invest in several funds that employ different strategies.

• FoHF have certain advantages: reduced need for due diligence, reduced volatility, professional management, ease of access, diversification with smaller amounts of capital, and lower manager and business risk.

• FoHF have certain disadvantages: additional costs, no guarantees of positive returns, low or no strategy diversification, insufficient or excessive diversification, and increased risk because of additional layers of leverage.

Chapter 22 Exchange-Listed Managed Products

• Closed-End Funds • Closed-end funds are pooled investment funds that initially raise capital by selling a

limited or fixed number of shares to investors and trade on exchange. • In general, the management fee charged by a closed-end fund is lower than the

management fee of a mutual fund with a similar investment objective. • Fund prices are based on market demand and underlying asset value. Funds can

trade at a discount, at par, at a premium relative to the combined net asset value of their underlying holdings. Historically, most closed-end funds trade at a discount to their NAVPS.

• Funds that have flexibility to buy back their outstanding shares periodically are known as interval funds or closed-end discretionary funds.

• Advantages of closed-end funds • Diversification can reduce the risks associated with the varying discounts of

closed-end funds. • Ability to short-sell • Increase investment flexibility for managers: managers can have the flexibility to

concentrate on long-term investment strategies without having to reserve liquid assets to cover redemption.

• Ease in tracking an adjusted cost base • Potentially lower management expense ratios than for open-ended funds

• Disadvantages of closed-end funds • Lack of liquidity • Possibility of trading below net asset value • Paying regular commissions • Possibility of lack of availability of income reinvestment plans • Highly taxed income from funds that trade on foreign exchange

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• Income Trusts • Income trusts are asset-back securities that have been created to purchase and hold

interests in the operating assets of a company (e.g., seafood processing, office rentals, shopping centres). These securities are exchange-traded and trade on the Toronto Stock Exchange.

• Income trusts react to changing interest rates, similar to fixed-income securities, but trade on an exchange, like equities. Depending on their structure, the priority and security of trusts typically rank below those of subordinated debentures.

• Categories of Income Trusts • Real estate trusts (RETs), which can be open or closed-end funds, consolidate

the capital of a large number of investors to invest in and manage a diversified real estate portfolio. Rental incomes (as much as 95% of that generated) are passed through to investors who buy units in the trust. The units are more liquid than buying real estate directly.

• Business income trusts purchase the assets of an underlying company, usually in the manufacturing, retail or service industry. Income trusts work best in markets where new competitors are unlikely to spring up - ideally a monopoly or a qusi-monopoly or a company operating in a protected niche. These companies have strong, stable earnings, but little growth potential so that management uses the income trusts to make an offering more attractive, since the company would be less attractive as a common share IPO.

• Exchange-Traded Funds (ETFs) • Exchange-traded funds are investment vehicles that combines some of the features of

mutual funds and individual stocks. They are structured as open-ended mutual fund trusts and are similar to index mutual funds. The units of the trust are listed and traded on stock exchanges, much like individual stocks representing a key difference with mutual funds.

• Advantages of ETFs • Diversification opportunities • The significantly lower MERs when compared to traditional mutual funds

• Comparing ETFs & Index Mutual Funds

ETFs Index Mutual Fund

Pricing Close to net asset value at any time during the day

Once per day using the closing price of the fund’s net asset value

Management Fees Very low MERs Commissions to buy & sell

Low MERs May have front or rear loads

Portfolio Turnover Low-lower taxable capital gains distributions lead to greater tax efficiency

Low-lower taxable capital gains distributions lead to greater tax efficiency

Short Selling Yes No

Use of Leverage Yes No

Ease of Trading Yes No

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• Recent Trends in ETFs • Active ETFs are constructed according to the fund manager’s investment

philosophy, for example a value, growth, top down, or bottom up strategy. The active portion of the fund is created and managed no differently than any other actively-managed open-ended mutual fund.

• An inverse ETF moves in the opposite direction of the index or benchmark it tracks. The ETF profits when the underlying index falls and posts a loss when the index rises. The inverse ETF is designed to hedge exposure to or profit from downward moving markets.

• A leveraged ETF is designed to achieve returns that are multiples of the performance of the underlying index they track. They use of leverage, or borrowed capital, makes them more sensitive to market movements.

• Inverse leverage ETFs seek to achieve a return that is a multiple of the inverse performance of the underlying index it is tracking.

• Inverse and leveraged ETFs expose investors to much greater risk compared to the traditional passively managed ETFs.

• Listed Private Equity • Listed Private Equity

• A listed private equity company is an investment company that uses its capital to purchase or invest in a wide range of other companies.

• The shares of a listed private equity company are publicly-traded on a stock exchange. These listed companies trade like common shares and are subject to the same regulator and reporting requirements as other publicly-traded companies.

• Private equity companies may also structure themselves as a private equity fund. These funds are pools of privately-managed capital formed for the purposes of making investments in other companies.

• Private equity is the financing of firms unwilling or unable to find capital using public means.

• Advantages of Listed Private Equity • Access to legitimate inside information • Influence over management and flexibility of implementation

• Disadvantages of Listed Private Equity • Illiquid investments • Dependence on key personnel

Chapter 23 Fee-Based Accounts

• Fee-Based Accounts • Managed Accounts

• Managed accounts offer professional portfolio management services whereby the manager has discretionary authority over the account. In this way, the manager plays an active role in making and carrying out investment decisions.

• Managed accounts include a bundled fee to cover the various services included in the package of related services.

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• Fee-Based Non-Managed Accounts • Non-managed fee accounts are full-services brokerage accounts that provide clients

with financial planning services with a fixed or unlimited number of trades, all bundled into a fee charged on the client’s assets under management.

• Discretionary Accounts • Both managed accounts and discretionary accounts allow the client to empower

someone else with discretion to make investment decisions on the client’s behalf. But discretionary accounts are usually opened for a short period of time. They serve as a matter of convenience for clients who are unwilling or unable to attend to their own accounts, for example, through illness or absence from the country.

• Discretionary authority with respect to a managed account must be given by the client in writing and accepted in writing by a partner or director. The authorization must specify the client’s investment objectives.

• Managed Accounts • Single-Manager Accounts

• Single-manager accounts are directed by a single portfolio manager who focuses considerable time and attention on the selection of securities, the sectors to invest in and the optimal asset allocation. The portfolio manager often maintains a mode portfolio and then executes bulk purchase and sales based on their investment decisions.

• With an advisor/investment counsellor account, the advisor providing the account servicing also provides the investment management. The advisor is licensed as a portfolio manager and tends to focus on the advisor’s area of specialty. The advisor/portfolio manager establishes the portfolio that is aligned with a suitable model.

• Exchange-traded fund (ETF) wraps are often directed by a single portfolio manager who creates the model for a specific managed account. The managed account holds a basket of exchange-traded funds for security selection and can be either a passive or active approach.

• Multi-manager accounts • Multi-manager accounts offer clients and their advisors more choice in terms of

product and services. These accounts focus on providing access to elite institutional portfolio managers. Each portfolio model is a component of the client’s greater diversified holdings. To provide oversight to the program, the portfolio managers are considered sub-advisors to the firm’s portfolio manager of record (overlay manager). • The overlay manager works with the advisors in servicing clients. This is

not a referral but a partnership, in which the advisor retains the client’s assets. The overlay manager conducts ongoing due diligence reviews of each of the underlying portfolio managers (the sub-advisors). As a manager of managers, he or she sets the metrics for ongoing evaluations, evaluates new managers and removes poorly performing ones from the program.

• Mutual fund wraps are established with a selection of individual funds managed within a client’s accounts. Mutual fund wraps differ from funds of funds. The clients holds the actual funds within their account, as opposed to a fund that simply invests in other funds.

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• With separately managed accounts, the sub-advisors control a dedicated account for the portfolio model. Each client has a separate dedicated account to hold the selected investments. As the sub-advisor makes the investment decisions, the actual securities are debited and credited to the client’s dedicated account within the firm. The overlay manager establishes a collection of these dedicated accounts for the clients, reflecting the optimal asset mix to help the client attain the overall investment objectives, while mitigating risk.

• With multi-disciplinary accounts, separate models are combined into one overall portfolio model in a single account. The overlay manager takes the investment decisions of the underlying sub-advisors and combines them into one overall balanced portfolio model for the single account. • Multi-disciplinary accounts hold a mix of securities selected in the models

of the sub-advisors, which are then combined with selected mutual funds and ETFs. By combining the models of sub-advisors with mutual funds and ETFs, higher levels of optimal asset allocations can be created.

• A unified managed account includes performance reports from the respective sub-advisors, outlining distinct models contained within the single custody account. These models are held within the account in sleeves to effectively combine detailed reporting of separately managed accounts, while maintaining the enhancement of the single custody account, as in a multi-disciplinary account.

• Private Family Office • A private family office is an extension of the advisor’s client servicing approach.

In this approach, instead of having only one advisor, a team of professionals handles all of an affluent client’s financial affairs within one central location. The client’s portfolio may include investments, trust and estates, philanthropy, corporate planning, tax planning and filling, legal work, basic account servicing, including bill paying, and others. The investment management is unique for each family.

Chapter 24 Structured Products

• Principal-Protected Notes (PPNs) • A principal-protected note is a debt-like instrument with a maturity date, whereby the

issuer agrees to repay investors the principal plus interest. The interest rate is tied to performance of underlying asset, such as a portfolio of mutual funds or common stocks, fixed-income investments, a market index, a hedge fund or a portfolio of hedge funds.

• Three main types of PPNs • Index-linked notes are certificate usually offered in three-year to five-year terms

by major banks. • Mutual fund-linked notes derive their return from an underling mutual fund or set

of mutual funds and often have a longer term of maturity. • Hedge fund-linked notes allow investors to participate in hedge fund returns

without the large minimum account size normally required for direct investment and without the downside volatility.

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• Although many PPNs are issued by chartered banks, they are not protected by Canadian Deposit Insurance Corporation (CDIC).

• PPNs Guarantors, Manufacturers & Distributors • The guarantor or issuer of the PPN is the entity that guarantees the principal at

maturity. • The manufacturer helps the issuer design the notes and market them to investors

and distributors. • The investment dealers and mutual fund dealers, which employ advisors to sell

PPNs, act as distributors. The distributor receives a commission for each PPN sold.

• The Structure of PPNs • In the zero-coupon bond plus call option, the PPN issuer invests most of the

proceeds in a zero-coupon bond that has the same maturity as the PPN. The zero-coupon bond guarantees the return of principal on maturity. The reminder of the proceeds invested in a call option on the underlying asset.

• In a constant proportion portfolio insurance (CPPI) structure, the portfolio manager shifts the portfolio’s allocation between a riskier asset and a risk-free asset in response to changes in interest rates and the value of the risky asset. As the value of the risky asset increases or interest rates rise, the allocation to the risky asset increases and the allocation to the risk-free asset decreases.

• PPNs are not appropriate for investors who rely on a regular and predictable investment income to fund their lifestyle.

• It is generally accepted that any return from a PPN held to maturity will be taxed as interest income.

• Linked Guaranteed Investment Certificates • Guaranteed Investment Certificates (GICs) are a type of fixed-income security that

offers fixed rates of interest for a specific term. • Structure of Linked GICs

• Index-, Mutual Funds-, and Hedge Fund-Linked guaranteed investment certificates (GICs) are hybrid investment products that combine the safety of a deposit instrument with some of the growth potential of an equity investment.

• While the principal is guaranteed, the total return on the instrument is not known until maturity, and this may be limited either by a maximum cap on returns or by a participation rate, depending on the issuer. • A maximum cap on returns means the investment cannot yield more than

the maximum return allowed by the issuer. • A participation rate means the performance of the linked GIC will be equal

to a predetermined percentage of the performance of the underlying asset. • Returns on Linked GICs (main variables used to determine the overall return)

• The initial index level • The ending index level • Index growth over the term • Any maximum cap on returns or a participation rate

• Risks Associated with Linked GICs • Although the principal is protected, investors must accept the risks associated

with an investment that tracks the performance of the stock market, mutual or hedge fund.

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• In most cases, investors cannot redeem these linked GICs prior to the maturity date.

• Tax Implication: the return on linked GICs is classified as interest income. If the instrument is purchased outside of a registered retirement savings plan, the gains will be added to income and taxed at the investor’s marginal tax rate.

• Split Shares • A split share is a security that has been created to divide (or split) the investment

attributes of an underlying portfolio of common shares into separate components that satisfy different investment objectives: preferred share and capital share components. • The preferred shares receive the majority of the dividends from the common

shares held by the split share corporation. This structure is of interest to equity investors seeking yield.

• The capital shares receive the majority of any capital gains on the common shares. Capital shares interest equity investors willing to sacrifice dividend income in favour capital gains.

• The preferred share has a priority claim on all available dividends from the underlying portfolio of common shares.

• Tax implications: split shares are issued for a specific term started in the prospectus; at the end of the term the split-share company will redeem the shares.

• Asset-Backed Securities • Asset securitization is a process that aggregates and transforms financial assets such as

mortgage, loans and other receivables into marketable securities. • Numerous financial institutions use securitization to transfer the credit risk of the assets

that originate from their balance sheets to those investors, such as life insurance companies, pension funds and hedge funds.

• The Structure Process • The originator of the security will group assets together to remove from its

balance sheet. The assets are pooled into a reference portfolio and then sold to a separate legal entity called a special purpose vehicle (SPV). Marketable securities are then sold against are the sold against the SPV.

• Most ABS securities now divide the reference portfolio into a number of classes, commonly referred to as tranches, each of which has different levels of risk and reward associated with it. These tranches are sold separately to investors who seek the appropriate risk-return opportunity from the SPV’s assets.

• Asset-Backed Commercial Paper (ABCP) is a particular type of ABS — it has a maturity date of less than one year, typically in the range of 90 to 180 days, with a legal and design structure of an ABS (as discussed above).

• Repayment of a maturing ABCP normally depends on the cash flows emanating front the assets owned by the SPV, as well as the ability of the ABCP issuer to issue a new ABCP (or renew the current one).

• Mortgage-backed securities • Mortgage-backed securities (MBSs) are bonds that claim ownership to a portion of the

cash flows from a group or pool of mortgages. They are also known as mortgage pass through securities.

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• Many MBS securities have prepayment risk, particularly those issued in the U.S. bond market and a portion of those issued in the Canadian market. This is due to the nature of the residential mortgage that form part of the pools of mortgages that underlie the MBS.

• The security backing the mortgage is residential properties (single-family, multi-family and social housing) fully insured as to interest, principal and timely payment by CMHC.

• NHA MBSs can be structured with an open or a closed pool. Because mortgages may have provisions for prepayment, which have significant effects on the cash flows and yields, MBSs are composed separately of pre-payable (open) and non-pre-payable (closed) mortgages.

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SECTION VIII Working With the Client

Chapter 25 Canadian Taxation

• The Canadian Taxation System • The Income Tax System in Canada

• The federal government imposes income taxes by federal statute (the Income Tax Act). All Canadian provinces have separate statutes which impose a provincial income tax on residence of the province and on non-residents who conduct business or have a permanent establishment in that province.

• Canada taxes the world income of its residents (including companies incorporated in Canada and foreign companies with management and control in Canada) and the Canadian source income of non-residents.

• Taxation year • All taxpayers must calculate their income and tax on a yearly basis. • Individuals use the calendar year while corporations may choose any fiscal

year. • Calculation of Income Tax

• Calculating all sources of income from employment, business and investments. • Making allowable deductions to arrive at taxable income. • Calculating the gross or basic tax payable on taxable income. • Claiming various tax credits, if any, and calculating the net tax payable.

• Types of Income • Employment income: taxed on a gross receipt basis. • Capital property income: dividend and interest income. • Business income, including income from self-employment: the profit earned from

producing and selling goods or rendering services. • Capital gains and losses: profit or loss from disposition of property.

• Calculating Income Tax Payable • Adding the provincial rate to the federal rate gives the taxpayer’s combined

marginal tax rate. The marginal tax rate is the tax rate that would have to be paid on any additional dollars of taxable income earned.

• Taxation of Investment Income • Employers are required to withhold income tax on salaries and wages and remit

this amount on their employees’ behalf to the government. Some individuals, and all corporations, pay their taxes by instalments.

• Interest income is reported annually regardless of whether the cash is received (for all investment contracts acquired after 1989).

• Dividend income received from a taxable Canadian corporation is grossed up by a specified factor and then the taxpayer receives a tax credit. • Eligible Canadian dividends are grossed-up by 38% to arrive at the taxable

amount of the dividend and then the taxpayer receives a federal dividend tax credit of 15.02% on this amount. Dividend tax credits are also available at varying provincial levels.

• Stock dividends and dividends that are reinvested in shares are treated in the same manner as cash dividends.

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• Foreign dividend income is generally taxed as regular income, in much the same way as interest income.

• Capital gains: only 50% of net capital gains is added to the investor’s income and taxed at their marginal rate.

• Income earned on strip bonds and T-bills must be reported annually.

• Investment Gains & Losses • A capital gain arises from selling a capital property for more than the adjusted cost

base plus any costs of disposing of the property. • A capital loss arises from selling a capital property for less than the adjusted cost base

plus any costs of disposing of the property. • Superficial loss occurs when securities sold at a loss are repurchased within 30 calendar

days before or after the sale and are still held at the end of 30 days after the sale. Superficial loss are not tax deductible as a capital loss.

• Tax Deferral Plans • A registered pension plan (RPPs) is a trust, registered with CRA or the appropriate

provincial agency, which is established by a company to provide pension benefits for its employees when they retire. Both employer and employee contributions to the plan are tax deductible. • Defined contribution plan (DCP) or Money purchase plans (MPP): contributions

to the plan are specified, and the eventual retirement benefit depends on money accumulated during the contribution period.

• Defined benefit plans (DBP): benefits at retirement are based on a formula that is specific and defined.

• Registered retirement savings plans (RRSPs) are vehicles for individuals to save for retirement. Contributions are tax deductible up to allowable limits, and income accumulates tax deferred while it remains in the plan. • Contributions to an RRSP: the maximum annual tax deductible contributions to

RRSPs an individual can make is the lesser of 18% of the previous year’s earned income, and the RRSP dollar limit for the year. A penalty tax of 1% per month is imposed on any portion of over-contribution that exceeds $2,000.

• Types of RRSPs • Single Vendor Plans: the investments are held in trust under the plan by a

particular issuer, bank, insurance company, credit union or trust company. • Self-Directed Plans: holders invest funds or contribute certain acceptable

assets such as securities directly into a registered plan. The plans are usually administered for a fee by a Canadian financial services company.

• Spousal RRSPs: a taxpayer may contribute to an RRSP registered in the name of a spouse or common-law spouse and still claim a tax deduction.

• Termination of RRSPs: an RRSP holder may make withdrawals or de-register the plan at any time but mandatory de-registration of an RRSP is required during the calendar year when an RRSP plan holder reaches age 71.

• Advantages of RRSPs include reduction in annual taxable income during high-taxation years as a result of tax-deductible contributions, the ability to shelter certain lump-sum types of income, accumulation of funds on a tax-deferred basis, deferral of income taxes to lower-taxed times, and the opportunity to split retirement income.

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• Disadvantages of RRSPs include the inability to use the funds now, assets cannot be used as collateral for a loan, and foregoing the benefits of favoured tax treatment of investments that produce dividends and capital gains. All income us taxed as regular income when withdrawal.

• A registered retirement income fund (RRIF) is a tax-deferral vehicle available to RRSP holders who transfer some or all RRSP fund to a RRIF. A RRIF holder must make minimum, annual taxable withdrawals based on a formula related to age; there is no maximum withdrawal.

• Deferred Annuities • An annuity is an investment contract in which a holder deposits money to be

invested in an interest-bearing vehicle. Payments are composed of interest and a portion of original capital.

• Deferred annuities start payments at a date in the future chosen by the investor, while immediate annuities begin payments immediately.

• Tax-Free Savings Accounts (TFSA) • Income earned within a TFSA will not be taxed in any way throughout an

individual’s lifetime. There are no restrictions on the timing or amount of withdrawals from a TFSA, and the money withdrawn can be used for any purpose.

• Contributions to a TFSA are limited to $5,000 a year. After 2009, that amount will be indexed to inflation and rounded to the nearest $500. Withdrawals can be made from a TFSA at any time.

• Registered Education Savings Plans (RESPs) • Registered education savings plans (RESPs) are tax-deferred savings plans intended

to help pay for the post-secondary education of a beneficiary. Contributions are not deductible but income accumulates in the plan on a tax-deferred basis.

• Contribution amounts to RESPs are subject to legislated maximums. The government matches a certain portion of eligible contributions (the Canadian Education Savings Grant [CEGS]).

• Pooled Registered Pension Plans (PRPPs) • Pooled registered pension plans (PRPP) are tax-deferred savings plans that the

government plans to implement sometime in 2013. • PRPPs are designed to fill the gap in employer pension plan coverage by providing

Canadians with an accessible, large-scale and low-cost pension plan. PRPPs hold assets pooled together from multiple participating employers, allowing workers to take advantage of lower investment management costs that result from membership in a large pooled pension plan.

• Tax Planning Strategies • Income splitting involves transferring income from a highly taxed family member to a

spouse, child, or parent who is in a lower tax bracket. Attribution rules may be triggered. • Transferring income to family members can trigger what are called attribution rules. • Paying expenses: the higher-income spouse should first pay all family expenses while the

lower-income spouse invests as much of his/her income as practical. • Making loans: when an investment can be expected to generate earnings in excess of the

interest, it is often worthwhile for the higher-income family member to loan funds, at the appropriate interest rate, to the lower-income family member.

• Discharging debts • Gifting to children or parents

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Chapter 26 Working With Retail Client

• Financial Planning • The financial planning approach means assessing clients’ current financial and personal

situation, constraints, goals and objectives and making recommendations through a financial plan to achieve these goals and objectives. • Gathering information properly fulfils legal requirements and allows an advisor to

plan effectively for the client. • Effective communication establishes a relationship, builds trust, and allows an

advisor to stay current with the client’s situation. • Educating a client helps to establish clear objectives, expectations, and

understanding of the client’s investment situation and risk tolerance. • Objectives that must ben considered

• must be achievable • must accommodate changes in lifestyle and income level • should not be intimating • should provide for not only the necessities but also some luxuries or rewards

• Financial Planning Process • Establishing the Client-Advisor relationship • Collecting data and information • Analyzing data and information • Recommending strategies to meet goals • Implementing recommendations • Conducting a periodic review or follow-up

• Life Cycle Hypothesis • Life cycle hypothesis states that the risk-return relationship of a portfolio changes

because clients have different needs at different points in their lives. • It is assumed that younger clients can take on more risk in the pursuit of higher

returns and that the risk-return relationship reverses as clients’ age. • Four Definable Stages In a Person’s Adult Life

• Early earning years - to age 35: the client is starting a career, building net worth and assuming family and home ownership responsibilities. Growth is usually the primary objective because of the magnitude and duration of expected future earnings.

• Mid-earning years - age 35 to 55: in this stage an individual’s expenses usually decline and income and savings usually increase. Because such clients have more discretionary income, investment objectives tend to focus on growth and tax minimization.

• Peak earning years - age 55 to retirement: as a client approaches retirement, preservation of capital becomes an increasingly important objective.

• Retirement years: the primary investment objectives of retired clients are preservation of capital and income.

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• The Code of Ethics • Registration must use proper care and exercise independent professional judgement; • Registration must conduct themselves with trustworthiness and integrity, and act in an

honest and fair manner in all dealings with the public, clients, employers and colleagues.

• Registration must, and should encourage others to, conduct business in a professional manner that will reflect positively on themselves, their firms and their profession, and registrants should strive to maintain and improve their professional knowledge and that of others in the profession.

• Registrants must act in accordance with the securities act(s) of the province(s) in which registration is held and must observe the requirements of all self-regulatory organizations (SROs) of which the firm is a member.

• Registrants must hold clients information in the strictest confidence.

• Standards of Conduct • Duty of care: know your client, due diligence, unsolicited orders. • Trustworthiness, honesty and fairness: priority of client interests, protection of client

assets, complete and accurate information, disclosure. • Professionalism: client business, personal business, continuous education. • Conduct in accordance with securities acts: compliance with securities acts and SRO

rules, inside information. • Confidentiality: client information, use of confidential information.

Chapter 27 Working With Institutional Client

• The Sell-Side & Buy-Side of The Market • The investment industry generally consists of the sell side and the buy side. • The Sell Side

• The term sell side refers to dealers in the business of selling securities and other services to investors.

• The term stems from the role that dealers play in selling investment ideas, research and advice, trade execution, corporate finance services and securities (both new and existing). Examples of sell-side firms include investment dealers, mutual fund dealers and exempt market dealers.

• The Buy Side • The term buy side refers to investors, both institutional and retail. • A buy-side firm refers to institutional investors. The term stems from the role

that institutional firms play in the buying of new-issue securities. An institutional client is a legal entity that represents the collective financial interests of a large group. A mutual fund, insurance company, pension fund and corporate treasury are examples.

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• Buy-Side Portfolio Manager & Trader • The Buy-Side Portfolio Manager

• The role of the buy-side portfolio manager includes creating the investment mandate and investment goals, developing and executing the portfolio strategy, supervising the portfolio management staff.

• The portfolio manager is responsible for all aspects of the effective and prudent regulatory compliant management of the portfolios, and is therefore ultimately responsible for their performance.

• The Buy-Side Trader’s primary role is to execute the portfolio manager’s trades at the best prices at the time of trade.

• Selecting a sell-side dealer is often based on an existing relationship with a trader or salesperson, the dealer’s execution speed and efficiency, the dealer’s block trading capabilities, the products the dealer is able to provide, the quality of the dealer’s research and the dealer’s access to industry experts.

• A Sell-Side Trading Firm • The Organizational Structure

• The back office functions include operations and information technology. • The middle office functions include risk management, legal and compliance and

corporate treasury. • The front office functions include sales and trading, corporate and government

finance, mergers and acquisitions, corporate and merchant banking, securities services and research.

• The functions specific to a typical sell-side equity trading firm include equity trading services, program trading, structured finance as well as futures and options services, securities lending, and research.

• The Revenue Sources • Best Execution

• The Universal Market Integrity Rules (UMIR) are a common set of equities trading rules designed to ensure fairness and maintain investor confidence. These rules create the framework for the integrity of trading activity on market place.

• Best execution requires participants to diligently pursue the execution of each client order on the most advantageous execution terms that are reasonably available.

• Revenue Sources of a Sell-Side Equity Trading Desk • Trading revenue from spreads: secondary equity market trading is structured

around providing continuous simultaneous bid-and-ask prices for individual equities. The difference between these two prices is commonly referred to as the equity’s bid-ask or pice spread.

• Commissions: when the dealer acts in the capacity of an agent in a client in a client’s equity trade, the dealer;s compensation for facilitating the trade is in the form of a commission.

• Fees: The dealer earns fee revenue when it performs equity underwriting, both for IPO and secondary offerings.

• Interest: interest income is a function of the amount and type of margin account balances it offers its institutional clients.

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• Revenue Sources of a Sell-Side Fixed-Income Trading Desk • Profits from trading: trading revenue is generated by the moment-to-moment

market movements and their effect on the net value of a trade’s inventory. • Sales revenue generated through transactions with clients: profit derives

from the difference between the trader;s price for a security and the price at which the client is willing to accept and execute the trade.

• origination or underwriting revenue: origination is the process of bringing new debt issues to market. The dealer works with a government or corporation that is issuing the debt to market the new debt issue. The dealer then buys a portion of the debt from the issuing company at a small discount from the new issue offer price and sells it to clients at the new issue offer price.

• A soft-dollar arrangement refers to a client purchasing services via commission dollars rather than the receipt of an invoice that requires cash payment.

• Institutional Clearing & Settlement • Clearing is the process of confirming and matching security trade details. Settlement is

the moment of irrevocable exchange of cash and securities. • The Settlement Process

• The typical institution trade involves (at least) the portfolio manager, the dealer and a custodian.

• Institutional equity trade clearing requires 26 trade-matching elements must be confirmed. Matching a transaction requires that both sides of the trade agree to the terms and that the custodian verifies the availability of the required funds and securities.

• Challenges with institutional trade processing include inadequate technology, notices of execution or allocation are missing or late, and incorrect trade data elements.

• Straight-through processing (STP) is a system designed to avoid human errors associated with security trading, settlement and record keeping activities. Straight-through processing is becoming an increasingly important component of many buy-side firms through which institutional trades are executed.

• Suitability Requirements for Institutional Clients • When dealing with an institutional client, a dealer must determine the level of

suitability owed to that client. • Most institutional clients are sophisticated and make their own investment decisions.

However, not all institutional clients are sophisticated and the ability to make an independent investment decision can vary from product to product.

• Where a dealer has reasonable grounds for concluding that the institutional client is capable of making an independent investment decision and independently evaluating the investment risk, then a dealer’s suitability obligation is fulfilled for that transaction.

• Participants in The Institutional Marketplace • The institutional salesperson is the client relationship manager, the conduit between

the customer’s needs and the dealer. The salesperson markets the dealer’s analysts, takes management teams for presentations to clients, takes clients to site visits or entertains clients.

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• Agency traders manage trades for institutional clients. They do not trade the dealer member;s capital, and they trade only when acting on behalf of clients. Agency traders must manage institutional orders with minimal market impact and act as the client’s eyes and ears for relevant market intelligence.

• Liability traders have the responsibility to manage the dealer’s trading capital to encourage market flows and facilitate the client orders that go into the market, while aiming to lose as little of that capital as possible. Liability traders can be considered those who set the direction for agency traders. Whereas agency traders have formal client responsibilities, liability traders have lighter responsibilities or non at all.

• Market markers specialize in providing a constant two-sided market for equities under their responsibility. They do so at an agreed-upon spread, and in compliance with all equity exchange rules and regulations. Market markers have revenue targets to meet that are set by the dealer.

• Buy-Side Portfolio Manager Investment Styles • Fixed-Income Styles

• Passive bond management styles • Buy-and-hold: purchasing bonds with available funds and holding each

bond to its maturity, thereby avoiding the interest rate risk on any early sale. • Indexing: the intent to create a portfolio that mirrors the performance of a

bond index. • Immunization: a means of protecting the bond portfolio from interest rate

risk by purchasing bonds that provide a defined return at a specific period of time, and is therefore immune to outside influences.

• Active bond management styles • Interest rate anticipation move funds from one end of the yield curve to

the other. • Bond swaps normally involve the purchase of one bond and the simultaneous

sale of another related or unrelated bond. • Equity Styles

• Passive equity management styles • Buy-and-hold: stocks are purchased and held for a long period of time

until they need to be sold. • Indexing mimics the performance of a specific market by replicating an

index, holding each stock within the fund portfolio in exact proportion to its weighting within the index, or holding a subset of the benchmark that faithfully mimics the index.

• Active equity management styles • Sector rotation is a top-down attempt to pick the best sectors by

identifying specific sectors that will offer expected superior performance. • Market timing: timing the general ups and downs of the market is

premised on forecasts of protected increases or decreases in the market. • Value-oriented: the bottom-up value-oriented manager looks for undervalued

securities, with little focus on overall economic and market conditions and is usually prepared to wait many years in order to recognize the stock’s full value.

• Growth-oriented: the bottom-up growth oriented manager choose stocks with superior earnings growth rates relative to the market in general.

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• Market capitalization: the so-called size effect has spawned a style that focuses on the size of the company as measured by market capitalization.

• Buy-side portfolio managers are usually very willing to share their guidelines and investment restrictions with sell-side sales staff to facilitate a more productive relationship.

• Algorithmic Trading • Algorithmic trading is used by institutional investors to aid in executing large block

trading. Algorithmic trading involves the use of sophisticated mathematical algorithms to disguise the true size and extent of the total order and therefore reduce the price movement that would ordinarily occur.

• High frequency trading (HFT) is a type of algorithmic trading characterized by a very large number of orders in very small trade sizes at very high speed. The goal of HFT is to profit from very small price imbalances in the market.

• A dark pool is a marketplace that does NOT offer pre-trade transparency on any trade orders. Dark pools allow institutional investors to trade large blocks of equities with our affecting the market price.

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