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Securities Industry EssentialsLive Virtual Review

[email protected] sheet on site – www.bullbeartraining.com

Password: seriessie

About the SIE

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Passing Score 70%

Number of questions 75, plus 10 “experimental” questions

Time Allowed 105 minutes

Format• Multiple choice• Including Except, Least, and Most Questions

Prometric will provide you with

• Paper & pencil• Calculator

SIE Content Outline

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Knowledge of Capital Markets

• 12 Questions, 16% of the Exam

Understanding Products and Their Risks


Understanding Trading, Customer Accounts and Prohibited Activities


Overview of Regulatory Framework


ChaptersModule I• Equity• Debt• Packaged Products• Trading MarketsModule II• Options• Customer Accounts• Retirement PlansModule III • New Issues• Regulations• Analysis

Questions Per ChapterNumber of Questions515105

51010

5155

APPROXIMATE NUMBER OF TESTQUESTIONS PER CHAPTER

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SIE Types of Debt 5

*Long Call Bull

Long Put Bear

Short Put Bull

Short Call Bear

*Repurchase Agreement

• Fed BUYS US Govts• Inject $ into $ supply• Loosening Credit• Interest Rates Go Down• Prices Go Up

*Reverse Repo• Exact Opposite

Corp VS Govt VS Agency VS

Muni

EXEMPT• Sec Act of ’33• Trust Indenture

Act of ‘39

Non-exempt

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EQUITIES

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COMMON STOCK

Common Stock

• Each share represents a proportionate ownership in the company.

• Par value is arbitrary and has no bearing on market value

• Market value (the current market price) is based on future expectations of the company (earnings)

• All corporations issue common stock Shares are in Book Entry form

• Common shareholders have the following rights:

Vote for the board of directors

Inspect books and records

Transfer their ownership

Maintain their proportionate interest

Receive dividends if declared by the BOD

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Corporate CharterAuthorized stock

• # of shares a corporation can issue in its lifetime (very inflated)

Issued stock

• # of shares issued in the market

Treasury stock

• # of shares the corporation holds in inventory• No voting rights/no dividend

Outstanding shares

• Issued stock – treasury stock • Number of shares trading actively in the secondary market

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Voting

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Items Requiring a Shareholder Vote Items That Do Not Require a Shareholder Vote

• Declare a stock split

• Declare a reverse stock split

• Issue convertible bonds or convertible preferred stocks

• Issue stock options to officers on a preferential basis

• Declare a cash dividend

• Declare a stock dividend

• Declare a rights distribution

• Repurchase shares for its treasury

Voting

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StatutoryVoting

• 1 vote per 1 share per directorship

Cumulative Voting

• # of shares x # of directorships to be chosen• Considered advantageous for the smaller investor

Proxies• Absentee ballot• B/Ds cannot charge shareholders for mailing proxies

11 12

PREFERRED STOCK

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Preferred Stock

• Senior security

• Preference over common stockoDividendsoBankruptcy

• Par value = $100

• Fixed dividendoDividend stated as an annual percentage of par value

• No voting rights

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Preferred Stock - Interest Rate Movements and Preferred Stock Prices

• Price is influenced by interest rates (not earnings)

• The relationship between interest rates and the price of existing preferred is inverse.

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Interest Rates

Interest Rates

Prices

Prices

Common Stock• Par Value – Arbitrary, set low, no relation to the actual value

• Dividend‐ declared and set by BOD varies, max tax 15%

• Corp. dividend exclusion Yes• Div. usually quarterly, paid after preferred

• Last in line at liquidation• Not convertible• Price driven by expectations of corporation future performance

• Pre‐emptive & voting rights Yes• Perpetual life no maturity date• Holders are part owners of corp.

Preferred Stock• Par Value‐ Generally $100 or $50 set at issuance

• Dividend – based on % of par set at issuance, max tax 15%

• Corp. dividend exclusion Yes• Div. Usually semi annual paid before common

• Next to last in liquidation• Maybe convertible to common• Price driven by interest rate changes

• Pre‐emptive & voting rights No• Perpetual life no maturity date• Holders are part owners of corp.

Comparison Common vs Preferred

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Preferred Stock Features

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Cumulative• Omitted dividend payments accumulate• All accumulated dividends must be paid before

common stock receives a dividend distribution

Callable• Issuer can call in the stock after a fixed date• Period of call protection• Called at a specific price

Cumulative Preferred Stock Example

ABC Corporation has issued a 6% cumulative preferred stock. In year 1 the preferred stock investor received $4 per share in dividend. In year 2 the investor received $5 in dividend and in year 3 he received $6 per dividend.

How much should ABC corporation pay to the cumulative preferred stockholders per share before the corporation can pay a dividend out to common stock in the 4th year?

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They want to pay out a common dividend, they must pay the preferred stock how much?

Year Paid out Owe?

Year 1

Year 2

Year 3

Year 4

$4 $2

$5 $1

$6 -

$6 + $3 = $9

Additional Potential Preferred stock features

Convertible

• Stock can be converted to common stock

• The conversion price is fixed at issuance

Participating

• Fixed dividend, can participate in any “extra” dividend declared by the Board of Directors

• Dividend is set to a minimum not a maximum

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SPECIAL SECURITIES

Rights

• Issued in conjunction with a corporation issuing additional shares

• Short term usu. 90 days

• Given to existing shareholders to preserve % of ownership

• Issued with intrinsic value

• No time value

Warrants

• Attached to some new bond and preferred issues

• Long term usu. 5‐years

• Added as a sweetener for fixed income securities

• Issued with time value

• No intrinsic value

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Comparison Rights vs Warrants

American Depository Receipts

• Vehicle for trading foreign securities in the U.S. market

• US banks purchase and hold the foreign security in the foreign country then issue and register receipts in the US that represent shares in that security

• Holder has right to receive dividends if declared oDeclared in foreign currencyoPaid out in U.S. Dollars

• No voting rights

• Subject to currency risk

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Equity Trading

• Trade in the secondary marketo Exchange or OTC

• Regular way settlemento Trade date + 2 business days

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DEBT INSTRUMENTS

SIE Types of Debt 24

Actual day / Actual month

T + 1ExemptSubjectU.S. Gov’t•Cash Mngmt Bills

•T-Bills

•T-Notes

•T-Bonds•TIPS•T-STRIPS

Accrued Interest

State TaxFed. Tax

Reg. Way

Settlement

Tax Status of the Interest Rec’d

Type of Debt

1 YR

10 YRS

30 YRS

T-Receipts = Non-exempt

; non-callable

; (could be) callable

protects against inflation;

zero-coupon

a.k.a. purchasing power risk

several days up to 6 months

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Types of Debt 25

30 / 360Varies / not tested

ExemptSubjectGov’t Agency

•Fed. Home Loan Banks

•Banks for Cooperatives

•Fed. Inter. Credit Banks

•Fed. Land Banks

Accrued Interest

State TaxFed. Tax

Reg. Way

Settlement


Type of Debt

Farmer Loans


30 / 360Varies / not tested

SubjectSubjectPrivatized Gov’t Agency

•Fed. Nat’l Mtg. Assn. (FNMA)

•Fed. Home Loan Mtg. Corp. (FHLMC)

•Gov’t Nat’l Mtg. Assn. (GNMA)

Accrued Interest

State TaxFed. Tax

Reg. Way

Settlement


Type of Debt

Issue Pass Through Certificates =

$25K Par

CMOs created by brokerage firms = non-exempt

= $1K par

Exempt


30 / 360T + 2SubjectSubjectCorporateSecured

• Mortgage Bonds

• Equipment Trust Certificates

• Collateral Trust Certificates

Unsecured•Debentures

–Convertibles

•Income / Adjustment Bonds

•Commercial Paper

Accrued Interest

State TaxFed. Tax

Reg. Way

Settlement


Type of Debt

= max maturity = 270 days= most common maturity = 30 days

= trade flat – w/o accrued interest

backed by real estate

backed by machinery/equipment

backed by securities

Three Gov’t Bonds Trade Flat

Cash Mgmt BillsT-BillsT-STRIPS

Issued by transports; common carriers


30 / 360T + 2Subject, BUT:

•If bought by state resident,

EXEMPT

•If issue is a territory,

EXEMPT

ExemptMunicipal•G.O.

•Revenue•Capital Appreciation Bond

•Special Tax

•Special Assessment

•Moral Obligation•Certificate of Participation

•Double Barreled

•Industrial Revenue*

•Build America*

Accrued Interest

State TaxFed. Tax

Reg. Way

Settlement


Type of Debt

1969 - Nixon - Rep. - $200K earned income – no taxes - AMT1975 - Ford - Rep. - NYC $1billion default1986 - Reagan- Rep. - $250K earned income – no taxes

Income

Earned Portfolio Passive

* Interest is federally taxable

$100K+ -$20K loss

Real EstateD.P.P.s

-$20K loss-$3K

$97K tax on-$17K loss carryover

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BOND BASICS

Bond Basics

• A bond is a debt instrument✔The purchaser of the bond is loaning $ to the issuer of the bond

✔The issuer has a legal obligation to repay the debt at maturity and to pay interest on the loan.

✔The interest due is stated as a percentage of par value aka: face value ($1000)

✔Interest is typically paid semi‐annual (½ the annual payment every 6 months

✔The stated rate on the bond is also known as the:

o Fixed Rate because it does not change once when the bond is issued

o Coupon Rate because bond used to have coupons attached which were submitted to the paying agent for payment of the interest due

o Nominal Rate‐ bonds are often referred to by their interest rate

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Typical Bond Example

• $1000 par bond with a 10% coupon rate✔Annual interest 10% of $1000 = $100 per year in interest✔Interest paid semi‐annually = $50 every six months✔At maturity, the final interest payment and payment of principal=

$50+$1000 par= $1050

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Zero Coupon Bonds

• Issued at a discount to par value

• No stated coupon

• Mature at par valueo Bond is issued a discount to par, every year the cost basis is

accreted upward (cost basis is adjusted upward) for phantom income

o Phantom income is taxable in the year it is added to the cost basis

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Debt 33

1 zero coupon, $1,000 par, purchased at $200 with 10 years to maturity

•how much will the bond's accreted value be after the first year?•what is the amount of interest that would be taxed?

1 zero coupon, $1,000 par, purchased at $800 with 5 years to maturity

•how much will the bond's accreted value be after the first year?•what is the amount of interest that would be taxed?

$280

$80

$840$40

$800 / 10 years = $80 a year

$200 / 5 years = $40 a year

10 Yrs

$200 $1,000

$800 / 10 = $80 annual

1st

$2802nd $360

5 Yrs

$800 $1,000

$200 / 5 = $40 annual

1st

$8402nd $880

BOND ISSUE STRUCTURE

TERM BONDS

All the bonds are issued on the same date and they mature on the same date – so all bonds in the issue have the same “term.”

❑Every bond has same interest rate and maturity

oQuoted on a percentage of par basis, meaning on a dollar price basis

oTypically used by Corporations and the U.S. Government and Muni Revenue Bonds

oFor municipals, also called “dollar bonds”

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BOND ISSUE STRUCTURE

SERIAL BONDS

oAll the bonds are issued on the same date, but they mature in even amounts over a sequence of years❑Differing maturities will require different interest rates

oMost municipal G.O. bonds and corporate equipment trust certificates are serial bonds

oQuoted on a yield basis, and the longer the maturity, the greater the yield

oCan have a “balloon maturity” where a large amount of bonds mature in the final year

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Bond Price Quotes: Treasury Securities

EXAMPLE:

• Quoted as a percentage of par in 32nds

oCustomer buys from dealer at “Ask”

oCustomer sells to dealer at “Bid”

• Most active trading market, with narrow Bid‐Ask spreads

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Bond Price Quotes: Treasury Securities

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EXAMPLE:

• A customer wants to sell the Jan ‘19 Note

• The customer will receive 99:24

• 99 24/32 = 99.75% x $1,000 = $997.50

EXAMPLE:

• Quoted as a percentage of par in 1/8ths

• Less active trading market than Gov'ts, therefore bid‐ask spreads are wider

• Municipal term bonds are often called "dollar" bonds because they are quoted on a dollar price basis

Bond Price Quotes: Corporate and Municipal Bonds

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Bond Price Quotes: Corporate and Municipal Bonds

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EXAMPLE:

• The ANR 8 5/8 bond maturing in 2019 is quoted at 96 1/8

• 96.125 x $1,000 = $961.25

Bond Price Quotes: Value of a Point Movement

• 1 Point On A Bond = 1% of $1,000 Par = $10

o Therefore A Change In Price Of 1 Point = $10

o EXAMPLE: 10% Coupon; $1,000 Par Bond; Quoted At 94 = Price = $940

o The Dealer Raises The Price one point To 95 = Price = $950

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Bond Price Quotes: Value of Bid / Ask Spread

• Dealer Is Willing To Buy At The Bid And Sell At The Ask

o 90:16 Bid = 90 16/32 = 90.50 = $905.00

o 90:24 Ask = 90 24/32 = 90.75 = $907.50

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Bond Price Quotes: Municipal Serial Bond

Basis Quotes

•Quoted on yield basis oA single issue can have 20‐30 different “serial” maturities

oEach maturity represents a different amount of interest received and a different principal repayment date

• Each maturity would have a separate dollar price, so it is much easier quoting these in terms of yield

• Examples:

oA dealer quotes a 10‐year, 6% bond on a 6.50 basis. This bond is trading at a discountoA dealer quotes a 10‐year, 6% bond on a 5.50 basis. This bond is trading at a premium

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Bond Price Quotes: Basis Points

• Basis point

o Minimum increment in expressing the terms of an interest rate

• VALUE OF A BASIS POINT MOVEMENT

o A Change Of .01% = 1 Basis Point = $.10

o A Change Of .10% = 10 Basis Points = $1.00

o A Change Of 1% = 100 Basis Points = $10.00

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Bond Yields

• Nominal Yield (NY, coupon, or coupon rate)o Fixed at issuanceo Based on an annual percentage of par valueo Paid out semiannuallyo NY is fixed at issuance (never changes)

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Bond Yields

• Current Yield (CY)

o Considers the market price for the bondo CY = annual interest income/ bond’s market price

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Bond Yields

• Yield to Maturity (TYM or basis)Takes into consideration:

o Market price for the bondo Capital gains or losses if bond is held to maturityo Reinvestment the coupon into a similar bond in the market

with a similar coupono Time value of money o (assumption)

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Bond See-Saw: Par Bond

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Price$1,000 YTMNY CY

Bond See-Saw: Discount Bond

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Price of the bond$800

YTM

NY

CY

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Bond See-Saw: Premium Bond

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Price of the bond$1100

YTM

NY

CY

SIE Debt 50

EFFECTS OF INTEREST RATE MOVEMENTS ON BOND PRICES

• DISCOUNT BOND

• PREMIUM BOND

• PAR BOND

SIE Debt 51

BOND YIELDS• NOMINAL YIELD = stated

rate of interest (the coupon)

• CURRENT YIELD

• YIELD TO MATURITY = takes into account both market price and gains/losses if held to maturity

• YIELD TO CALL/PUT = takes into account both market price and the price at which the bond is called (or put)

SIE Debt 52

Discount $800

$1,000 Par, 10 %, w/ 10 years to maturity

Interest rates going up

SIE Debt 53

Discount $800



Current Yield = 12.5%


SIE Debt 54

Discount $800



Yield to Maturity = 13.3%

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SIE Debt 55

+20

+20

+20

+200 over 10 years

SIE Debt 56

Discount $800





Yield to Call = 15.5%

SIE Debt 57

+40

+40

+40

+200 over 5 years

SIE Debt 58

Discount $800






YtC > YtM > CY > NY = Discount BondYtC < YtM < CY < NY = Premium Bond

SIE Debt 59

Premium $1,200


Interest rates going down

SIE Debt 60

Premium $1,200




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SIE Debt 61

Premium $1,200





SIE Debt 62

-20-20

-20 -200 over 10 years

SIE Debt 63

Premium $1,200





Yield to Call = 5.5%← Bond must be priced here

SIE Debt 64

-40

-40

-40

-200 over 5 years

SIE Debt 65

Premium $1,200





YTC < YTM < CY < Coupon for a premium bond


SIE Debt 66

Premium $1,200





Yield to Maturity = 13.3% ← Bond must be priced here


Discount $800

interest rates


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SIE Debt 67

A corporation has issued 10% AA rated sinking fund debentures at par. Three years later, similar issues are being offered in the primary market at 12%. Which are true statements about the outstanding 10% issue?

I The current yield will be higher than the nominal yieldII The current yield will be lower than the nominal yieldIII The dollar price of the bond will be at a premium to parIV The dollar price of the bond will be at a discount to par

A. I and IIIB. I and IVC. II and IIID. II and IV

Discount

$1,000 Par

Current Yield

Yield to Maturity

Yield to Call

YTC > YTM > CY > NY

SIE Debt 68

When the price of a bond increases, which of the following statements regarding yields are true?

I Current yield increasesII Current yield decreasesIII Yield to maturity increasesIV Yield to maturity decreases

A. I and IIIB. I and IVC. II and IIID. II and IV Premium

$1,000 Par

Current Yield

Yield to Maturity

Yield to Call <- Bond must be priced here

YTC < YTM < CY < NY

Premium

$1,000 Par

Current Yield

Yield to Maturity

Yield to Call <- Bond must be priced here

YTC < YTM < CY < NY

SIE Debt 69

A customer buys 5 GMAC 10% debentures, M‘51. The interest payment dates are Feb 1 and Aug 1. The bonds are callable as of 2031 at 103. The current yield on the bonds is 11.76%. The bond is trading:

A. at a premiumB. at a discountC. at parD. in the money

SIE Debt 71

A premium bond must be quoted to a customer based on the bond’s:

A. Nominal Yield

B. Current Yield

C. Yield to Maturity

D. Yield to Call

SIE Debt 72

A discount bond must be quoted to a customer based on the bond’s:

A. Nominal Yield

B. Current Yield

C. Yield to Maturity

D. Yield to Call

Approximating the Price of a Long Term Bond

• by using the current yield formula, one can get an approximate price of a long term bond issue

• note, that Current Yield = Annual Income

Market Price

• thus, to solve for Market Price = Annual Income

(Current) Yield

SIE Debt 77

$800 $1,200

• approximating a 4%, $1,000 par bond trading on a 5% basis

• approximating a 6%, $1,000 par bond trading on a 5% basis40 =

.0560 =.05

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Practice Question

A 5% ABC bond is being traded on a 5 basis. What is the relative price for the bond?

a) Par

b)Discount

c) Premium

d)Cannot determine with information provided

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Practice Question

A 6% ABC bond is being traded on a 6.7 basis. What is the relative price for the bond?

a) Par

b)Discount

c) Premium

d)Cannot determine with information provided

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Practice Question

A 9% ABC bond is being traded on a 5.7 basis. What is the relative price for the bond?

a) Par

b)Discount

c) Premium

d) Cannot determine with information provided

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Call and Put Features on Bonds

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Call Feature Put Feature

• Issuer has the right to “call in” the bond early

• Call protectiono Traditionally 10 years

• Bonds are traditionally called in when interest rates go down

• Holder has the right to “put” or sell the bond back to the issuer

• Given to holders when interest rates are low

• Put feature used when interest rates in the market are high

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BOND RISKS

Bond Risks: Credit Risk

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Also called default risk

01

Two main credit rating agencies:• Moody’s• S&P

03

Risk that the issuer will miss interest and/or principal payments

02

Third credit rating – know by name only: Fitch’s

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SIE Debt 84

S&P Moody's

AAA Aaa

AA Aa

A A

BBB Baa

BB Ba

B B

CCC Caa

CC Ca

C C

Investment

Grade

Speculative

Grade

SIE Debt 85

essentially the top 2 are investment grade

SG ("Speculative Grade")

NP ("Not Prime")

MIG3P3

MIG2P2

MIG1P1

Municipal Short Term Note Ratings

Commercial Paper Ratings

SIE Debt 86

What is the highest investment grade?

A. AAA+B. AAAC. AAD. A

SIE Debt 87

A bond is rated BBB by Standard and Poors. The bond is:

A. Highest Quality Investment GradeB. High Quality Investment GradeC. Lowest Quality Investment GradeD. Highest Level Speculative Grade

SIE Debt 88

The lowest investment grade rating is:

A. BaaB. BaC. CCCD. C

SIE Debt 89

At which rating is a bond first considered to be speculative?


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SIE Debt 90

Below which rating is a bond first considered to be speculative?


SIE Debt 91

Which of the following ratings applies to commercial paper?

A. MIG1B. P3C. BbD. A+

Bond Risks: Interest Rate Risk

92

Risk that rising interest rates will cause existing bond prices to fall• Interest rate risk is greatest for long

maturity bonds and low coupon bonds

Inverse relationship• Interest rates go up existing bond

prices go down• Interest rates go down existing bond

prices go up

Bond Risks

93

Risk that the bond will be difficult to sell• Not an issue for Governments• A little bit of an issue for corporates• A huge issue for municipals

• Inflation Risk• Risk that rising inflation will raise

interest rates, which will lower value of bond

PurchasingPower

Marketability

Bond Risks

94

• Risk that the new tax laws reduce value of security

• Big issue for municipal bonds

• Risk that security can only be sold by incurring large transaction costs

• Longer the term, the lower the quality, the lesser the liquidity

Liquidity

LegislativeRisk

Bond Risks

95

• Risk of holding long term bonds that make semi-annual interest payments.

• Investors can avoid this risk by investing in zero coupon bonds

• Risk that bonds are called because market interest rates have dropped

• Proceeds reinvested at current lower market rates, and any call premium received does not compensate for this

Call Risk

ReinvestmentRisk

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Bond Risks

96

• Risk of investing in 3rd world foreign countries that have weak political/legal systems

• The risk that the U.S. $ strengthens compared to the foreign currency in which the bond is denominated.

• When the bond’s value is converted to U.S. $, it “buys” fewer $ because the U.S. currency is more expensive

o so the bond price declines

Exchange Rate Risk

PoliticalRisk

SIE Debt 97

Purchasing power risk is the risk that:

A. the issuing corporation will defaultB. the security will be difficult to sellC. the security will be called prior to it maturingD. inflation will reduce the value of future

interest payments

SIE Debt 98

U.S. Treasury securities are subject to which of the following risks?

A. default riskB. marketability riskC. purchasing power riskD. credit risk

SIE Debt 99

Which of the following securities is the safest and has the lowest level of credit risk?

A. Equipment Trust CertificateB. General Obligation BondC. Industrial Revenue BondD. Treasury Bond

SIE Debt 100

A risk that rising interest rates will cause bond prices to fall is:

A. Credit riskB. Purchasing Power riskC. Legislative riskD. Interest Rate risk

SIE Debt 101

Securities subject to reinvestment risk are those that:

I make periodic payments to investorsII do not make periodic payments to investorsIII are held for short time horizonsIV are held for long time horizons


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SIE Debt 102

Which of the following investments has the lowest level of reinvestment risk?

A. Preferred StockB. Municipal BondC. Collateralized Mortgage ObligationD. Treasury Bill

103

CORPORATE DEBT

Corporate Bonds

• Corporations issue debt in order to raise capital without diluting common stockholders’ equity

• Bonds are issued in book entry form

• Corporations can issue secured or unsecured debt

✔Secured debt – backed by specific assets

✔Unsecured debt – backed by the full faith and credit of the issuer also known as a Debenture

104

Corporate Bonds: Secured Debt

105

Mortgage Bonds

• Backed by physical property owned by the issuer

Equipment Trust Certificates

• Backed by equipment owned by the corporationo Planes, buses, trucks

Collateral Trust Certificates

• Issued by a subsidiary• Backed by the parent company’s stock

Corporate Debt: Commercial Paper

• Maturity range ✔14 days to 90 days – 30 days most common

✔Maturity cannot exceed 270 days in order to remain exempt from SEC registration

• Issued at a discount

• Matures at face value

• Book entry

• Limited trading

106

Corporate Bonds: Unsecured Debt

Debenture (unsecured bond)

•Backed by the full faith and credit of the issuer•No collateral backing debt•Higher credit risk when compared to secured bonds of same quality

Subordinate Debenture

•Debt holders agree to lower status in the event of bankruptcy•Can have a convertible feature to attract investors

107

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Corporate Bonds: Unsecured Debt

Guarantee Bonds

•Backed by the full faith and credit of the issuer’s parent company

•NOT backed by assets of parent company

Income Bonds

• “Adjustment bonds”

•Higher risk, traditionally issued by companies that have declared or are declaring bankruptcy

• Trade flat

108

Corporate Bonds: Convertible Bonds

• Can be converted at the option of the holder into common stock

• At the time of issuance, the conversion price is set per share at a premium to the current market price of the stock

• Bond can be converted into a fixed number of common shares based on par value

109


Trader buys the lower priced security and simultaneously sells equivalent higher priced security to lock in profit Convertible Arbitrage

For example, a bond convertible into 20 shares of stock is selling in the market for $1,000 while the common stock is selling at $51.

• A trader seeing this could simultaneously:

✔Buy 1 bond at $1,000 and

✔Borrow and sell 20 shares of stock at $51 for $1,020, locking in a $20 profit.

✔Then the bond is tendered for conversion and the 20 shares received are used to replace the borrowed shares

110 SIE Debt 111

CONVERTIBLE CORPORATE DEBT (cont.)

Conversion Ratio =Par Value

Conversion Price

Conversion Ratio =Bond' s Market / Parity Price

Stock' s Market / Parity Price


Conversion Example:

• EXAMPLE: A 10%, $1,000 Par Convertible Bond Is Issued When The Market Price Of The Common Stock Is $40 Per Share. The Conversion Price Per Share Is Set At $50 Per Share.

• What is the Conversion Ratio Is?

112

1,000 = C.R.

C.P.

1,000 = C.R.

$50

1,000 = 20:1

$50


Conversion Example:

• EXAMPLE: A 10%, $1,000 Par Convertible Bond Is Issued When The Market Price Of The Common Stock Is $40 Per Share. The bond is convertible into 25 shares of stock.

• What is the Conversion Price Is?

113

1,000 = C.R.

C.P.

1,000 = 25:1

C.P.

1,000 = $40

25

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Corporate Bonds: Convertible BondsBond Parity Price = Conversion Ratio x Stock’s Market Price

• EXAMPLE: A 10%, $1,000 Par Convertible Bond Is Issued When The Market Price Of The Common Stock Is $40 Per Share. The Conversion Price Per Share Is Set At $50 Per Share. Currently The Market Price Of The Stock Is $60 Per Share.

• The Parity Price Of The Bond Is?

114

Bond’s Parity = C.R.

Stock’s Parity

Bond’s Parity = 20

$60

1,000 = C.R.

C.P.

1,000 = C.R.

$50

1,000 = 20:1

$50

$1,200 = 20

$60

SIE Debt 115

A customer bought a $1,000 par convertible subordinated debenture at par, convertible into common at $25 per share. If the bond's market price increases by 20%, the parity price of the stock will be:

A. 25B. 30C. 40D. 48

1000 = C.R. ; 1000 = 40:1

C.P. $25

1200 = 40 ; 1200 = 40:1

P.P. $30

SIE Debt 116

A convertible debenture is convertible into common at $40 per share. If the market price of the bond rises to a 10 point premium over par, which statements are true?

I The conversion ratio is 20:1II The conversion ratio is 25:1III The parity price of the stock is $44IV The parity price of the stock is $50


1000 = C.R. ; 1000 = 25:1

C.P. $40

1100 = 25 ; 1100 = 25:1 ; 1100 = 25

P.P. X $44SIE Debt 117

A corporation has issued 10%, $1000 par convertible debentures, convertible at $40. The common stock is currently trading at $45. If the bond and the common are trading at parity, a customer purchasing 5M of the bonds will pay:

A. $4,950B. $5,000C. $5,625D. $6,550

SIE Debt 118

ABC has 10%, $1,000 par convertible bonds outstanding convertible at a 40:1 ratio. The common stock is currently trading at $24.75. If the bond is currently trading at 101, at what market price of the common stock would an arbitrage possibility exist between the convertible bond and the stock into which it is convertible?

A. 24B. 25C. 25.25D. 26

1010 = 40 ; 1010 = 40P.P. $25.25

Corporate Bonds: Settlement

• Regular way settlement is T + 2 business days

120

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Corporate Bonds: Bankruptcy

In the event a corporation goes bankrupt, the following is the priority of making payments:

• Secured creditors – i.e. secured bonds•Unpaid wages, taxes, and trade credits•Unsecured debt – i.e. debentures• Subordinate debentures• Preferred stock•Common stock

121 122

U.S. GOVERNMENT DEBT

U.S. Government Debt: Characteristics

• Largest and most active trading market in the world

• Exempt from registering with the SEC under the Securities Act of 1933

• Exempt from the regulation under the Securities Exchange Act of 1934

• Book Entry

• Highest rated debt (AAA)

123

U.S. Government Debt: T-Bonds

• 30‐year maximum maturity

• $100 par minimum, but test uses $1,000

• Pay interest semi‐annually

• Quoted as a percentage of par value in 32nds

• Are non‐callable

124

U.S. Government Debt: T-STRIPS

• Separate Trading of Registered Interest and Principal of Securities

• Zero‐coupon Treasuries issued directly by the U.S. Gov’t

• Typical 30‐year maturities, aimed at tax‐deferred pension plans that wish to avoid reinvestment risk

• No reinvestment risk

• High level of interest rate risk

olong term, zero coupon security

125

T-STRIPs and T-Receipts

126

T-STRIPs T-Receipts

• Discounted security

• Zero Coupon security

• Created by the U.S. Government

• Used primarily in pension plans

• Backed by the full faith, credit and taxing power of the U.S. Government

• Discounted security

• Zero Coupon security

• Created by a BD

• Used primarily in pension plans

• It is NOT backed by the full faith, credit, and taxing power of the U.S. Government

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U.S. Government Debt: TIPS

Treasury Inflation Protection Securities

• Fixed interest rate over the bond’s life

• Principal amount is adjusted every 6 months by an amount equal to the change in CPI

• Pays semi‐annual interest

oIncrease if principal amount is adjusted upward due to inflation

oDecrease if principal amount is adjusted downward for deflation

• Lower interest rates than other treasury securities

127

U.S. Government Debt: T-Notes

•Maturities range from 1 to 10 years

•Minimum denomination is $100 oAssume par value is always $1,000 unless told otherwise

•Pay interest semi‐annually

•Quoted as a percentage of par value in 32nds

•Are non‐callable

128

U.S. Government Debt: T-Bills

• Issued with 4‐week, 13‐week, 26‐week, and 52‐week maturities

• Issued at a discount from par

•Discount is considered interest income

•Quoted on a discount yield basis

129

US government Cash Management Bills

• Issued with maturities from several days to six months

• Issued at a discount from par

• Have slightly higher yields than T‐bills

• Sold in $100 min

• Issued on an as needed basis

130

US Government Debt - Series EE Bonds

• Issued through Treasury Direct in electronic form

• Minimum purchase $25

• Amounts up to $10,000 in increments of 1 penny

• Bonds pay interest up to 30 years

• Interest is paid and subject to federal taxation at maturity or redemption

131 132

U.S. GOVERNMENT AGENCY OBLIGATIONS

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U.S. Government Agency Debt: Federal Farm Credit System

•Provides low rate financing for farmers

• Federal Farm Credit System corporation issues securitiesoDiscount Notes = short term debt maturing in 1 year or less

oDesignated Bonds = traditional non‐callable bonds maturing in 2‐10 years

oBonds = traditional callable bonds with up to 30 years until maturity

oRetail Bonds = similar to bonds, but are available for retail investors

133

U.S. Government Agency Debt: Secondary Market for Home Mortgages

• The following agencies make a second market for home mortgages:

oFederal Home Loan Banks oFederal National Mortgage Association ‐ Fannie Mae

oGovernment National Mortgage Association ‐ Ginnie Mae

oFederal Home Loan Mortgage Corporation ‐ Freddie Mac

134

FNMA (Fannie Mae)

• Buys government guaranteed and insured mortgages (VA & FHA) and conventional mortgages from banks

• Sells certificates to public to raise money to buy the mortgages from banks

• Earns interest and fees for servicing on the mortgages

• Due to bankruptcy in 2008 placed under government conservatorship

• Debt has the implied backing of the U.S. Government

135

GNMA Pass Through Certificates

• GNMA purchase mortgages and packages them together to create a pass‐through certificate

• GNMA pass through certificate o Guaranteed by the full faith, credit and taxing power of

the U.S. Governmento Pay out monthly income to investors (interest and principal)o Subject to prepayment risk – risk that consumers can pay off their

debt early

136

Practice Question

Which of the following securities is backed by the full faith, credit and taxing power of the U.S. Government?

a) FNMA

b) GNMA Mutual Fund

c) FHLMC Bonds

d) GNMA Pass Through Certificate

137 138

MUNICIPAL DEBT

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Municipal Bonds

• Debt instruments created states, territories and local governments

• Two main types

o General Obligation bonds

o Revenue bonds

• Tax free interest income (federal level)

• Best for higher taxpayers (wealthy)

o Investor who is in a 28% or higher tax bracket, assume they need a muni

139

Two Types of Muni Bonds

140

GO Bonds Revenue Bonds

• Backed by the full faith, credit and taxing power of the municipality

• Backed by taxes

o State income tax

o Property tax (ad valorem tax) based on mill rates

o Debt limits apply, voter approval required to raise limit

• Back by revenues from the facility or the project “user fees”

• Feasibility study required

• IDR – industrial development revenue bond

o Issued by the municipality and backed by the corporation

o Subject to alternative minimum tax

Muni Bonds

• How do I know if a muni bond is a better choice for an investor versus a corporate bond?

• Corporate bond’s net yield = annual interest x (100% ‐ tax bracket)

• 10% Corp and in 30% tax bracket, to find MUNI yield you MUltiply

• 10% X (100% ‐ Tax Bracket) = 10% X .70 = 7%

• 7% Muni = 10% Corp if in the 30% tax bracket

• What is the bond’s interest after the investor pays taxes

• Corp bond yield 9% and a muni bond yielding 6.5% which bond is better for an investor in a 30% tax bracket.

141

Practice Question

Interest income on municipal bonds purchased by a resident of the state other than where the bond were issued are

A. Exempt from federal tax and subject to state and local tax

B. Subject to federal tax and exempt from state and local tax

C. Subject to federal, state and local tax

D. Exempt from federal, state, and local tax

142

Special Tax Bonds

• Bond issue backed by taxes other than Ad Valorem ( not backed by full taxing power)

• Usually excise taxes

• Cigarette tax

• Liquor tax

• Gasoline tax

143

Moral Obligation Bonds

• Promise to pay but no legal obligation to pay

• Often issued when the project may not be able to produce enough revenue to pay bond holders

• If there is a short fall in revenues the state legislature may appropriate funds but is not legally obligated.

• These bonds have a high level of credit risk

• Have high coupon rates

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Practice question

Which of the following bonds is most likely to have the highest interest rate

A. General Obligation Bonds

B. Revenue Bonds

C. Special Tax Bonds

D. Moral Obligation Bonds

145 146

MONEY MARKET INSTRUMENTS

Money market instruments

• Investors mainly use for Capital preservation and liquidity

• Types:

o T‐bills

o Commercial paper

o Banker’s acceptance

o Negotiable CD (min par value of $100K)

• Jumbo CDs

147 148

PACKAGED PRODUCTS

Investment Companies

149

Pooled account of securities

• Packaged product

Diversification

• Larger pool to invest in, less risk for the investor

Professional Selection

• Professionals pick the securities in the portfolio

Three Types of investment companies

• Face Amount Certificates

• Unit Investment Trust

• Management Companies

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Types of Investment Companies

Face‐Amount Certificate Company

151

Forced savings plan

Invested in bonds

No longer exist

Unit Investment Trust

• Fixed Trust

✔Trust selects fixed portfolio of securities (usu. Bonds)

✔No ongoing management✔The trust sells units to investors that represent a portioned interest of the

portfolio

✔When all bonds have matured the portfolio self liquidates

• Participating UIT (Variable Annuity)

✔The trust invests in shares of a management company

✔Used mainly as a retirement vehicle since growth is tax deferred

152

MANAGEMENT COMPANIES Open‐End and Closed‐End Funds

153

Management Company Structure

154

Fund Sponsor(Underwriter)

CustodianInvestment

AdviserSelling Group

Open-End and Closed-End Fund Characteristics

155

Characteristic Open-End (Mutual Funds) Closed End

Prospectus Required On every new purchase Only during the IPO

Fund shares Continuously issued by the fund Once IPO is sold, the shares trade in the secondary market

Ownership of the fund Common share of the fund Common share of the fund, or preferred stocks/bonds

Pricing Sell at NAVPurchase at POP

Trades in the secondary market based upon supply & demand

Diversified Investment Company

156

75% or more of the assets must meet the following:

▪ Maximum of 5% of its assets invested in one issuer, regardless of security type

▪ Maximum 10% ownership in any other company’s voting stock

If an investment company meets the 75% rule, the other 25% can be invested how the investment adviser sees fit, as long as it meets the objective of the fund

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Types of Funds

157

• Large well-known companies who have been around for a long time

• Invests in growth stock (younger investors who can take risk)

Growth Fund

Blue Chip Fund

Equity Funds

GrowthFund

BlueChip Fund

Types of Funds

158

Income Funds

• U.S. Government Funds

• Municipal Bond Fundso Seeking income but in high tax bracket

• Corporate Bond Funds

• Money Market Fundso Invest in short term debt

Types of Funds

159

Other Funds

• Balanced Funds

• Index Fundso Invests in stocks that mirror a specific indexo Lower expenses they are passively managed

• Specialized Funds

• Special Situation Funds

160

MUTUAL FUND CHARACTERISTICS

Buying and Selling Fund Shares

• Open‐end funds are continuously offered in the primary market

o Prospectus required for new purchases

• Fund’s Net Asset Value (NAV) is calculated every business day at 4 pm eastern

o Securities in the fund are “marked to market”

o Investors REDEEM at the NAV

161

Buying and Selling Fund Shares

• Fund’s Public Offering Price (POP) is based off the NAV

o Investors BUY at the POP (production)

• Maximum sales charge is 8.5% of the POP

o Set by FINRA

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Series #7 Investment Companies 163

Open End VS Closed End Funds

Open• continuous issuance of new shares &

redemption of old ones• pay a sales charge – max. = 8 ½% on

the dollar amount invested• NAV is calculated based on the

closing values of the securities in the portfolio

Closed• one time stock issuance – and

then the books are closed• pay a commission or mark-up• market price is determined by

market supply & demand


Open End VS Closed End Funds (cont.)

Open End Prices1. NAV POP

$9.15 $10

2. NAV POP

$9.15 $9.15

• buying the fund at the POP (which may include a sales charge) and redeeming at NAV

Closed End Prices1. NAV Price

$9.15 $10

2. NAV Price

$9.15 $9.15

3. NAV Price

$9.15 $9.00

• buying and selling at the "Price"

• the NAV is how much the securities in the fund are valued at NOW


A customer places an order to buy a mutual fund with:

NAV = $9.15 and POP = $10.

How much will the customer pay for 1 share?

A. $9.15B. $9.15 + commissionC. $10D. $10 + commission


A customer places an order to sell a mutual fund with:

NAV = $9.15 and POP = $10.

How much will the customer receive for 1 share?

A. $9.15B. $9.15 - commissionC. $10D. $10 - commission


A customer places an order to buy a closed end fund with:

NAV = $9.15 and Price = $10.

How much will the customer pay for 1 share?

A. $9.15B. $9.15 + commissionC. $10D. $10 + commission


A customer places an order to sell a closed end fund with:

NAV = $9.15 and Price = $10.

How much will the customer receive for 1 share?

A. $9.15B. $9.15 - commissionC. $10D. $10 - commission

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Forward Pricing

• Mutual funds use forward pricing

o Next available price

• Purchase requests

o Received before 4 pm eastern get that day’s POP

o Received after 4 pm eastern get the next business day’s POP

• Redemption requests

o Received before 4 pm eastern get that day’s NAV

o Received after 4 pm eastern get the next business day’s NAV

o Redemption proceeds must be sent within 7 calendar days

169

Reduction in Sales Charges

• Mutual funds may offer reduced sales charges through

o Breakpoints

o Letter of Intent (LOI)

o Rights of accumulation (ROA)

170

Per FINRA – the maximum sales charge for a mutual fund is 8.5% What must the fund offer in order to charge 8.5% according to

FINRA? Breakpoints, LOI, ROA


171

Breakpoints Breakpoint Sale

Mutual-Fund Certificate Company

Dollar levels where sales charge is reduced

Violation according to FINRA


172

Letter of Intent (LOI)

• Gives investors 13 months total to deposit the balance

• Can be backdated 90 days• Capital appreciation doesn’t count


173

Rights of accumulation (ROA)

• Over time as the client invests, the sales load will become lower on the new money invested

• Capital appreciation counts towards ROA

• Advantageous for the small investor

Practice Question

Which of the following best describe the characteristics of a ROA program but not an LOI program?

a) Discounted sales charge

b) Uses breakpoints

c) Capital appreciation does not count towards the discounted sales charge

d) Capital appreciation does count towards the discounted sales charge

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Redeeming Shares

• Redeem at the next calculated NAV

o Maximum redemption fee is 2%

o Redemption fee + sales load cannot exceed 8.5%

175

Reinvestment of Dividends and Capital Gains

• Dividends and capital gain distributions are taxable in the year received whether reinvested or taken in cash

• Reinvested dividends and capital gains are NOT subject to a sales charge

176

12B-1 Expenses

• Annual fee assessed to shareholders

• Maximum per year is ¾% (75 basis points)

o No‐load funds maximum 12B‐1 fee can be ¼% (25 basis points)

• 12B‐1 fee covers:

o Advertising expenses

o Sales literature expenses

177

Mutual Fund Share Classes

178

Class A Shares

Charge an upfront sales charge (load)

Class B Shares

Charge a CDSC (contingent differed sales charge)

Class C Shares

Level load

Mutual Funds: Prohibited Practices

179

Inappropriate Recommendation

for B SharesLate TradingBreakpoint Sale

‐ BREAK-POINT SALES

inducing customers to buy enough of a fund so that they do NOT qualify for a reduced sales charge i.e. customers must be aware of the ability to get a reduced sales charge for large dollar purchases

‐ INAPPROPRIATE RECOMMENDATION OF CLASS B SHARES

investors may think that Class B shares are less expensive, as they have no "up-front" sales charge however, they impose annual 12b-1 fees which can be much more expensive to a customer who has a large dollar amount to invest

over the longer term because the one-time up-front sales charge for Class A shares reduced by a breakpoint for a large dollar investment is usually less costly than incurring annual 12b-1 fees over a long time span

‐ LATE TRADING / MARKET TIMING

buying and selling a fund's shares to exploit the inefficiencies in how the fund company computes NAV i.e. if the fund has overseas stocks that might prevent the most current computation of NAV, while a sophisticated investor may have

proprietary software to compute the NAV faster than the fund company – thereby it could buy shares that it found undervalued; or sell shares that it found overvalued

Closed-End Funds

• Once all stock is sold, the fund’s “book” is closed

• Publicly traded

• Trades in the secondary market based on supply and demand

o Price can be at a premium or discount to net asset value

• Shares are not redeemable

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Net Income of a Fund

• Gross income

• Dividends from common and preferred stock

• Interest from bonds and other debt instruments

• Minus the fund’s expenses

181

Net Income of a Fund

Fees and Expenses (Expense ratio)

182

Management Fees(largest expense)

Custodial Fees

Transfer Agent Fees

Printing Costs

Legal and Audit Fees

Overhead

Taxes

12B-1 Expenses (12b1 fee) (if applicable)

• INCOME STATEMENTS COMPUTE NET INVESTMENT INCOME

– EXAMPLE: Assume that a fund has collected $200,000,000 of Total Net Assets. Also, assume that the fund's income statement shows the following:

Gross Investment Income: = $20,000,000

Expenses: Management fee = $ 1,000,000 Distribution fee = $ 550,000 Custodial fee = $ 200,000 Printing fee = $ 50,000 Legal & audit fee = $ 100,000 Administrative fee = $ 100,000

Net investment income = $18,000,000

Question 2: What Is The Fund's Net Return On Assets?

This Fund's Net Return On Assets Is: 18,000,000 / $200,000,000 = 9%

Question 3: What Is The Expense Portion Of The Fund's Return On Assets?

The Expense Portion Of The Fund's

Return On Assets Is: 1%

Question 4: The Fund’s Expense Ratio Has Just Been Computed:

The Expense Ratio In This Instance Is:

2,000,000 / 200,000,000 = 1%

Investment Companies 183

Question 1: What Is The Fund's Gross Return On Assets?

This Fund's Gross Return On Assets Is:

20,000,000 / $200,000,000 = 10%

Subchapter M

• For a fund to fall under Subchapter M 90% of NII (Net Investment Income) must be distributed to shareholders

• Subchapter M is also called

o Conduit or pipeline theory

• Most fund distribute more than 90% of NII to investors

184

Exchange Traded Funds (ETFs)

• Legally classified as an open‐end fund, but trades like a closed‐end fund and stocks

• Passively managed index funds

• Popular ETF today is SPDRS (“SPIDERS” – S&P depositary receipts)

• Leveraged ETFs

o Borrowing magnifies the return

• Inverse ETFs

o Use short selling in the market to move prices inversely to the index

185

Real Estate Investment Trust

• REITs are similar to closed end funds except they invest in properties and mortgages instead of stocks and bonds

• Equity REITs invest in properties like apartment buildings, hotels, office buildings and shopping malls

• Mortgage REITs invest in mortgages and construction loans

• REITs are used in portfolio construction to add diversification because they are non‐positively correlated to the stock and bond markets

• REITs are very liquid since they trade on exchanges or OTC as opposed to buying the actual real estate

186

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Hedge Funds

• Private investment funds open only to wealthy accredited investors

• Not registered and are very lightly regulate

• Involve sophisticated investment strategies high potential for return but also high risk

• Unlike mutual funds the portfolio manager of a hedge fund usually shares in the portfolio gains in addition to earning a management fee

187

Direct Participation Programs

• Set up as partnerships instead of corporations

• Not a taxable entity instead gains, and losses flow through to the partners who will either get the deduction or owe the taxes for the business

• A DPP must have at least one General Partner and a least one Limited Partner

• The GP manages the partnership

• The LPs are silent partners they are not allowed to be involved in the management

• DPPs are illiquid

• Common forms of DPPs are invested in real estate, or oil and gas drilling or equipment leasing

188

189

TRADING (SECONDARY) MARKETS

Market Definitions (secondary markets)

190

FIRST Market

• Trading of stocks on an exchange floor -> exchange listed stock • NASDAQ became the first virtual FIRST market in 2006

SECOND Market

• OTC trading of stocks included in the OTCBB and Pink Sheets

THIRD Market

• OTC trading of exchange listed stocks

FOURTH Market

• Direct trading of stocks between institutions on ECNs and ATSs like Instinet

Broker-Dealer

191

Broker Dealer

• Does NOT hold stock in inventory

• Acts as a “middleman” matching buyer and seller

• Effects transactions on an agency basis

• Earns a commission

• Virtually no risk on the transaction

• Holds stock in inventory

• Effects transactions on a principal basis

• Earns a mark-up or mark-down

• Very risky on the transaction

192

TYPES OF ORDERS

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TYPES OF ORDERS

MARKET ORDER

• To be filled at current market price

• No price specified on order

• Every order is a market order unless the order says something else

• Guaranteed execution, not guaranteed a price

MARKET NOT HELD (cannot be held in the specialist’s book)

• To be filled when trader thinks price is best

• Gives trader discretion over price and time of execution

• Cannot be handled in automated systems

• Must be executed that day

193

TYPES OF ORDERS

LIMIT ORDER

• Specifies price at which to:

o Buy which is lower than the current market; or

o Sell which is higher than the current market

LIMIT ORDER TO SELL

• Placed above current market and is executed only if market rises. To be filled at limit price or higher

LIMIT ORDER TO BUY

• Placed below current market and is executed only if market drops. To be filled at limit price or lower

194

TYPES OF ORDERS

LIMIT ORDERS

• When the market price of ABC is at $62, a customer wishes to place an order to buy at $60o This is a Buy Limit Order which is placed BELOW the current market. It will be filled

at $60 or lower in a falling market.

• When the market price of ABC is at $62, a customer wishes to place an order to sell at $65. o This is a Sell Limit Order and will be filled at $65 or higher in a rising market.

195

TYPES OF ORDERS

STOP ORDERS

• Specifies a trigger price, that if hit, turns the order into a market order. Also known as a “stop loss” order

o Sell Stop is placed lower than the current market; or

o Buy Stop is placed higher than the current market

196

Trading Markets 197 Trading Markets 198

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Trading Markets 199 Trading Markets 200

TYPES OF ORDERS

STOP ORDER

BUY STOP ORDER • Used to limit loss on a short stock position• Placed above current market and executed if market rises (as soon as the order is

triggered, it is executed at the next available price)

SELL STOP ORDER • Used to limit loss on a long stock position• Placed below current market and executed if market falls (as soon as the order is

triggered, it is executed at the next available price)

201

TYPES OF ORDERS

STOP ORDERS

• When the market price of ABC is at $62, a customer wishes to place an order to Sell at $60 Stop.

o This is a Sell Stop Order which is placed BELOW the current market. Assume that the next trades in the stock occur in order at

o $60.50, $60.10, $59.90, $59.85, $59.80 sequence of trades

o Find the trigger – first time the stock on the ticker tape is $60 or WORSE (lower)

o Find the execution price

202

TYPES OF ORDERS

STOP ORDERS

• When the market price of ABC is at $62, a customer wishes to place an order to Buy at $65 Stop.

o This is a Buy Stop Order which is placed ABOVE the current market. Assume that the next trades in the stock occur in order at

o $64.50, $64.10, $65.10, $65.05, $65.20

o Find the trigger – first time the stock on the ticker tape is $65 or WORSE (higher)

o Find the execution price

203

TYPES OF ORDERS

OSLOBS

• Orders entered and filled above current market

• Open Sell Limits Open Buy Stops

OBLOSS

• Orders entered and filled below current market

• Open Buy Limit Open Sell Stops

• The only orders reduced on ex‐date for cash dividends

204

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Practice Question

Buy Limit Orders are

I. Placed below the current market value

II. Placed above he current market value

III. Executed if the market rises

IV. Executed if the market falls

A. I & II

B. II & III

C. III & IV

D. I & IV

205

Regulation SHO

206

• Sets rules for SHOrt sales

• Every Sell order must be marked “Long” or “Short”

• A Sell order can only be marked “Long” if the customer owns:

o the stock and will deliver on settlement

o a convertible security and gives instructions to convert and will deliver on settlement

o a call, right or warrant and exercises and will deliver on settlement

• If the customer must borrow the shares to deliver, then it is a Short sale

• If it is a Short sale, the location of the shares to be borrowed must be determined and documented

• Requires the exchanges to prepare a daily threshold list of “hard-to-borrow” securities

207

PROHIBITED TRADE PRACTICES

Prohibited Trading Practices

• Front Running

o Firm /RR cannot place an order for its own account ahead of a customer’s order “block transfer” assume the firm/RR is front running

• Trading ahead

o of research

o of customer orders

• Trade Shredding

o Take a large order and break it down into several small order to be executed more money

208

Prohibited Trading Practices

• Interpositioning

o Placing a 3rd party between the customer and the BD (make more money)

• Trading Pools

o Private place to trade securities (dark pools)

• Wash Trades/Painting the Tape (ghosting)

o Two traders on the floor of an exchange they are trading a security back and forth to show artificial movement in the stock price= to attract other traders to raise the price

o The securities never leave the customer’s account until the very end

• Marking the Open/Close

o Trying to influence the open or close price for a security

o Price manipulation

209

Practice Question

Which of the following are prohibited trading practices

I. Backing away

II. Marking to the market

III. Using a correspondent

IV. Interpositioning

A. I & II

B. II & III

C. III& IV

D. I & IV

210

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211

CUSTOMER DISCLOSURE AND SETTLEMENT RULES

FAIR PRICES TO CUSTOMERS

• FINRA states that prices charged to customers must be “fair and reasonable,” with 5% as a guide

o Does not apply to municipal bonds and new issues (mutual funds)

o 5% is a GUIDE, not a RULE

• Both a commission and a mark‐up cannot be charged on the same trade

212

• Under the 5% Policy, when determining a “fair and reasonable” commission or mark‐up, the firm should consider:

o Dollar amount of the transaction

o Difficulty of the transaction

o Level of service provided to the customer

o Related compensation, such as a proceeds transaction

• Don’t consider:

o Customer net worth

o Customer education

213

FAIR PRICES TO CUSTOMERS FAIR PRICES TO CUSTOMERS

MSRB “Fair Price”

• 4 considerations:o Dealer’s best judgment of value of the securitieso Expenseso Dollar amounto Fact that the dealer is entitled to a profit

• To determine a “fair price” in a municipal agency transaction, there are 4 considerations:o Availability of securityo Expenseso Level of service provided to cliento Related compensation (proceeds transaction)

214


• The MSRB has an issue with the pricing of bonds quoted on a yield basis (serial bonds)

• The dealer quotes a yield without giving the dollar price. The price is then computed for the confirmation

• The issue arises when these bonds are callable. The MSRB requires that the bonds be priced to the “worst case” scenario

o For discount bonds, the worst case is when the bonds are held to maturity – in this case, the discount is earned over the longest time frame

o For premium bonds, the worst case is when the bonds are called early – in this case, the premium is lost over the shortest time frame

215


• Therefore, for municipal bonds quoted on a yield basis:

o Discount bonds are priced based on holding the bond to maturity

o Premium bonds are priced based on holding the bond to the near‐term in whole call date

• When pricing callable premium bonds, only in whole calls are considered – not calamity calls; not sinking fund calls

216

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DISCLOSURE ON CUSTOMER CONFIRMS

• Confirmations sent day after trade (T + 1) for regular way trade; same day (T) for cash settlement

• Commission disclosed if agency trade

• Mark‐up or mark‐down in principal transactions only disclosed for NASDAQ stocks; NOT disclosed for principal transactions in OTCBB and Pink Sheet stocks or any bonds (but still must be “fair”)

• Whether a payment for order flow was accepted must be disclosed

217

SETTLEMENT DATES

218

REGULAR WAY -CORPORATES &

MUNIS

• 2 business days after trade date• Settlement occurs on T + 2

REGULAR WAY -U.S. GOV'TS &

OPTIONS

• Next business day• Settlement occurs on T + 1

CASH • Same day before 2:30 pm, eastern• Settlement occurs on Trade Date

SETTLEMENT DATES

219

SELLER'S OPTION

• Used if more than 2 business days are needed to deliver; delivery cannot occur earlier than the 3rd business day

WHEN, AS, AND IF ISSUED (WAII)

• Used for new issues whose issuance is announced, but the certificates aren't yet available for trading

• 2 Confirmations are sent. 1st confirm specifies price and trade date, but not settlement date or accrued interest because securities are not available yet; 2nd confirm is sent when settlement date is set, with both price and accrued interest

COMPARISONS / DK NOTICES

Dealer‐to‐dealer trade confirmations are called comparisons, sent in real time on trade date (T)

DK

• DON'T KNOW NOTICE

o For example, your firm receives comparison for a trade executed at $50 and comparison shows trade at $60; to clear record, your firm will "DK" comparison

o DKs are required to be resolved within 20 minutes of receiving the mismatched trade report

220

GOOD DELIVERY RULES

221

Good delivery rules cover delivery of stock and bond certificates from dealer to dealer.

• Do not apply to deliveries from customers

• Do not apply to book entry securities held in the DRS (Direct Registration System) at DTC (Depository Trust Corp.)

To be a good delivery, certificates:

• Must be endorsed (assigned) on the back in the exact name as registered (this can also be done on a separate "stock power" or "bond power”);

• Must have the signature guaranteed (not notarized) by a member of the Medallion Signature Guarantee Program

• Cannot be mutilated, unless accompanied by a validation letter from the issuer, transfer agent, registrar or paying agent

GOOD DELIVERY RULES

222

Stock certificates must be delivered in either “piles” of 100s or multiples of 100 on 1 certificate

• For example, for a 400-share trade, 1 certificate of 400 shares; 4 certificates of 100 shares; 8 certificates of 50 shares; are all “good.”

• NOT good would be 10 certificates of 40 shares

Registered bond certificates must be delivered in $1,000 units or multiples, up to $100,000 per certificate

Bearer bonds must be delivered in either $1,000 or $5,000 units with all unpaid coupons attached

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GOOD DELIVERY RULES

223

Bonds trade “and interest,” so the accrued interest must be included.

• Calculated up to, but not including, settlement

▪ Calculated 30/360 for corporates and municipals

▪ Calculated Actual/Actual for government bonds

Municipal bonds must have a legal opinion and insured municipal bonds must be delivered with proof of insurance

Bonds that trade “flat” – no accrued interest – defaulted bonds, zero-coupon bonds, income bonds, trades that settle on interest payment date

Dividend Dates

224

DECLARATION DATE

• Date dividend is declared by corporation – at least 10 days in advance of record date

RECORD DATE

• Date on which corporation takes shareholder name from transfer agent to mail dividend

• Last day to buy and get the dividend is 2 business days prior to record date

PAYABLE DATE

• Date dividend checks will be mailed by corporation's transfer agent – usually 1 month after record date

Dividend Dates

225

CUM DIVIDEND DATE

• Stock trades “with dividend”

EX-DIVIDEND DATE

• First day that the stock trades without the dividend because the trade will settle after record date

• At the opening, the SRO reduces the stock price is reduced by the amount of the dividend distribution

• Ex-date is set at: 1 business day before record date

SIE Equities 226

June

S M T W H F S

1 2 3 4 5 6 7

8 9 10 11 12 13 14

15 16 17 18 19 20 21

22 23 24 25 26 27 28

29 30If record date is set at Wednesday June 11, when is the last day to buy the stock and receive the dividend: reg. way settlement? cash settlement? when is ex-date?

SIE Equities 227

June

S M T W H F S

1 2 3 4 5 6 7

8 9 10 11 12 13 14

15 16 17 18 19 20 21

22 23 24 25 26 27 28

29 30

If record date is set at Tuesday, June 10, when is the last day to buy the stock and receive the dividend: reg. way settlement? cash settlement? when is ex-date?

SIE Equities 228

July

S M T W H F S

1 2 3 4 5 6 7

8 9 10 11 12 13 14

15 16 17 18 19 20 21

22 23 24 25 26 27 28

29 30 31

If record date is set at Friday, July 6, when is the last day to buy the stock and receive the dividend: reg. way settlement? cash settlement? when is ex-date?

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Dividend dates

229

Cum‐DividendIf a customer buys on the 11th or before in a regular way trade, he or she will get the dividend. The stock is trading with the dividend ‐ "cum‐dividend."

Ex‐DividendIf the customer buys on the 14th or later, he or she does not get the dividend ‐ the stock is now trading "ex‐dividend."

230

SIE Equities 231

A corporation declares a dividend on Mar 20 for those on record for owning the stock on Fri., Apr 19. The ex-date is set at Thur., Apr 18; and the payable date is Apr 30.

When is the earliest date that the stock can be sold regular way and still allow the customer to receive the dividend?

A. Apr 16B. Apr 17C. Apr 18D. Apr 19

Tax Treatment

232

If the sale proceeds exceed the cost basis, a capital gain exists

If the sale proceeds are lower than the cost basis, a capital loss occurs

Total purchase price for the security with after tax dollars• Always assume FIFO,

unless told otherwise

Cost Basis

Sale Proceeds

What the investor receives upon selling the position

In January, 20XX a customer buys 100 shares of ABC stock at $30 per share and pays a $2 commission per share. The customer receives $1 in cash dividends during the year. The customer's cost basis in the stock is:

A. $28 per share B. $30 per share C. $31 per share D. $32 per share

233Taxes

In January, 20XX a customer sells 100 shares of ABC stock at $30 per share and pays a $2 commission per share. The customer's sales proceeds in the stock is:

A. $28 per share B. $30 per share C. $31 per share D. $32 per share

234Taxes

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Capital Gains

235

Short Term Gains Long Term Gains

Holding Period 12 months or less 12 months + 1 day or longer

Tax Implication Taxable as ordinary income at the investor’s tax bracket

Taxable at long term cap gains rate of 15% (though 20% for high wage earners)

SIE 236

A capital gain is considered to be long term if an investment is held over:

A. 6 monthsB. 12 monthsC. 18 monthsD. 24 months

Taxes

Dividend Taxation

237

Cash Dividends on stock

• Subject to preferential rates

• For most investors 15% (qualified dividend)

Stock dividend on stock

• Cost basis is adjusted downward

• Stock dividend is taxable upon sale as a capital gain or loss event

An investor holds shares of a stock that declares a 10% stock dividend. Which of the following are true regarding the stock position after the dividend is paid?

I The cost basis per share is adjusted II The cost basis per share remains the same III The distribution is taxable IV The distribution is not taxable

A. I and III B. I and IV C. II and III D. II and IV

SIE 238Taxes

Equities 239

A corporation declares a 5:4 stock split. For a customer who owns 100 shares at $60, how many shares will he now have and at what dollar price?

A. 120 shares at $50B. 125 shares at $48C. 120 shares at $40D. 125 shares at $50

100 shrs @ $60 = $6,000

4 shares now = 5 shares

5:4 = 1.25:1

1 shr = 1.25 shrs

100 shares = 125 shares

$60/1.25 = $48

125 shrs @ $48 = $6,000

Capital Losses

• If the cost basis exceeds the sale proceeds the investor has a capital loss.

• Per the IRS the customer can only use $3,000 of the loss per year as a deduction against ordinary income

240

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241

A customer buys $23,000 of ABC stock in March of 2020. On January 31, 2021, the stock is valued at $10,000. The customer will be able to deduct how much on this year's tax return?

A. 0B. $3,000C. $6,500D. $13,000

Taxes 242

A customer buys $23,000 of ABC stock in March of 2020. On January 31, 2021, the stock is valued at $19,000 and the customer sells the position. The customer will be able to deduct how much on this year's tax return?

A. 0B. $1,500C. $3,000D. $4,000

Taxes

243

A customer has $3,000 of capital losses and $7,000 of capital gains in a tax year. On that year's tax return, the investor has:

A. no loss to put on his tax returnB. a $3,000 capital loss deduction with no loss

carryforwardC. a $3,000 capital loss deduction and a $4,000

loss carryforwardD. a $7,000 capital loss deduction with no loss

carryforward

Taxes 244

A customer has $7,000 of capital losses and $3,000 of capital gains in a tax year. On that year's tax return, the investor has:

A. no gain or loss to put on his tax returnB. a $3,000 capital loss deduction with no loss

carryforwardC. a $3,000 capital loss deduction and a $1,000

loss carryforwardD. a $7,000 capital loss deduction with no loss

carryforward

Taxes

A customer in the 28% tax bracket has $6,000 of capital gains and $9,000 of capital losses. How much unused loss is carried forward to the next tax year?

A. 0 B. $3,000 C. $6,000 D. $9,000

245Taxes 246

OPTIONS

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•Buyer•Holder•Owner• Long•Pays Prem creates a debit

•Has a right

• Seller•Writer

•Grantor• Short•Recv. Prem creates a credit

•Has an obligation

247

Options Contract Two Parties

248

1 ABC Jan 50 Call @ 5

# of contracts1 contract = 100 shares

ABC is the underlying stock

January is the expiration -on the 3rd Friday of the month at 11:59 PM EST

50 is the Strike Price

Call is the type of option

Premiums are quoted in increments of $.05 (a nickel)

Quoted on a per SHARE basis

Intrinsic Value

Definition

• Difference between strike price and market price if exercise is profitable to the holder

• Does not consider the seller

• Does not consider the premium

Premium = intrinsic value + time value

249

Intrinsic Value = “in the money amount”

250

If ABC is at 55, contract is “In the Money” by $5 and Intrinsic Value = 5

If ABC is at 50, contract is “At the Money” and Intrinsic Value = 0

If ABC is at 45, contract is “Out the Money” by $5 and Intrinsic Value = 0

Anytime a call contract is at the money or out the money it has NO intrinsic value

1 ABC Jan 50 Call

Intrinsic Value = “in the money amount”

251

If ABC is at 45, contract is “In the Money” by $5 and Intrinsic Value = 5

If ABC is at 50, contract is “At the Money” and Intrinsic Value = 0

If ABC is at 55, contract is “Out the Money” by $5 and Intrinsic Value = 0

Anytime the contract is at the money or out of the money there is NO intrinsic value

1 ABC Jan 50 Put

Intrinsic Value

252

Sell 1 ABC Jan 50 Call @ 7

ABC = 55

Intrinsic value = 5Time Value = 2

Premium = Intrinsic Value + Time Value

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SIE Options 253

A customer sells 1 ABC Oct 50 Call @ $4 when the market price is $51.50. The intrinsic value of the contract is:

A. 0B. -1.50C. +1.50D. +2.50

Opening & Closing Transactions

Every options order ticket must be marked “Open” or “Close” so that the OCC (which keeps the record of the contract) knows what to do

254

OpeningPurchase • Establishes a long position

OpeningSale • Establishes a short position

ClosingPurchase • Liquidates a short position

ClosingSale • Liquidates a long position

SIE Options 255

Opening & Closing Transactions (cont.)

How is the order ticket marked to establish a long call options contract?

A. Opening Purchase

B. Opening Sale

C. Closing Purchase

D. Closing Sale

SIE Options 256


How is the order ticket marked to establish a short call options contract?

A. Opening Purchase

B. Opening Sale

C. Closing Purchase

D. Closing Sale

SIE Options 257


How is the order ticket marked to liquidate a long call options contract?

A. Opening Purchase

B. Opening Sale

C. Closing Purchase

D. Closing Sale

SIE Options 258


How is the order ticket marked to liquidate a short call options contract?

A. Opening Purchase

B. Opening Sale

C. Closing Purchase

D. Closing Sale

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SIE Options 259


How is the order ticket marked to establish a long put options contract?

A. Opening Purchase

B. Opening Sale

C. Closing Purchase

D. Closing Sale

SIE Options 260


How is the order ticket marked to establish a short put options contract?

A. Opening Purchase

B. Opening Sale

C. Closing Purchase

D. Closing Sale

SIE Options 261


How is the order ticket marked to liquidate a long put options contract?

A. Opening Purchase

B. Opening Sale

C. Closing Purchase

D. Closing Sale

SIE Options 262


How is the order ticket marked to liquidate a short put options contract?

A. Opening Purchase

B. Opening Sale

C. Closing Purchase

D. Closing Sale

SIE Options 263

All of the following would be considered an opening options transaction EXCEPT:

A. Assuming a long ABC Dec 50 Call positionB. Assuming a short ABC Dec 50 Call positionC. Going long an ABC Dec 50 Put as an initial

option transaction D. Going long an ABC Dec Put after going short an

ABC Dec 50 Put

ABC ABC

Equity Contract Characteristics

264

Option can be traded, exercised,

or let expire

Trades settle regular way next

business day

Exercise results in a regular way

stock delivery, so it settles in 2

business days

Trading Cut-Off: 4:00 PM ET; 3:00

PM CT on the third Friday of the month

Exercise Cut-Off: 5:30 PM ET; 4:30

PM CT on the third Friday of the month

Expiration: 11:59 PM ET; 10:59 PM

CT on the third Friday of the month

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Equity Contract Characteristics

• The O.C.C. (Options Clearing Corporation):

o Issues listed options contracts

o Keeps the record of all contractso Guarantees performance if a contract is exercised

o Standardizes the contracts (type, size, strike price, expiration) to make then easy to trade

• The OCC does NOT:

o Trade listed options contracts

o Set the premium on listed options contracts

265 SIE Options 266

The Options Clearing Corporation is responsible for all of the following EXCEPT:

A. standardization of listed options contractsB. trading of listed options contractsC. issuance of listed options contractsD. assignment of exercises of listed options

contracts

SIE Options 267

If an opening trade of an option contract occurs on the CBOE, the issuer of the contract is the:

A. CBOEB. OCCC. SECD. Registered Options Trader

Reasons Investors Use Options

• Speculation: buying or selling an option to “bet” on the direction of market movement

• Hedging: in conjunction with a stock position buy an option to protect the stock position

• Income: in conjunction with a stock position selling an option to create additional income

268

269

SPECULATIVE STRATEGIES

Options 270

Option Chart

Call

Put

Long Short

Max Gain = Prem

Max Loss = BE to 0

BE = Strike – Prem

Max Gain = BE to 0

Max Loss = Prem.


Max Gain = Unlim.

Max Loss = Prem.

BE = Strike + Prem

(Right to Buy)

(Right to Sell)

(Obligation to Sell)

(Obligation to Buy)

Max Gain = Prem.

Max Loss = Unlim.

BE = Strike + Prem.

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Bullish and Bearish

• If we want the price to go up = bullish

o Buying calls

o Selling puts

• If we want the price to go down= bearish

o Buying puts

o Selling calls

271 SIE Options 272

Options - Using the T-Chart

Do options in two steps:

1. Set up initial transactions2. Determine if the contracts

are exercised;-if they are, use the S.P. sign in the chart

Calls are exercised if Mkt Price > Strike PricePuts are exercised if Mkt Price < Strike Price

SIE Options 273

Which of the following positions could give a maximum potential gain of unlimited?

A. long callB. long putC. short callD. short put

SIE Options 274

Which of the following positions could give a maximum potential loss of unlimited?

A. long callB. long putC. short callD. short put

SIE Options 275

Speculative StrategiesLong Calls

A customer buys 1 ABC Jan 30 Call @ $4 when ABC = $29. ABC goes to 47 and the customer exercises the call selling the stock in the market. What is the:

•MPG

•MPL

•B/E

•gain or loss in this situation

ABC = 0

O S

ABC = $1MM

O S

ABC = $47

O S

-4 -4-4

-4 X 100 = -400

MPL

-30-30

-4 + +17 = +13

+ 13 X 100 = +1300

34+1MM

+1MM

MPG

+47

+17

SIE Options 276

A customer buys 1 ABC Jan 35 Call @ $3 when the market price of ABC is at $34. ABC goes to 42 and the customer exercises the call and sells the stock at the market. The customer has a:

A. $200 gainB. $300 gainC. $400 gainD. $700 gain

Speculative Strategies Long Calls

O S

-3 -35

-3 + +7 = +4 X 100 = +400

+42

+7

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SIE Options 277

In November, a customer buys 1 ABC Jan 70 Call @ $4 when the market price of ABC is 71. If the customer closes out the position prior to expiration by selling the call at $10, the gain or loss is:

A. $400 gain B. $400 loss C. $600 gain D. $1000 loss

Speculative Strategies Long Calls

+6 X 100 = +600+10

+6

O S

-4

SIE Options 278

Speculative StrategiesShort Calls

A customer sells 1 ABC Jan 30 Call @ $4 when ABC = $29. ABC goes to 47 and the customer is exercised delivering the stock. What is the:

•MPG

•MPL

•B/E


ABC = 0

O S

ABC = $1MM

O S

ABC = $47

O S

+4 +4+4

+4 X 100 = +400

MPG

+30+30

+4 + -17 = -13

- 13 X 100 = -1300

34-1MM

-1MM

MPL

-47

-17

SIE Options 279

A customer sells 2 ABC Feb 30 Calls @ 2.15 when the market price of ABC is $28.75 per share. The market price of the stock falls to $26 and the customer closes the contracts at a premium of .15 per contract. The customer has a:

A. $200 gainB. $215 gainC. $400 gainD. $430 gain

Speculative Strategies Short Calls

+2 X 200 = +400

-.15+2

O S

+2.15

SIE Options 280

Speculative StrategiesLong Puts

A customer buys 1 ABC Jan 30 Put @ $4 when ABC = $31. ABC goes to 14 and the customer exercises the put buying the stock in the market. What is the:

•MPG

•MPL

•B/E


ABC = 0

O S

ABC = $1MM

O S

ABC = $14

O S

-4 -4 -4

-4 + +30 = +26

+26 X 100 = +2600 MPG

+30 +30

-4 + +16 = +12

+ 12 X 100 = +1200

-4 X 100 = -400 MPL

26- 0

+30

-14

+16

SIE Options 281

A customer buys 1 ABC Feb 50 Put @ $7 when the market price of ABC is 49. If the stock goes to $41 and just prior to expiration, the holder closes out the position with a closing sale at intrinsic value, the gain or loss is:

A. $200 gain B. $200 loss C. $700 lossD. $900 gain

Speculative StrategiesLong Puts

O S

-7

+9

+2 -7 + +9 = +2 X 100 = +200

SIE Options 282

Speculative StrategiesShort Puts

A customer sells 1 ABC Jan 30 Put @ $4 when ABC = $31. ABC goes to 14 and the customer is exercised. What is the:

•MPG

•MPL

•B/E


ABC = 0

O S

ABC = $1MM

O S

ABC = $14

O S

+4 +4 +4

+4 + -30 = -26

-26 X 100 = -2600 MPL

-30 -30

+4 + -16 = -12

- 12 X 100 = -1200

+4 X 100 = +400 MPG

26

+ 0

-30

+14

-16

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SIE Options 283

A customer shorts 1 ABC Jul 40 Put at $6 when the market price of ABC is 38. ABC stock rises to $60 and stays there through July. The customer:

A. gains $600 B. loses $600 C. gains $1400D. loses $1400

Speculative StrategiesShort Puts

O S

+6

+6 X 100 = +600

SIE Options 284

Which of the following options strategies has ever increasing gain as the market keeps rising?

A. long callB. short callC. long putD. short put

SIE Options 285

Which of the following options strategies has ever increasing loss as the market keeps rising?

A. long callB. short callC. long putD. short put

SIE Options 286

Stock with Options Strategies

Long Stock / Short Call

Long Stock / Long Put

Short Stock / Long Call

Short Stock / Short Put

sell stock

buy stock

IncomeStrtgy

HedgeStrtgy

To Collar ALong Stock

SIE Options 287

Stock with Options Strategies (cont.)

A. Long Stock / Short CallB. Long Stock / Long PutC. Short Stock / Long CallD. Short Stock / Short Put

Which of the following give a MPG of unlimited?

SIE Options 288

Stock with Options Strategies (cont.)

A. Long Stock / Short CallB. Long Stock / Long PutC. Short Stock / Long CallD. Short Stock / Short Put

Which of the following give a MPL of unlimited?

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Strategies

289

HEDGING AND INCOME

Stock with Options Strategies

• Long Stock / Short Call = Income in a Flat Market = called covered call writers

• Long Stock / Long Put = Protection in a Down Market = protective put purchase

• Short Stock / Long Call = Protection in an Up Market = protective call purchase

• Short Stock / Short Put = Income in a Flat Market = covered put writer

290

Long Stock / Short Call

• Covered call writers = Income strategy in a flat market

• Sale of call is “covered” by ownership of stock – if call is exercised, the stock that is owned is delivered

• Most popular options strategy – used to enhance returns on stock portfolios

• Not suitable if market drops – customer loses on the stock position and call expires

• Not suitable if market rises – stock is called away at the strike price and customer does not enjoy the upside gain

291 SIE Options 292

Customer Buys 100 ABC @ $50 and sells 1 ABC Jan 50 Call @ 5. ABC goes to 65 and the customer is exercised. What is:

MPG hedge/income/spread/straddle

MPL bull/bear/neutral

B/E exercise/expire

gain/loss

Long Stock / Short Call (cont.)

ABC = 0

O S

ABC = $1MM

O S

ABC = $65

O S

+5 +5+5-50 -50-50+0 +50 +50-50

XX-4,500 +500 +500

B/E = 45

SIE Options 293

Customer Buys 100 ABC @ $48 and sells 1 ABC Jan 50 Call @ 4. ABC goes to 65 and the customer is exercised. What is:



B/E exercise/expire

gain/loss

Long Stock / Short Call (cont.)

ABC = 0

O S

ABC = $1MM

O S

ABC = $65

O S

+4 +4+4-48 -48-48+0 +50 +50

-48-4,400 +600+600+2 +2

B/E = 44

Long Stock / Long Put

• Protective put purchase

• Customer is bullish on the stock, but worried that it might decline

• Purchase of put protects stock position in a falling market

• If market price drops, put will exercised and stock is sold at the strike price

• The cost of the “insurance” is the premium paid

• If market rises, the customer paid for insurance that was not needed. The premium paid effectively increases the cost of the stock position

294

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SIE Options 295

Customer buys 100 ABC @ $50 and buys 1 ABC Jan 50 Put @ 5. ABC goes to 36 and the customer exercises the put. What is:



B/E exercise/expire

gain/loss

Long Stock / Long Put (cont.)

ABC = 0

O S

ABC = $1MM

O S

ABC = $36

O S

-5 -5-5-50 -50-50+50 +1MM +50XX

-500 +unlt. -500

B/E = 55

SIE Options 296

Customer buys 100 ABC @ $53 and buys 1 ABC Jan 50 Put @ 5. ABC goes to 13 and the customer exercises the put. What is:



B/E exercise/expire

gain/loss

Long Stock / Long Put (cont.)

ABC = 0

O S

ABC = $1MM

O S

ABC = $13

O S

-5 -5-5-53 -53-53+50 +1MM +50

-3-800 +unlt-800+1MM -3

B/E = 58


• Protective call purchase

• Customer is bearish on the stock so the stock is shorted, but he or she is worried that it might rise

• Purchase of call protects short stock position in a rising market. If call is not purchased, short stock position has unlimited loss potential

• If market price rises, call will be exercised and stock is bought in at the strike price, limiting upside loss

• The cost of the “insurance” is the premium paid

• If market falls, the customer paid for insurance that was not needed. The premium paid effectively reduces any potential profit on the short stock position

297 SIE Options 298


• short 100 ABC @ 50 and buy 1 ABC Jan 50 Call @ 5, what is the:

MPG = hedge/income/spread/straddle

MPL = bull/bear/neutral

B/E = exercise/expireABC = 0

O S

ABC = $1MM

O S

-5 -5+50 +50-0 -50

+50X

+4,500 -500

B/E = 45

SIE Options 299

Short Stock / Long Call (cont.)

• short 100 ABC @ 48 and buy 1 ABC Jan 50 Call @ 4, what is the:



B/E = exercise/expireABC = 0

O S

ABC = $1MM

O S

-4 -4+48 +48-0 -50

+48+4,400 -600

B/E = 44

-2

Short Stock / Short Put

• Covered put writer

• Income strategy in a flat market

• Sale of put is “covered” by short sale proceeds received from selling borrowed stock – if put is exercised, the short sale proceeds are used to pay for the resulting stock purchase and the borrowed shares are replaced

• Not very popular because it has unlimited risk potential in return for premium received, but it is tested

• Not suitable if market rises – customer can lose an unlimited amount on the short stock position and the put expires

• Not suitable if the market falls – short put is exercised and stock that was sold short must be bought in at the strike price

300

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SIE Options 301

Short Stock / Short Put• short 100 ABC @ 50 and sell 1 ABC Jan 50

Put @ 5, what is the:



B/E = exercise/expire

ABC = 0

O S

ABC = $1MM

O S

+5 +5+50 +50-50 -1MMX

+500 -unlt

B/E = 55

SIE Options 302

Short Stock / Short Put (cont.)

• WHAT?! The MPL was unlimited! How is this a Covered Put Writing Strategy?!?– As already indicated the PUT CONTRACT that

was sold is COVERED by the SHORT STOCK POSITION

– as the Put gets exercised, it is covered by the short stock position

SIE Options 303

Short Stock / Short Put (cont.)• short 100 ABC @ 68 and sell 1 ABC Jan 65

Put @ 5, what is the:



B/E = exercise/expire

ABC = 0

O S

ABC = $1MM

O S

+5 +5+68 +68-65 -1MM

+800 -unlt

B/E = 73

+3

Placing a collar ona long stock position

• A collar on a long stock position typically is used in the following scenario:

o A customer has an appreciated stock position that he is worried will fall in price, so he or she wants to buy a put.

o When he or she hears the amount of premium to be paid, the response usually is: “I don’t want to spend all that money.”

o The broker’s response could be: “Well, if you are willing to give up some of your upside potential by writing a call against the stock, the premium received will offset the cost of the put.”

• Essentially the strategy is a combination hedge (buy a put) and income strategy (sell a call), locking in a sales price for the stock (within a range) at minimal cost – collar for your long position.

304

Long Stock Collar

305

Call

Put

Long Short

Max Gain = Prem

Max Loss = BE to 0


Max Gain = BE to 0

Max Loss = Prem.


Max Gain = Unlim.

Max Loss = Prem.

BE = Strike + Prem

(Right to Buy)

(Right to Sell)

(Obligation to Sell)

(Obligation to Buy)

Max Gain = Prem.

Max Loss = Unlim.

BE = Strike + Prem.

To Collar Long Stock Position – Take Both Down Arrows

PLACING A COLLAR ON A LONG STOCK POSITION

• Collar is:– Long an "out the money" Put AND Short an "out the

money" Call• i.e. customer bought ABC stock at $40 and it is now worth $60• customer wants to hold onto the gain and wishes to sell if the stock

falls below $55• customer would:

– Buy 1 ABC Jan 55 Put @ $1 AND Sell 1 ABC Jan 65 Call @ $1– here, the net cost is "0"

• if the stock falls below $55, the put gets exercised and the customer has a 15 point gain on the stock (buy at $40 and sell at $55)

• if the stock rises above 65, the call contract is exercised and the customer gains 25 (buy at $40 and sell at $65)

SIE Options 306

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A customer has bought stock and wishes to generate some additional income as the market is anticipated to remain flat over the next few months. The appropriate strategy is:

A. long callB. short callC. long put D. short put

SIE Options 307

SELL for income

A customer has sold short stock and wishes to generate some additional income as the market is anticipated to remain flat over the next few months. The appropriate strategy is:

A. long callB. short callC. long put D. short put

SIE Options 308

SELL for income

A customer has bought stock. To protect the stock position in a falling market, the appropriate strategy is to:

A. buy a callB. sell a callC. buy a put D. sell a put

SIE Options 309

BUY for protection

A customer has sold stock short. To protect the stock position in a rising market, the appropriate strategy is to:

A. buy a callB. sell a callC. buy a put D. sell a put

SIE Options 310

BUY for protection

Long the stock and short the call is an appropriate strategy in a:

A. declining marketB. rising marketC. stable marketD. fluctuating market

SIE Options 311

The practice of buying a put and selling a call against a long standing stock position is called a:

A. collarB. strangleC. spreadD. condor

SIE Options 312

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To create a collar on a long stock position, a customer would:

A. buy a call and buy a putB. sell a call and sell a putC. buy a put and sell a callD. sell a put and buy a call

SIE Options 313

Index Options

• Broad based : OEX S&P 100, SPX S&P 500, DJX & XMI Dow Jones Industrial Average, VIX Volatility Index based on anticipate volatility of the S&P 500 (often referred to as the fear gauge)

• Narrow based: focus on a particular industry or segment of the market

• Index option settle in cash for the in the money amount

314

SIE Options 315

Comparison of Equity VS Index Options

The 3rd Friday of the month @ 11:59 PM ETExpiration

4:15 PM ET4:00 PM ETTrading Cut-Off

AmericanLEAP Style

tested as 36 Monthstested as 28 MonthsLEAP Max Life

AmericanStyle

tested as 4 Monthstested as 9 MonthsMaximum Life

Next Day Delivery of Cash2 business Day Delivery of

StockExercise Settlement

Next DayTrade Settlement

100Multiplier

OEX OptionStock Option

CUSTOMER ACCOUNTS

316

New Account Form

317

New Account Form

Customer’s NameCustomer’s

Physical AddressCustomer’s

SS# or Tax IDCustomer’s Date of Birth

These are the 4 critical pieces of information, and these must be verified promptly after account opening by either: matching to a valid government issued photo ID;

or using a database service to do the match

New Account Form

318

Customer citizenship:

• If the customer is a non-U.S. citizen, then to prove identity the firm must obtain:

• a copy of the customer’s foreign passport: and• the customer’s U.S. Tax ID number

Suitability Determination:

• Required if recommendations are being made to the client; not required if the customer makes own investment decisions. Covered later in this section.

Occupation and Employer:

• If the customer is employed by another financial services firm, the employing firm must be notified.

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New Account Form: Associated Person

319

FINRA Rule MSRB Rule

If an associated person of another FINRA member firm wishes to open a securities account:

• Prior written consent of the employing member firm must be obtained;

• The executing member must be notified in writing of the employee's association with another member firm; and

• The executing member must provide duplicate confirmations and statements to the employer member upon written request

If an associated person of another MSRBmember firm wishes to open a securities account:

Duplicate confirms must be sent to the employer

Note the rule doesn’t apply if the person simply wants to buy investment company

securities (like mutual funds) or 529s

New Account Form

320

Who Signs the New Account Form

Who is Not Required to Sign the New Account Form

Principal

Customer

However, almost all firms have the customer sign an arbitration agreement

Customer must be sent a copy of the new account profile, including Suitability Info, within 30 days of account opening for review. New account profile must be sent to customer every 36

months thereafter for review

Practice question

Under FINRA rules, initial approval of new accounts must be performed in writing by the

A. Financial and operations principal

B. Branch office manager

C. Registered representative

D. Supervisory analyst

321

FINRA Suitability Measures

If recommendations are going to be made, a suitability determination must be completed. The rules on suitability are both general and specific. The FINRA general rule is:

FINRA Rule – 3 Levels of Suitability

Reasonable Basis: (aka Product Level Suitability) Before a security can be recommended to a client, the BD must determine that the recommendation has the best risk/return characteristics of other similar products.

Customer‐Specific: Once a security has cleared “reasonable basis” suitability, it cannot be recommended to all customers – only to those for which it is suitable.

Quantitative Suitability: Once a security clears “customer‐specific” suitability, it cannot be recommended unless that customer can afford it.

322

Suitability

Specific suitability rules are set for recommendations of different products and for specific investor groups. These specific rules typically arose because of “problems” that occurred. These are recommendations of (or to):

323

Options Municipal Bonds Senior Citizens

Suitability: OPTIONS ACCOUNT

324

Reasonable efforts must be made to obtain:

• Investment Objective• Investment Experience• Financial Situation • Financial Needs• Income• Net Worth• Liquid Net Worth• Marital Status• # of Dependents• Tax Status

Account must be approved by Registered Options Principal

The RR must put the date on the New A/C Form that the customer was given the latest ODD – Options Disclosure Document

The customer must be sent the Options Agreement for signature and return within 15 days. If not returned, closing trades only

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Suitability: MUNICIPAL BONDS

To recommend municipal bonds to a client, other than the usual suitability information, the client must be asked:

• State of residence• Tax bracket

If customer does not give suitability information, recommendations cannot be made, but unsolicited trades can still be accepted

If a client tells a representative to do a trade that the rep believes is unsuitable, the rep must discuss this with the client and if the client still says, “Do it!” – then “Do it.”

325

Suitability: SENIOR CITIZENS

Rather than a product type that has specific suitability requirement, FINRA has a rule for elderly investors

When making a recommendation to a senior citizen, the RR should consider, the senior citizen’s:

• Lowered risk tolerance• Shortened investment time horizon

•Need for continuing income in retirement

Certain recommendations are usually unsuitable:

•Variable annuities, equity indexed annuities, and DPPs• Structured products •Mortgaging residence to obtain funds for investment purposes

•Using retirement monies to make risky investments

326

Suitability: SENIOR CITIZENSRisky investments can still be recommended to sophisticated, wealthy, non‐risk averse senior citizens

FINRA strongly discourages the use of high‐pressure “free lunch seminars” when soliciting seniors

Bogus certification on business cards, like “Certified Senior Investment Specialist” are prohibited

• If a senior citizen appears to be “out of it,” then:

• The matter should be escalated to compliance;

•Next of kin (if known) should be contacted about this

327

Suitability: SENIOR CITIZENS

328

Financial Exploitation

• FINRA allows a firm to place a temporary 15-day hold on disbursements from the client’s account when fraud is suspected – and if it is believed that the client is being exploited, the hold can be extended for another 10 business days

Trusted Contact Person

• If a hold is placed on the account, the firm must document the reasoning and notify the “trusted contact person” named on the account

• This person is a resource when administering the customer’s account and protecting the customer’s assets if the firm suspects the customer isn’t “with it”

Opening Paperwork

At account opening, the customer must be provided with:

Privacy Statement

SIPC Brochure

BrokerCheck Information

329

Opening Paperwork

• BrokerCheck is run by FINRA. FINRA maintains the database (called CRD – Central Registration Depository) of all member firm records and registered representative records.

• BrokerCheck uses the CRD files to create a publicly accessible record where customers can “check out” member firms and associated persons.

• The BrokerCheck information for associated persons includes:

o Licenses Held

o States Where Registered

o 10 Year Employment History

o Disciplinary Record

o Pending Serious Customer Complaints

o Outside Business Activities

330

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Practice question

Which of the following information about a registered rep would not be available to customers on Broker Check

A. Licenses Held

B. States Where Registered

C. 10 Year Employment History

D. Address

331

Documentation for Margin Accounts

If the account will be a margin account, the customer:

• Must sign the Margin (Hypothecation) Agreement. The customer pledges the securities in the account to the broker in return for the margin loan. The securities go into street name (so the broker can sell them at will)

• Is usually required to sign a Loan Consent Agreement, where the customer permits his or her securities to be lent out on short sales

• Must be provided with a Credit Disclosure Statement that explains how the loan is computed and interest charged

• Must be provided with a Margin Risk Disclosure Document that explains the risks of leverage

332

Account Procedures

333

• No special paperwork needed • States allow an individual account to be held TOD, where the customer names the account beneficiary at account opening.

• This allows the customer to maintain control over the account, but upon death the assets transfer to the named beneficiary, avoiding probate. No one can contest the transfer

INDIVIDUAL ACCOUNTINDIVIDUAL A/C - TOD - (TRANSFER ON

DEATH)

Account Procedures

334

JOINT ACCOUNT

Each named owner signs a joint account agreement and can enter orders and can draw checks to full account name

JTWROS- JOINT TENANTS WITH RIGHTS OF SURVIVORSHIP

Each party 100% owns account. If one dies, the other 100% owns account. Typical for a husband and wife. Transfer bypasses the will and probate, but not necessarily death tax

TENANTS IN COMMON

Each party has a specified ownership %. If that person dies, the % goes to the estate – not to the other owners

Practice question

Assets in which of the following accounts would go through probate in the event of the death of one of the owners.

I. TOD

II. Individual

III. TIC

IV. JTWROS

A. I & II

B. II & III

C. III & IV

D. I & IV

335

Other Account Paperwork

336

• A corporate resolution, naming the individuals authorized to trade, signed by the Corporate Secretary, must be obtained. This must have the corporate seal

• A copy of the corporate charter is required to prove customer identity

• A copy of partnership agreement must be obtained. It will contain a paragraph stating that what type of account can be opened and who is authorized to trade. If the account is for a limited partnership, the only signature required to open the account is that of the general partner

CORPORATE ACCOUNT PARTNERSHIP ACCOUNT

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FIDUCIARY ACCOUNTS

Name a 3rd party who manages the account for a beneficiary.

Unless the account documentation says otherwise:

Cannot be margin accounts – they are set up as cash accounts

Cannot have 3rd party trading authorizations, because there already is a 3rd party to the account

TRUST ACCOUNT

A copy of the Trust Document must be obtained. The Trustee has authority over the account. The account is set up as a cash account unless the Trust Document permits.

All trades must be done for the benefit of the beneficiaries…

Options transactions are permitted (test point) – for example, in a cash account, covered call writing is a safe income strategy

337


GUARDIAN ACCOUNT

A court appointed guardian manages the account for an orphan or incompetent.

A copy of the court order is required

CUSTODIAL ACCOUNT

UGMA/UTMA

No special paperwork needed

Can be opened by any adult for any minor

Any adult can donate – all gifts are irrevocable

All securities registered in account name: 1 Custodian For 1 Minor

Minor’s SS# used on the account for tax purposes

338

Discretionary Accounts

POWERS OF ATTORNEYThe parties to an account are:

1st Party: Broker2nd Party: Customer(s)3rd Party: Anyone Else

A customer can enter trades and draw checks to account nameA customer can give a written power of attorney to either a 3rd Party or the 1st Party3rd Party Trading Authorization names the 3rd party who can trade, signed by the client.

This is a Power of Attorney that can be:• Durable or Non‐Durable: Durable continues if customer is incapacitated; non‐

durable ceases on mental incapacitation• Full or Limited: Full allows 3rd Party to draw checks and trade; limited is trading

only

339


1st Party Trading Authorization names broker as the person authorized to trade, signed by the client. This is a discretionary account. The rules for Discretionary Accounts are

• Signed Power of Attorney (Limited) must be obtained• Every order ticket must be marked as “Discretionary”• The manager must review and endorse the orders at the end of the day (NOT

before they are entered)

End of day approval is OK because transactions are not recorded in customer accounts until settlement (T + 2), so it can be fixed

There is NO requirement to renew the POA annuallyIf the customer dies, the POA dies as well (true for all POAs)

340


When writing an order, the following must be chosen:

Buy or SellSize of tradeSecurity to be tradedPrice of executionTime of executionA written POA in a discretionary account is only needed if the RR chooses Size or Security.

The RR can choose Price and Time without needing a written POA from the client –this is the same as a Market‐Not Held order

If RR chooses Price and/or Time, trade must be performed that day for a retail client; for institutional clients, trade can occur anytime

341

Accounts for Investment Advisers

342

12

Omnibus AccountIndividual new account forms and trading authorizations for each customer

Wrap Accounts• Not a BD product 🡪 used by IA firms

(investment advisers)• IAR license required to offer IA accounts

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Numbered/Coded Accounts

• For customers who want to retain anonymityo Example: 12343lk23

• The firm must keep on file the name of the customer

• The firm must keep on file a written statement signed by the customer showing the customer owns the account

343

Account Maintenance

Confirmations must be sent to clients the day after trade date for regular way trades

Confirmations must be sent to a client on the trade date for cash trades

• Error on confirmation – correct and reconfirm

• Error in execution – customer gets correct price if trade could have been executed per the customer’s instructions

344

Account Maintenance

Statements must be sent:• Quarterly if there is no account activity• Monthly if a trade occurred in that month

Duplicate confirmations and statements can be sent to another party with written customer consent

All mail must be sent to the address provided by the customer; cannot be sent to the branch office or RR

345

Account Maintenance

Customer mail cannot be held UNLESS the customer requests this in writing.

If the customer wants the mail held for longer than 3 months, the customer must state the reasoning why, and “convenience” is not an acceptable reason.

Customer mail can be sent to a PO Box if the customer requests in writing.

346

Death of a Customer

If an RR is notified that a customer has died, then:• All open orders must be canceled; • The account is frozen;• The date of death is noted on the account;• Wait for further instructions

The notification must come from next of kin. If the notice is from someone further removed, a copy of the death certificate should be obtained before taking these actions

The paperwork needed to transfer the account assets to a beneficiary depends on how the account is titled

If it’s a TOD or JTWROS: The beneficiary is known – only need death certificate

If Individual account or tenants in common: Don’t know beneficiary – need death certificate; will; and probate court filing

347

Account Transfer

ACCOUNT TRANSFER (to another firm)

• Customer completes an account transfer instruction at the receiving (new) firm detailing positions to be transferred, signs it, and signature is guaranteed

• New/receiving firm must submit instructions to (old) firm currently carrying account immediately

• Upon receipt of transfer form, old/carrying firm must:

o Cancel open orders – all orders now go through the receiving firm

o Validate the positions within 1 business day

o Transfer the positions in another 3 business days

348

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AML Rules- Patriot Act

349

To thwart terrorism, every new customer

name must be matched to the

terrorist watch list

Examples of suspicious activities:

• If a customer deposits or withdraws cash totaling over $10,000 within a 2-week window, a CTR (Currency Transaction Report) must be filed with FinCEN

• If you are suspicious about a client, an SAR (Suspicious Activities Report) must be filed with FinCEN within 30 days

• Dealing in cash • Making multiple wire transfers of small amounts to

Third World countries• No regard for the cost of transactions • “Structuring” – customers depositing or withdrawing

cash in amounts under $10,000 thinking it won’t be reported

Regulation SP

• Privacy notice deliveredo At account opening

o Every year after

• Acceptable opt‐out noticeso Reply form together with the opt‐out notice

o Providing a toll‐free number to call and opt‐out

• Unacceptable opt‐out noticeso Have the customer write a letter exercising her right to opt‐out

o Check‐off box form only included in the initial notice

350

351

MARGIN RULES

Regulation T

• Reg. T of the Federal Reserve controls credit on securities from broker to customer

• Reg. T does much more than set initial margins at 50%.

• Reg. T defines which securities are marginable. The marginable securities are exchange or NASDAQ listed.

• OTCBB and Pink Sheet stocks are NOT marginable. New issues are not marginable until they have seasoned in the market for 30 days

• Reg. T defines the types of securities accounts.

• Cash Account: Buy any security – pay in full; Sell long

• Margin Account: Buy marginable securities; Sell long or short

• Arbitrage Account: Go “short against the box”

352

Regulation T

When stock is purchased in a cash or margin account, Reg. T requires that the funds be deposited “promptly” but no later than S + 2 (2 grace days past settlement)

Industry rules require payment by settlement (T+2). If payment is not received, under extraordinary circumstances, an extension can be requested from FINRA

FINRA granting an extension is a courtesy and is not automatic – FINRA can say no

If funds do not arrive, the unpaid position must be sold out and the account is frozen for 90 days.

Some firms call this putting a “CUF” on the account – Cash Up Front for 90 days – if the customer behaves, the freeze comes off after 90 days

353 354

Under Regulation T, full payment in a cash account must be made:

A. promptlyB. within 4 business days of trade dateC. within 35 calendar days of trade dateD. within 90 calendar days of trade date

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355

Payment for a securities transaction must be received by how many days in order for the account not to be frozen?

A. promptlyB. next business dayC. 3 business daysD. 4 business days

Regulation T

356

• Reg. T does not apply to exempt securities – Gov’ts, Agencies, municipals – these are only subject to FINRA minimum margins

• Reg. T sets the Initial Margins for stock positions. These are:

Long Short

• After initial margin has been deposited, the account must be marked to market at the end of the day. If the account loses value, then the FINRA minimum margins kick in.

• The FINRA Minimum Maintenance margins are:

Long Short

50% 50%

25% 30%

Minimum Margin

• When the account is marked to market each day, nothing happens in a long account until it falls below the 25% FINRA minimum. If this happens, a maintenance call is sent to bring the account back to the 25% minimum – NOT to 50% initial margin

• When the account is marked to market each day, nothing happens in a short account until it falls below the 30% FINRA minimum. If this happens, a maintenance call is sent to bring the account back to the 30% minimum – NOT to 50% initial margin

• Aside from the minimum margin percentages, FINRA has a whole bunch of quirky minimums. There are situations where the FINRA minimum is more than Reg. T – and the larger amount prevails

357

Minimum Margin

• FINRA Minimum Equity To Open New Long Account: $2,000 but never more than full payment (which is max loss)o Initial Transaction, new account, customer buys $3,000 of stock Deposit is

$2,000o Initial Transaction, new account, customer buys $1,000 of stock Deposit is

$1,000 (full payment = max loss)

• FINRA Minimum Equity To Open New Short Account: $2,000 Rock Bottom!o Initial Transaction, new account, customer shorts $3,000 of stock. Deposit is

$2,000o Initial Transaction, new account, customer shorts $1,000 of stock Deposit is

$2,000 ($2,000 rock bottom because potential unlimited loss)

358

359

Long Account

$1,700*$850

$2,000$1,000

$2,000$1,500

$2,000$2,000

$2,500$2,500

100 @ $17

100 @ $20

100 @ $30

100 @ $40

100 @ $50

New

Customer

Deposit

Existing

Reg. T

(50%)

Long

Account

360

Short Account

$2,000*$850

$2,000$1,000

$2,000$1,500

$2,000$2,000

$2,500$2,500

100 @ $17

100 @ $20

100 @ $30

100 @ $40

100 @ $50

New

Customer

Deposit

Existing

Reg. T

(50%)

Short

Account

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Practice question

Which of the following statements are true about minimum requirements in a margin account

A. Minimum initial requirement for a long account is 25%

B. Minimum initial requirement for a short account is 30%

C. Minimum maintenance for a short account is 50%

D. Minimum initial for a long account is 50%

361 362

VARIABLE ANNUITIES

363

• Until the 1950s, insurance companies sold 2 products:• fixed life insurance

• fixed annuities

– with these products, the insurance company collects a premium from the policyholder and invests it in its general account

– no matter how good or bad the investments in the general account perform, it doesn't affect the amount of insurance or the amount of annuity paid to the holder

– product type insurance• since the insurance company bears the investment risk

364

• In the 1950s, insurance companies started selling 2 new products:

• variable life insurance

• variable annuities

– with these products, the insurance company collects a premium from the policyholder and invests it in a designated SEPARATE account that buys mutual fund shares (SEPARATE from the insurance co.'s gen. acct.)

– the amount of insurance or the amount of annuity paid to the holder depends on the performance of the mutual fund in the separate account

– product type securities• since the policyholder bears the investment risk

CAUTION!!• other investment vehicles (i.e. IRAs and employer-

sponsored 401(k) plans), provide the investor with tax-deferred growth

• for most investors, it is advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity. – also, there is NO additional tax advantage of the variable

annuity if you are investing in a variable annuity through a tax-advantaged retirement plan (such as a 401(k) plan or IRA)

• consider buying a variable annuity only if it makes sense because of the annuity's other features, such as lifetime income payments and/or death benefit protection

FIXED ANNUITY

• Insurance company retains the investment risk o The insurance company makes very conservative investment choices (U.S.

Government debt)

• Insurance Company has the expense risk (cost of maintaining the annuity)

• Insurance Company has the mortality risk

• Tax deferred

• The money invested into a fixed annuity goes into the general account for the life insurance company

• Generally used for older investors

365

VARIABLE ANNUITY

• Investor assumes the investment risko Now the money goes into a separate account

▪ In the separate account the investor can now pick what packagemeets their needs – investing in different “sub‐accounts”

▪ Structured as Participating UITs / mutual fund subset

• Insurance Company has the expense risk (cost of maintaining the annuity)

• Insurance Company has the mortality risk• Tax deferred• The money invested into a variable annuity goes into the sub‐account for the life

insurance company• Generally used for younger investors long term

366

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367

10% Penalty + Income Tax

No penaltyWithdrawal prior to age 59 ½:

MandatoryOptionalDividend reinvestment is:

Tax deferredTaxableDividends received are:

Separate Account

PortfolioInvestments are held in a:

Accumulation Unit

SharePurchaser is buying:

Variable Annuity

Mutual FundComparison VARIABLE ANNUITY

• The trust collects the premiums from the purchaser and invests them in the designated separate account, where they buy “accumulation units”– not shares

• There is no tax deduction for amounts contributed

• Dividends from the mutual fund in the separate account must be reinvested and build tax deferred

• Payments at retirement ‐ only the build‐up portion (earnings) is taxed always at ordinary income rates

368

SIE Investment Companies 369

Moneys that are deposited to a variable annuity contract go into the insurance company's:

A. Cash AccountB. Special Memorandum AccountC. Separate AccountD. General Account


The accounting measure that is used to show a person's ownership interest in a variable annuity contract is a(n):

A. Accumulation UnitB. ShareC. Accumulation AccountD. Annuity Unit

VARIABLE ANNUITIES ACCUMULATION PERIOD (Pay in period)

• Used by “younger investors” who want supplemental retirement

• Every time the investor is purchasing into his annuity, he is buying accumulation units

• ALWAYS ASSUME AN ANNUITY IS FUNDED WITH AFTER TAX DOLLARS UNLESS THE TEST TELLS YOU OTHERWISE

• Earnings grow tax deferred and they are taxable upon withdrawal

• As the investor puts more money in the number of accumulation units will go up

• What if an investor withdraws his money from the annuity before he is age 59 ½

o Contributions – tax free (why? He/she already paid taxes on that portion)

o He must pay ordinary income tax on the taxable portion PLUS the taxable portion is subject to a 10% premature distribution penalty

371

VARIABLE ANNUITIES

If owner chooses a lump sum distribution, then he or she will get all contributed dollars and growth out the separate account. This can be taken as installments:

for a designated time; orof a designated amount

These are taxed LIFO. Also note with this option, the customer can outlive the accountWe always assume a withdrawal from an annuity is a single distribution, even if they are taking the same $ amount every month – do not assume the customer annuitizedEarnings go out first and they are taxable at ordinary income…once the earnings are exhausted then the cost basis is taken out (not taxable)

If the owner chooses to annuitize, then the insurance company converts the accumulation units into a fixed number of annuity units, based on the client’s expected mortality (from the mortality tables that consider age, weight, sex, smoking, etc.)The fixed number of annuity units x unit value (varies) = monthly payment

372

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The major tax advantage of variable annuities is the:

A. tax deductibility of contributions madeB. tax deferral of the earnings build-up in the

separate accountC. taxation of distributions at long-term capital

gains ratesD. tax exemption given to distributions from the

separate account


A customer contributed $20,000 to a variable annuity contract. The account value has grown over the years and the NAV is now $35,000. The customer is now age 60, and takes a lump-sum distribution of $20,000 to pay for expenses. Which statement is true?

A. The entire $20,000 distribution is not taxable B. $5,000 of the distribution is taxable and $15,000

is not taxable C. $15,000 of the distribution is taxable and $5,000

is not taxable D. The entire $20,000 distribution is taxable

Do variable annuities have a death benefit during the accumulation phase?

YES• The death benefit for the beneficiary is the greater of the

o Contributions made OR

o Market value on the investor’s date of death

• Does the payout option (straight life, joint and last survivor, etc.)

o NO! the payout option only matters when you annuitize

375

VARIABLE ANNUITIES

ANNUITY OPTIONS ‐

LIFE ANNUITY (straight life):

Only makes payments for that person’s life. Walk in front of a truck the day after annuitization and the annuity stops. Gives the LARGEST monthly payout because, when looking at a large group of people, the insurance company expects to pay for the shortest time period

LIFE WITH PERIOD CERTAIN:

The insurance company promises to pay for a minimum guaranteed period (e.g., 10 years), regardless. If the insured walks in front of a truck the day after annuitization, 10 years of payments are made to a beneficiary. Because the insurance company must pay for at least 10 years for everyone, the monthly payment is less than a Life Annuity

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Annuitization phase = investor has traded their contributions for payments over their life

VARIABLE ANNUITIES

JOINT AND LAST SURVIVOR:

For husband and wife, makes payments until the second one dies. Because one spouse typically lives a bunch longer than the other, the insurance company expects to pay for the longest time period – thus this gives the SMALLEST monthly payout.

UNIT REFUND:

If the policyholder dies before his or her expected mortality, the insurance company “refunds” the remaining annuity unit value in the separate account to a beneficiary

377 SIE Investment Companies 378

A variable annuity contract holder wants an annuity payout option that will guarantee that payments continue only for his or her life. The appropriate payout option is:

A. Life annuityB. Life annuity with period certainC. Joint and last survivor annuityD. Unit refund annuity

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Which annuity payout option usually results in the largest periodic payment?

A. Life annuityB. Life annuity with period certainC. Joint and last survivor annuityD. Unit refund annuity


Which of the following annuity payment options will continue payments for a specified time period if the annuitant dies prematurely?

A. Life Annuity B. Life Annuity with Period Certain C. Joint and Last Survivor Annuity D. Unit Refund Annuity


All of the following are purchase and payout options for variable annuity contracts EXCEPT:

A. Lump sum payment; Deferred annuity B. Periodic payments; Immediate annuity C. Periodic payments; Deferred annuity D. Lump sum payment; Immediate annuity

VA SUITABILITY

• The RR must make a reasonable effort to obtain information regarding the customer's:o Age, income, investment experience/objectives, risk tolerance, tax status,

investment time horizon ‐ and any other info that is needed to make a reasonable recommendation to the customer

• The RR must have a reasonable basis to believe that:o The customer has been informed of the material features of the product and

understands the costs of the product;o The customer will benefit from the features of the product; ando The particular annuity, the separate accounts to which funds are allocated,

and the riders to the policy are suitable • The RR MUST sign a statement that these determinations were performed • Note – the RR signs – NOT the customer

382

To sell a variable annuity, what license(s) is (are) needed?

A. Series #6 only B. SIE only C. Series #6 or SIE D. Series #6 or SIE plus a state insurance license


VA TAXATION

• Variable annuities are a non‐qualified retirement plan• VA should only be considered after a client has “maxed out” his or her qualified

plan contributions• The appropriate age range to start contributing is 40–60 (Younger and you have

other pressing expenses like paying a mortgage and kid’s schooling; older and you don’t have a big‐enough build‐up period)

• There is no limit to the amount contributed and no deduction for the contribution

• Dividends must be reinvested and build tax‐deferred• When distributions commence after age 59 ½, only the build‐up portion is

taxable• If an investor annuitizes the payment will be blended – a portion is the cost basis

(not taxable) and portion will be earnings (ordinary income)

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1035 EXCHANGE

• The exchange of one annuity contract for another to get a contract, perhaps, with better performance or lower expenses

• This can be done without a tax consequence‐ 1035 exchange:

385

• CAN EXCHANGE TAX‐FREE:• Annuity For Annuity (either Fixed or

Variable)Life• Insurance for Life Insurance• Life Insurance for Annuity

• CANNOT EXCHANGE TAX‐FREE:• Annuity for Life Insurance• (Because IRS would lose out – taxable

income from annuity starts earlier than death benefit payment)

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RETIREMENT PLANS

Contribution Tax Status

387

Tax Qualified Non-Tax Qualified

Contribution is pre-tax dollars (no taxes are paid) Contribution is after tax dollars (we already paid taxes on the contribution)

Contributions grow tax deferred Contributions grow tax deferred

No cost basis Cost basis = original contributions (already taxed)

At retirement everything is taxed as ordinary income Only the build-up is taxed as ordinary income

What types of plans:Pension/Defined Contribution/BenefitTraditional 401k403b Qualified annuityTraditional IRAs

What types of plans:Roth 401k (hybrid)Roth IRA (hybrid)Non-qualified variable annuitiesSome IRAs529 plans (hybrid)Coverdell ESA (hybrid)

EMPLOYEE CONTRIBUTIONS

• Employee contributions are tax deductible (pretax, qualified)

• Early withdrawal (before age 59 ½) will create a 10% penalty unless

o Death

o Disability

o Terminally ill and at least 55

o Divorce settlement (QDRO – qualified domestic relations order)

o Substantial payments over lifetime

o Medical expenses that exceed 7.5% of AGI

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ERISA

Employee Retirement Income Security Act of 1974

• Protects employees from their employers

• Plan must be in writing

• Plan cannot be discriminatory

• Private sector including corporations and sole proprietors

• Plan must have a written vesting schedule ‐ Employees ownership of employer contributions (an employee is always 100% vested in their own contributions)

o 3 year “ cliff vesting “ or

o 5 year 20% per year vesting

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Only for private corporations and sole proprietors

PENSIONS

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These plans are noncontributory

Define Benefit PlansBenefits are defined –I know the amount I get at retirement

Contributions may vary (could become ‐0‐)

Benefit out at retirement is based

on a formula

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Traditional 401-k

Salary deferral plan

• Defined contribution

• Part of salary goes in pre‐tax

• Employer may make contributions as well

• Loans are allowed

• Current maximum contribution is ‐ $19,500 per year

• Catch‐up to $6,500 if 50 years or older

• May begin withdrawing at 59 ½

• Typically a 5‐year vesting on employer contributions

• Upon withdrawal once we are age 59 ½ or older = everything is taxed at ordinary income rates

• MRDs begin at age 72

391

ROTH 401-k

• Contributions are after tax – not tax qualified

• Growth (interest, dividend, and capital gain distributions) is tax deferred

• Current maximum contribution is ‐ $19,500 per year

• Catch‐up to $6,500 if 50 years or older

• Withdrawals are tax free is after 59 ½

• No MRDs

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403-b plans

NOT an ERISA planFor nonprofit organizations( School, Hospital and Church employees)501(c)3 – is the organization the non‐profit403(b) plan works just like a traditional 401k, but it is not a 401k• Pre‐tax contributions up to $19,500 per year (if I am age 50 or older

catch up is $6500)• 403(b) – qualified annuity tax deferred annuity (TDA) or

tax sheltered annuity (TSA)• Can invest in Annuities and Mutual Funds (managed accounts only)• May withdraw as of 59 ½• Must withdraw April 1st of the year that follows the year that

the customer turns 72• If age 59 ½ or older – withdrawals are taxed fully as ordinary income

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KEOGH (HR-10 PLANS)

• Plans for self employed persons

o DBA customers (doing business as)

• Under ERISA

o Contributions can only be based on the income earned as a sole proprietor

• Must cover employees that are 21 years of age and have worked there for over 1 year

• MAXIMUM 20% for the EMPLOYER capped at $58,000

• MAXIMUM for employees 25% of income

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A customer earns $100,000 per year as a self employed foot doctor. The maximum annual contribution to a Keogh plan is:

A. $6,000B. $20,000C. $54,000D. $58,000


A customer earns $200,000 per year as a self employed foot doctor. The maximum annual contribution to a Keogh plan is:

A. $40,000B. $58,000C. $108,000D. $150,000

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A doctor earns $290,000 per year and contributes the maximum for the year to a Keogh. The doctor employs a male nurse earning $40,000 a year. The contribution to be made on behalf of the male nurse is:

A. $4,000B. $6,000C. $8,000D. $10,000

IRA ACCOUNTS

• IRA means the investor works and they want to contribute into a retirement account for themselves outside of any possible work plan

• max contribution ‐ 100% of earned income up to $6,000

• Catch Up if 50 years or older is $1,000

• Spousal IRAs are available

• If a working spouse has a non‐working spouse, how much can be contributed into the non‐working spouse’s IRA? Assume underage of 50 for the test

$6,000 (the total contribution $12,000 between the two accounts cannot exceed 100% of the working spouse's income)

• 6% excess contribution penalty

398


An individual makes $1,000 a year. What is the maximum permitted IRA contribution?

A. 0B. $1,000C. $3,000D. $6,000

Traditional IRA’s

If not covered under a work sponsored plan, the contribution is ALWAYS tax deductible (funded with pretax dollars)

If there is a work sponsored retirement plan:

Income $76,000 or more – no deduction If I make $76,000 or more per year, I can still fully contribute into my IRA, but I must contribute Nonqualified/ after tax dollars

If income between $66,000 and $76,000 there is a partial deduction

Under $66,000, contribution is fully deductible

400

IRAs

• Contribution must be made by tax filing date of the tax year

• Traditional IRA we must start taking distributions in the year he/she turns 72

o If the investor doesn’t take a withdrawal from his/her IRA by April 1st after the investor turns 72 the penalty per IRS is 50% PLUS the investor has to pay ordinary income on withdrawal

• Can an investor still contribute into their IRA after age 72?✔Answer is YES if the investor has earned income

• Cannot borrow from an IRA

• Can invest in everything but Life Insurance and Collectibles (gold and silver coins minted by the U.S. Treasury are OK)

401

All of the following are allowed investments in an Individual Retirement Account EXCEPT:

A. Preferred Stock B. U.S. Government Gold Coins C. Antiques, Art, and Other Collectibles D. U.S. Government Bonds


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Practice Question

For retirement plans that require minimum required distributions those distributions must begin by

A. Age 59 ½

B. Age 65

C. Age 70 ½

D. Age 72

403

EARLY WITHDRAWAL

• OK at 59 ½

• We can take out the money before age 59 ½ without a penalty if:

o Dead or disabled

o Health expenses in excess of 7.5% of AGI

o Higher Education expenses

o $10,000 for 1st time home buyer

o Substantially equal payments under rule 72T (if you lost your job and you substantially receive the same payments over 5 years)

• If none of these, there will be a 10% penalty on the taxable portion

404

405

Rollovers

60‐day Rollover• You may rollover an IRA once a year

• Rollovers must be completed within 60 calendar days

• You take physical custody

• There is a 20% withholding on rollovers

Direct Transfer• It is between Administrators –Customer has no physical custody

• No withholding for tax purposes


To maintain the tax-deferred status of a distribution from a qualified pension plan into an Individual Retirement Account, a rollover must be completed within how many days of the distribution:

A. 10B. 30C. 60D. 90

DEATH OF THE OWNER

• Upon death, generally, the beneficiary must take the proceeds over 10 years

• Though if the beneficiary is the spouse, they can use their own life expectancy or roll it over to their own IRA

• Distributions are taxable

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ROTH IRA

• All contributions are after tax• Grows tax deferred• Withdraw tax free if we have held the account for 5 years and:

1. 59 ½ or older Before 59 ½

2. Dead/disabled3. First time homebuyer – up to $10,000

• No mandatory withdrawal at 72• Can an investor still contribute into their Roth IRA after age 72?✔Answer is YES if the investor has earned income

• Very wealthy investors cannot contribute into a Roth IRA

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Distributions from Roth IRAs:

A. must commence by April 1st of the year prior to reaching age 72 without being penalized

B. must commence by April 1st of the year of reaching age 72 without being penalized

C. must commence by April 1st of the year after reaching age 72 without being penalized

D. can commence at any time after reaching age 59 1/2 without being penalized

All of the following retirement plans require that minimum distribution amounts be taken once the participant reaches the age of 72 EXCEPT:

A. 403(b) plansB. 401(k) plansC. Roth IRAsD. Traditional IRAs


NON-QUALIFIED PLANS

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Contributions are after tax

Growth is tax deferred

Growth is taxed as ordinary income when withdrawn

Contributions should not be rolled over

EDUCATIONAL PLANS

Coverdell Plans

• $2,000 per year

• Contributed after tax

• Must stop contributions at 18 years

• No longer available at 30 years – if not used

1. pay tax or

2. transfer to a relative of an equal or younger generation

• Very generous regarding what you can spend the money on‐ not just higher education

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EDUCATIONAL PLANS

529 plans

• Treated as a gift so $15,000‐ or 1‐time gift of $75,000 (5 yrs. x $15,000 gift tax rule)

• Not tax deductible

• If used for Qualified Education expenses the assets are withdrawn tax free

• Up to $10K annually can be used for education below college level

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Local Government Investment Pool

LGIP

• State created investment pool

• Serves as a vehicle for people for investing public funds of government entity

• If it is marketed by the LGIP personnel to governmental entities, they are not subjected to MSRB rules

• If it is marketed by a broker‐dealer it is subject to MSRB rules

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Achieve a Better Life Experience (ABLE) account

• Allows up to $15,000 after tax dollars per year to be contributed into an account to pay for the care of a disabled individual

• To qualify, the beneficiary must be disabled before age 26

• If distributions pay for qualified expenses, they are tax free

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Health Savings Accounts (HSAs)

• Only insurance plans that have a high deductible can set up an HSA

• Allows the employer or employee to make a deductible contribution of up to $3,600 for an individual; or $7,200 in 2021 for a family

• The account grows tax deferred; and distributions to pay for qualified medical expenses are tax‐free

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