Chapter 2: Equity and Debt Securities

What are the two important GSEs?

Two important GSEs are the Federal National Mortgage Association, known as Fannie Mae, and the Federal Home Loan Mortgage Corporation, known as Freddie Mac. Both entities are privately-owned, publicly-traded companies that purchase mortgages on the secondary market and pool them to create mortgage-backed securities. Thus, both Fannie Mae and Freddie Mac are issuers of mortgage-backed securities.

Serial Bond

a serial bond is a bond issue whose maturities are staggered in equal installments over a specific time period. That same $20 million might come due in $2 million installments during each of the years of the bond's 10-year life.

Residual Claims

a stockholder's claim to corporate earnings when all debt obligations have been satisfied after a liquidation.

Banker's Acceptance

A banker's acceptance is a short-term credit instrument issued by a business for the purchase or sale of goods, usually in an international market. For example, imagine that a U.S. importer would like to purchase a large amount of machines from Japan. The Japanese manufacturer may be reluctant to accept the order because of fear it may not receive payment. The U.S. importer could issue a banker's acceptance, which is an order for a bank to pay a certain amount of money at a later date. The banker's acceptance is guaranteed by the bank so it is considered a secured debt security. Banker's acceptances are usually issued at a discount to face value, like a Treasury bill, and they can be traded on the secondary market.

Bond Point

A bond point represents one hundredth or 1% of par. Thus, ten bond points is 10% of par, and five bond points is 5% of par. Because corporate bonds typically have a par value of $1,000, one bond point is equal to $10.

Discount Bond

A bond that sells below its par value is called a discount bond. The benefit of such a bond is that investors receive the face value of the bond when it matures, which is greater than the price they paid for it.

Balloon Maturity

A maturity schedule where a large number of the bonds mature at the same time.

Mortgage-Backed Security (MBS)

A mortgage-backed security (MBS) is a bond backed by the mortgage payments of a pool of mortgages. From an investor's perspective, an MBS is similar to any other kind of bond, except instead of receiving a fixed coupon payment, the investor receives monthly interest payments that vary depending on how quickly homeowners pay off their mortgages. That is, an investor who purchases a $1,000 mortgage-backed security will receive monthly interest payments that are based on the interest and principal payments of the underlying mortgages.

General Obligation Bonds

A municipal bond backed by the full faith and credit of the municipality. (unsecured) GO bonds are sold to fund the general operating expenses of the municipal government or to provide funds for capital improvement projects, such as roads, parks, courthouses, and schools. They are backed by the full faith and credit of the issuer, which means that the issuer must use its full taxing and borrowing authority to ensure the timely payment of principal and interest. Voter approval is often required for the issuance of general obligation bonds. This makes sense, because the taxpayer is the creditor of last resort. Only entities that have the right to levy and collect taxes may issue general obligation bonds. In addition, most municipalities have debt limits that cannot be exceeded without voter approval. State GO bonds are usually paid with income, sales, and excise taxes collected at the state level. Since general obligation bonds are meant to benefit the public, they are paid for by everyone subject to that state. Local GO bonds are most commonly backed by ad valorem property taxes. Ad valorem taxes are a type of tax based on the value of the asset being taxed. Non-tax revenue, such as parking fees, parks and recreation fees, and licensing fees, may be applied to pay interest on these bonds as well.

Premium Bond

A premium bond is a bond sold above its par value. Suppose interest rates have fallen to 4% and you hold a 6% bond. You're not likely to be interested in selling such a bond and giving up its higher interest rate without receiving some sort of incentive, such as a premium above the stated value of the bond.

Arbitrage

A price of a convertible bond will never vary far from its conversion parity, because if it did, many investors would try to profit from the difference between a bond's conversion value and its selling price. This investing strategy of profiting from differences in prices across markets is called arbitrage. To illustrate, suppose a convertible bond has a conversion value of $1,200, but is selling at $1,160. An arbitrageur (a fancy word for an investor who wants to take advantage of this difference) purchases the bond and immediately converts it, making a risk-free $40 profit. Because there are always arbitrageurs that will make a profit by doing this in quantity, bond prices never vary far from parity.

Repurchase Agreement and Reverse Repurchase Agreement

A repurchase agreement, or repo, is typically a short-term contract to sell an asset and simultaneously buy it back in the future at an agreed-upon price (typically a higher price). On the other side of the transaction, the party who is agreeing to buy the asset and sell it back at a fixed price has engaged in a reverse repurchase agreement. The assets involved are usually government or municipal securities. At its simplest, a repo is a form of short-term borrowing. Within the financial industry, financial institutions use them as short-term loans to cover needed expenses. There is no secondary market for repurchase agreements.

Brady Bond

A sovereign debt security issued in U.S. dollars by Latin American and other developing countries.

Stock Appreciation Right

A stock appreciation right is an option given to a company employee to receive a bonus equal to the appreciation in a set number of shares of the company's stock. Stock appreciation rights are granted at a set exercise price, usually the fair market value of the stock on the date they were granted. Stock appreciation rights have a vesting period during which the option cannot be exercised, usually one to three years, and they have an expiration date, usually 10 years. Once vested, an employee can exercise the option at any time prior to the expiration date. When the employee exercises the right, the employee receives the difference between the exercise price and the current market price of the stock. Payment may be made to the employee in cash or stock or both.

How is a warrant different from a call option?

A stock warrant is just like a stock option because it gives you the right to purchase a company's stock at a specific price and at a specific date. However, a stock warrant differs from an option in two key ways: 1) A stock warrant is issued by the company itself 2) New shares are issued by the company for the transaction. Unlike a stock option, a stock warrant is issued directly by the company. When a stock option is exercised, the shares usually are received or given by one investor to another; when a stock warrant is exercised, the shares that fulfill the obligation are not received from another investor, but directly from the company.

Fixed-Rate Preferred Stock

A stock with a dividend payment that is set at a fixed dollar value ($5) or on a percentage of the par value of the stock as stated on the stock certificate (5%).

Subscription Right and Follow-on Offering

A subscription right is similar to a warrant but has a shorter life, usually lasting two to four weeks. Essentially, subscription rights originate when a company decides to raise additional money by offering additional shares of an existing stock to the public. This is called a follow-on offering.

Warrant

A warrant is a financial instrument that gives the holder the right to purchase securities from an issuing company at a specific price in the future. When warrant holders execute their right to buy shares, it increases the number of shares outstanding in the market, thereby diluting the holdings of existing shareholders.

Zero Coupon Bonds

A zero coupon bond (or "zero") is one that makes no periodic interest payments. Instead, zero coupon bonds are issued at a deep discount to their face value, with the face (or par) value being delivered at maturity; a zero thus is a type of discount bond. Zero coupon bonds may be issued for as little as 10% to 15% of their face value, depending on prevailing interest rates and the term of the bond. Zeros are usually issued in $5,000 increments. For example, a 20-year bond that has a par value of $5,000 may have a $1,000 issue price. A lower price means a greater return.

American Depository Shares (ADSs)

ADR shares held in the custodian bank are called American Depository Shares (ADSs). The conversion rate or ratio is set by the custodian bank, and it adjusts based on changes in the exchange rate of the home country currency and the U.S. dollar. The price of ADRs in the U.S. market closely follows the price of their underlying securities in the foreign market.

American Depository Receipts (ADRs)

ADRs are receipts issued by a U.S. bank that represent shares of a foreign stock. ADRs are traded on U.S. exchanges. The purpose of ADRs is to make it easier for U.S. investors to trade shares of a foreign-based corporation in the U.S. stock market.

A customer purchases a 6% XYZ convertible debenture at par for $1,000. The bond is convertible at $25. If the stock is selling at $30 per share and the bond is sold at parity, what will it be sold at?

Answer: $1,200 Explanation: First, find the conversion ratio by dividing the conversion price into the par value: $1,000 / $25 = 40 shares of common for 1 bond. Then multiply 40 shares times $30 to find the parity value (40 x $30 = $1,200). Another way of doing it is to find the conversion value: $1,000 / $25 = 40 shares per bond. Then subtract the current share price from the convertible share price to get the difference: $30 - $25 = $5 per share. Then multiply $5 times the number of shares per bond, or $5 x 40 = $200. Finally, add that $200 to the bond's par value of $1,000 to get the answer: $1,200.

If the bid-ask spread of a corporate bond is 98 3/8 to 99 7/8, what is the spread in dollars?

Answer: $15.00 Explanation: Recall that the face value of a corporate bond is $1,000. The bid price in dollars on a corporate bond is therefore 98 3/8 = 0.98375 x $1,000 = $983.75. The ask price is 99 7/8 = 0.99875 x $1,000 = $998.75. The spread is the difference between bid and ask, $998.75 - $983.75 = $15.00.

XYZ issues preferred stock with a 10% annual dividend. The par value on the preferred stock is $100 per share. The share price of the preferred stock is $110, and the share price of the common stock is $200. What is the quarterly per-share dividend on the preferred stock?

Answer: $2.50 Explanation: The annual dividend would be par value times dividend rate ($100 x 0.10 = $10.00). The quarterly per-share dividend will be $2.50. The current price of the preferred stock and common stock are irrelevant to calculating the dividend.

A customer purchased a 6% XYZ convertible debenture at par for $1,000. The bond has a conversion ratio of 50. The price of the stock has risen to $25 per share. The bonds are trading 10% above parity. What can the customer sell his bond for in bond points?

Answer: 137.5 bond points Explanation: First, find the conversion parity value by multiplying the conversion ratio by the stock price: 50 shares x $25 = $1,250. Then multiply the parity value by 110% ($1,250 x 1.1 = $1,375). So he could sell his bond for 137.5 bond points.

A customer purchased a 6% XYZ convertible debenture at par for $1,000. The conversion price is $20. If the bond's market price increases by 10%, what is the conversion ratio?

Answer: 50 Explanation: Find the conversion ratio by dividing the conversion price into the par value: $1,000 / $20 = 50 shares of common for 1 bond. The conversion ratio is not influenced by a rise in the market price of the bond.

Hot Box Lunches Corporation carries out a 1-for-5 split. Sheila has 1,000 shares. Before the split, each share was trading for $20 per share. How many shares does Sheila have after the split, and at what price will they trade? A. 200 shares at $100 each B. 5,000 shares at $4 each C. 200 shares at $20 each D. 5,000 shares at $20 each

Answer: A Explanation: A 1-for-5 split is called a reverse split, because each investor will receive one share for every five shares. After the split, Sheila will have 200 shares (1,000 / 5 = 200) at $100 each ($20 x 5 = $100). The value of her investment will stay the same at $20,000.

Daredevil Dave, a famous skydiver, is your client. "Double D," as he is known, comes to you and tells you that in 18 months he is planning on doing his most dangerous dive yet: a free fall from an orbiting space station. Double D says that he doesn't have life insurance, and in case he doesn't survive this space dive, he wants to make sure his family will be provided for. He wants them to receive a monthly payment of $5,000 in perpetuity. He asks you how much money he will need to pay now in order to achieve this. Assuming a 2% rate of return and assuming this is going to be Double D's last dive, you tell him that he will need to contribute: A. $3 million B. $6 million C. $9 million D. $12 million

Answer: A Explanation: A perpetuity is an annuity or stream of payments without end. To calculate the present value of a perpetuity, you divide the periodic payment by the rate of return (also known as interest rate or yield). In this case there are two ways to reach the answer: (1) divide the 2% rate of return by 12 to get the monthly rate of return (0.001667), then divide the monthly payment by the monthly rate of return ($5,000 / 0.001667 = $2,999,400), or (2) multiply $5,000 times 12 months to get a $60,000 annualized payment to the family and then divide that by the 2% yield, or $60,000 / 0.02 = $3 million.

Jon Pierre lives in France and wishes to buy a bond that is issued by a Japanese company, with its interest and principal paid in U.S. dollars, and that is sold in France. What type of bond would be appropriate? A. Eurobond B. Eurodollar bond C. Yankee bond D. Sovereign bond

Answer: B Explanation: Eurodollar bonds are Eurobonds denominated in U.S. dollars, meaning that the interest and principal will be paid in U.S. dollars, but the bonds will be sold outside the U.S.

Tax Equity and Fiscal Responsibility Act of 1982

As a result, the Tax Equity and Fiscal Responsibility Act of 1982 prohibited their further issuance, although many 50-year bonds still remain active. Today anyone depositing coupons must present identification, and that information is passed to the IRS.

A $100 convertible preferred stock certificate is issued in March 2009. The stock pays 4% in dividends and is convertible at $20. The price of the company's common stock at issue was $10.27 per share. On the conversion date of March 15, 2013, the common stock is at $13.10 per share. What is the conversion parity price for the preferred share, if the shareholder converts on the conversion date? A. $51.35 B. $20.00 C. $65.50 D. $100.00

Answer: C Explanation: The convertible price tells the shareholder how many shares of common stock she will get for one share of convertible preferred stock. To find the number of shares, divide the convertible price into the face value of the preferred stock. In this example, it is $100 / $20 = 5. Thus, the conversion ratio is 5; the shareholder will receive 5 shares of common stock upon conversion. The conversion parity price is the current market value of the preferred share if converted. It is calculated by multiplying the current market price by the conversion ratio ($13.10 x 5 = $65.50). If the convertible is trading at lower than $65.50, the investor will want to convert her shares. If the convertible preferred is trading at higher than $65.50, the investor will want to hang on to her shares.

Ruby Red Jewelry has issued both common stock and cumulative preferred stock. The cumulative preferred stock pays an 8% annual dividend on stock with a $100 par value. Ruby Red Jewelry has not paid a common or preferred dividend for two quarters. It has committed to pay a $2 per share dividend to its common stockholders. How much will it be required to pay its preferred shareholders per share? A. $0 B. $2 C. $5 D. $6

Answer: D Explanation: Before Ruby Red Jewelry can pay its common stockholders a dividend, it must pay its cumulative preferred shareholders their dividend and all missed dividends. Ruby Red must pay $2 per share for each quarterly dividend (8% / 4 quarters x $100 = $2). It must pay two missed dividends and the current dividend, for a total of $6.

ABC has a bond with a duration of 10. XYZ has a similar bond with a duration of 8. Which of the following are true? I. If interest rates fall by 1%, ABC's bond price will decrease by about 10%. II. If interest rates rise by 1%, XYZ's bond price will decrease by about 8%. III. XYZ's bond is more sensitive to interest rate changes than ABC's bond. IV. ABC's bond is more sensitive to interest rate changes than XYZ's bond. A. II and III B. I and III C. I and IV D. II and IV

Answer: D Explanation: Duration measures the sensitivity of a bond's price to change in interest rates. A duration of 10 means that a 1% change in interest rates will result in about a 10% change in price. Since price and interest rates have an inverse relationship, for ABC's bond, a 1% increase in interest rates will result in a 10% decrease in price. For the XYZ bond with a duration of 8, if interest rates rise by 1%, the price will fall by about 8%. Because the ABC bond has a higher duration than the XYZ bond, it is more sensitive to interest rate changes.

Bank CDs

Bank CDs are issued by a bank and offer up to $250,000 of FDIC protection. They are not considered securities. Bank CDs typically offer low yields and, therefore, do not protect against purchasing power (inflation) risk. What an individual gains is a safe place to put his money while earning a little interest.

Coupon Bond

Bearer bonds, also called coupon bonds, are bond certificates that have no owner's name printed on them and have coupons attached. Anyone who possesses the bearer bond certificate may present a coupon to receive an interest payment or present the bond itself for payment at maturity. Bearer bonds are highly negotiable instruments, and the owner can receive interest payments anonymously without having to declare them at tax time.

Junk Bonds

Below-investment grade bonds (BB+ credit rating or lower) are also known as junk bonds. Junk bonds are a type of unsecured or partially secured corporate bond that typically offers significantly higher yields to compensate for their lower credit rating. For this reason, junk bonds are also known as high-yield bonds. Non-investment-grade ratings are usually given to companies that do not have a long track record or that have a questionable ability to meet their debt obligations.

Bond Anticipation Notes (BANs)

Bond anticipation notes (BANs) enable work to start on a capital project before the municipality completes its issuance of a long-term bond. Rather than issue bonds before the project is finished and final costs are known and certain, a municipality may sell notes that will be retired by proceeds from the new bond issue.

Asset-Back Securities (ABS)

Bonds that are backed by the cash flows of other kinds of debt are called asset-backed securities (ABS). These securities can be backed by many kinds of debt, including residential mortgages, commercial mortgages, auto loans, and credit card debt obligations.

Brokered Long Term CDs vs. Negotiable/Jumbo CDs

Broker-dealers also sometimes sell brokered long-term CDs, which offer higher returns but come with liquidity risk. If the investor would like to sell this type of CD before maturity, the customer will usually pay a penalty, which can cut into the principal. In contrast, negotiable CDs are CDs that can be sold to someone else in a secondary market. These CDs offer higher yields but are not FDIC insured. Instead, they may be guaranteed by the issuing financial institution. Negotiable CDs are also called jumbo CDs because they are often denominated in millions of dollars.

Brokered CDs

Brokered CDs are CDs that your broker-dealer may be sponsored to sell for different banks. Purchasing a CD through a broker means more choice to the customer; in return, the broker will take a commission on the sale, lowering the customer's overall return. Brokered CDs may be bank products or they may be securities. If they are securities, they will not be FDIC insured.

Trust Indenture Act of 1939

By the Trust Indenture Act of 1939, bond indentures are required to be registered and qualified by the SEC for each corporate bond issue valued at over $5 million. Qualification requires the issuance of an indenture containing the required information and SEC acceptance of the eligibility of the designated trustee.

Callable Preferred Stock

Callable preferred stock gives the issuing company the right to call in its shares after some set date at a set price. An issuer will usually choose to call in the stock if interest rates drop and the issuer can issue new preferred stock at a lower rate. Callable preferred shares are usually redeemed at a premium to par. For example, if the shares have a par value of $100, the investor may receive $110 to redeem the shares. Callable preferred stock tends to pay higher dividends than non-callable stock to compensate for the fact that the stock may be called.

Certificates of Deposit (CDs)

Certificates of deposit allow bank, savings & loan, and credit union customers to receive higher interest on their deposits than a savings or checking account. To obtain the higher returns, customers must be willing to tie their money up for a fixed period, typically one month to five years. The longer the term, the higher the interest rate offered. If a customer wishes to withdraw money early, he will pay an "early withdrawal" penalty and forfeit some of his interest.

Collateral Trust Bonds

Collateral trusts are secured by financial assets, such as stocks and bonds. They are issued by companies that have few hard assets but significant amounts of securities. The indenture usually requires that the market value of the collateral securities always be greater than the face value of the bonds by a specified margin. Should it fall below this minimum, the issuer must provide more collateral to the trust.

Collateralized Mortgage Obligations (CMOs)

Collateralized mortgage obligations (CMOs) are another type of asset-backed security. CMOs are pass-through securities that are issued by a GSE or a private sector financing corporation and are often backed by Fannie Mae, Freddie Mac, and Ginnie Mae. They often are rated AAA.

Registrar

Companies also hire a registrar to monitor and audit the transfer agent. The registrar makes sure that the transfer agent cancels old stock certificates whenever it issues new ones so that the company will always have the proper number of shares outstanding. A registrar makes sure that the company does not issue more shares than were authorized and ensures that the company's files are kept current as to the owners of an issue. Registrars are usually banks and always are separate from and independent of the transfer agent.

Transfer Agent

Companies typically keep track of their securities issues by hiring a transfer agent, usually a bank or trust company. The transfer agent keeps records on who owns stocks and in what form, recording changes of ownership as they occur. It cancels stock certificates surrendered by the seller and issues new ones in the name of the buyer. It also may pay out dividends and mail proxy materials on behalf of the issuer.

What are the typical call provisions for convertible bonds?

Convertible bonds have yet another complication. They are callable by the issuer. Usually a company will call a bond within the callable period soon after the conversion value exceeds the call price. When this happens, investors will have 30 days' notice to redeem their bonds at the redemption price, which might be at par, or at a call price representing some premium to par.

Convertible Debentures

Convertible debentures are usually offered as subordinated debt. Convertible debentures have two distinct advantages for the issuer, assuming the company flourishes: (1) They raise equity capital now at prices that reflect expected future performance, and (2) they raise equity capital without seriously deflating the current price of stock the way a new stock issue would. If the company flounders, convertibles provide the company with borrowed money at substantially lower interest rates.

Cumulative vs. Non-Cumulative Preferred Stock

Cumulative preferred stock allows dividends to accumulate when a payment is not made. If a corporation misses a dividend payment, it will have to pay the accrued dividend the next time it offers a dividend, before it pays common stockholders. Non-cumulative preferred stock, also called straight preferred, does not accrue unpaid dividends. Few companies issue shares of non-cumulative preferred, since they are unattractive to investors. Non-cumulative will typically offer higher dividends than cumulative preferred stock.

Current Yield

Current yield is a snapshot approximation that represents the return an investor might expect to receive if she purchased a bond today and held it for a year. It is calculated by this formula: current yield = coupon payment / current market price

Debentures

Debentures are bonds not secured by a physical asset or collateral but rather by the "full faith and credit" of the issuer. Generally issued by well-established companies with a high credit rating, debentures are purchased in the belief that the issuer is unlikely to default on the repayment. Less creditworthy companies may add protective covenants to provide assurance for the potential bondholder. Investors in debentures have a general claim on all assets not pledged to secure other debt. They also have a claim on pledged assets to the extent they yield greater value than is needed to satisfy secured creditors.

Demand Deposits

Demand deposits refer to accounts where funds can be withdrawn at any time. In other words, the funds are payable on demand. Both checking and savings accounts are considered demand deposits. Most money market accounts are now considered to be demand deposits, because checks can be drawn on the funds. Typically, financial institutions must make the funds available within a certain time period, and there is no limit on the amount that can be withdrawn. Demand deposits usually pay a small amount of interest.

Global Depository Receipts (GDRs)

Depository receipts are like ADRs, but they are created and sold in countries other than the United States. Global Depository Receipts (GDRs) are sold in countries throughout the world to broaden the issuer's markets or raise new capital. They act exactly like ADRs and are often denominated in U.S. dollars. Shares of GDRs are called Global Depository Shares (GDSs).

Duration

Duration is a measure of a bond's sensitivity to changes in interest rates. A bond's duration expresses the percentage of change in the price of a bond that would result from a 1% change in yield. A bond with a high duration is more sensitive to interest rate changes than a bond with a low duration. If a bond has a duration of 5, its price will decrease roughly 5% with a 1% increase in interest rates, while a bond's price will decrease 10% if it has a duration of 10. Duration measures the risk of interest rate volatility.

What are the similarities and differences in Stock Appreciation Rights vs. Employee Stock Option Plans?

Employee stock options operate exactly like stock appreciation rights, except that the employee must pay the grant price to receive the shares. With stock appreciation rights, the employee receives the difference between the grant price and the market price without having to shell out any money.

Equipment Trust Certificates (ETCs)

Equipment trust certificates (ETCs) are commonly issued by transportation companies. When an airline buys a fleet of new planes, it may issue an ETC. ETCs are bonds in which a trustee sells the bond to investors and delivers the proceeds to the manufacturer. The trustee holds legal title to the mortgaged equipment, which it will lease to the airline until the bond is paid off. The trustee will collect rent from the airline, which it will use to send the interest payments to the bondholders. Equipment trust bonds are considered the safest of corporate bonds, because the mortgaged equipment has a ready market and is easily transferable. If the company defaults, the trustee can lease the equipment to another company. Defaults on ETCs are more common in recessionary times.

Eurobonds

Eurobonds are a type of international bond and are unique primarily in the way they are issued. A Eurobond is denominated in a currency other than that of the country where it is issued (sold) or where the company is headquartered. Typically issued by multinational corporations and national governments, Eurobonds are underwritten by an international syndicate and sold to a market dominated by institutional investors. The bonds may be issued and sold in Britain by a Kuwaiti company, for example, and denominated in yen. Whatever currency the Eurobond is denominated in will be the currency that the principal and interest are paid in. Eurobonds may be denominated in any international currency. Issuers of Eurobonds can choose to issue the bond in a country with the fewest regulatory constraints and in a currency most acceptable to the international market. Eurobonds are bearer bonds and, thus, provide anonymity to the owners and allow them to avoid paying taxes on the interest they receive. Issuers can therefore offer these bearer bonds at an even lower yield.

Eurodollar Bonds

Eurodollar bonds are Eurobonds denominated in U.S. dollars, meaning that the interest and principal will be paid in U.S. dollars, but the bonds will be sold outside the U.S. Since Eurodollar bonds are not offered to U.S. investors or issued on its shores, they do not have to meet SEC registration requirements, and the bondholders are not subject to U.S. taxes.

Government-Sponsored Enterprises (GSEs)

Government-Sponsored Enterprise (GSEs) are privately-owned, corporate entities that are chartered by the federal government. Their purpose is to direct funds into areas of national importance where borrowing is in high demand but lending may be scarce. GSEs are given certain privileges not provided to private corporations. They do not have to pay state and local taxes and are exempt from SEC oversight. They have access to a standing line of credit in excess of $2 billion, and their securities are issued and paid through the facilities of the Federal Reserve Bank. While loans by GSEs have never been backed by an explicit guarantee of the federal government, they have customarily been assumed to have an implied guarantee, and their securities have been priced accordingly.

When you start your new job, the company grants you 1,000 stock appreciation rights at the current market price of its stock ($15). After your three-year vesting period, the stock has risen in price to $30. How much would you make in this scenario if you exercise your employee stock option rights?

He decides to exercise his stock options. He purchases 1,000 shares at $30 and immediately sells them at the market price for a profit of $70,000 (($100 - $30) x 1,000 shares).

STRIPS (Separate Trading of Registered Interest and Principal of Securities)

Here's how it works. A financial institution will buy a Treasury bond or 10-year T-note and turn the principal and each interest payment into separate securities with maturities that correspond to the timing of each interest payment. The separate securities are sold at deep discount, increasing in value each year until they reach their face value at maturity. Thus, STRIPS are considered a type of zero coupon bond. When a broker-dealer issues and sells STRIPS, they are often called Treasury Receipts.

How do ADRs work? Where is the custodian bank and where is the depository bank?

Here's how they work. A bank in the U.S. purchases the issuing company's shares in the issuer's home country. This U.S. bank is called the depository bank. The depository bank deposits the purchased shares in a bank located in the issuer's country, called the custodian bank. The custodian bank is usually a branch of the U.S. depository bank. The depository bank then issues ADRs, which represent the shares held in the custodian bank, and sells them in U.S. markets.

Preemptive Right

If a corporation decides to issue additional common stock, current stockholders may have the right to maintain their share of ownership by purchasing a proportionate amount of the new issue before it is offered to the public. This is a stockholder's preemptive right. A preemptive right serves as anti-dilution protection for common stockholders—they have the right to protect their ownership from dilution.

Tax and Revenue Anticipation Notes (TRANs)

If a government needs an influx of cash to pay expenses for various projects funded by both GO and revenue bonds, it may issue tax and revenue anticipation notes (TRANs).

What does it mean for a MBS to be a "pass through security"?

In fact, the interest and principal payments from the mortgages are "passed through" to the MBS investor, and for this reason, they are known as a pass-through security. MBSs are also called pass-throughs or participation certificates.

Income Bonds

Income bonds are a long-term debt security in which the principal is usually secured by a mortgage, like a mortgage bond. The coupon payments, unlike those of a mortgage bond, are not guaranteed but are contingent on a company's ability to pay, like preferred stock dividends. Income bonds are generally issued by financially-strapped companies, often in an effort to avoid bankruptcy. Typically, companies offer income bonds to existing creditors prior to going into default in exchange for the company's outstanding debentures in an effort to make its capitalization more flexible and reduce its fixed charges. Income bonds are seldom accepted by investors out of choice. Faced with an insolvent company, a junior bondholder may have no better option than to accept an income bond or lose her entire investment.

Commercial Paper

Large corporations, banks, and financial firms with high credit ratings may issue commercial paper to cover short-term needs such as payroll and inventory and to finance general operations. Commercial paper is unsecured, issued at a discount, and typically matures in less than 90 days, although it can have a term as long as 270 days. It is generally issued in lots of $100,000. Even though it is unsecured, because it is short-term and issued only by banks and large corporations with high credit ratings, commercial paper is generally considered safe enough to be purchased by money market funds.

How would you quote T-Notes and Bonds?

Like corporate bonds, Treasury notes and bonds are quoted in the secondary market on a price basis where one point equals one percent of par. Unlike corporate bonds, whose percentages are split into eighths of a percent, government securities are split into units of 32nds. A price quote of 98-11 refers to a price of 98 11/32% of par value, or 98.34375% of par. If the Treasury bond had a par value of $1,000, then the bond would sell for $983.44. A price of 103-08 refers to a price of 103 8/32% of par, or 103.25% of par. A Treasury bond with a par value of $1,000 would sell for $1,032.50.

Convertible Preferred Stock

Like participating, convertible preferred stock allows shareholders to participate in the growth of a company. These investors have the right to convert their preferred shares to common stock at a set conversion ratio.

Money Market Securities

Money market securities are debt securities that mature in 397 days or less. Since 397 days is around one year, you may see one year on your exam. Money market securities are usually highly liquid, meaning they can be easily bought and sold. They are also considered very safe. In fact, they are often referred to as cash equivalents, because they are almost as liquid and safe as cash. They usually offer interest payments, but the yields are small compared to riskier, longer term investments. Money market investments are subject to purchasing power risk, because they offer such low yields that they often can't keep up with inflation. Some of the more common money market securities are U.S. Treasury bills, commercial paper, and banker's acceptances. Repurchase agreements and tax-exempt municipal notes are also considered money market securities.

Mortgage Bonds

Mortgage bonds provide bondholders with a first lien on corporate property. This means that if the corporation defaults on its payments, the trustee can sell property to pay the bondholders. Trustees rarely have to seize property, however, since the company has strong incentives to find other means to pay its bondholders rather than selling off its hard assets. Mortgage bonds pay interest semiannually.

Municipal Notes

Municipal notes are short-term debt obligations, whose term usually does not exceed a year. Municipal notes are issued at a discount to par. The investor receives a fixed amount on a certain date and does not receive interest payments. The primary purpose of municipal notes is to meet a municipality's cash flow needs in anticipation of the taxes, fees, or other sources of revenue that fund its ongoing commitments. Municipal notes are called anticipation notes, because they are issued in anticipation of an expected source of income. Anticipation notes allow a project to get underway before funding has been received. Notes are issued by different names, depending on where the anticipated receipts are coming from, whether from taxes, grants, or fees. Like any cash advance, municipal notes are meant to smooth out cash flows until income is received. They are tax-exempt to the note holders.

Call Premium and Call Price

Optional calls may also demand a call premium to lessen the risk of a call. When a call price is set at a higher value than the face value of the bond, the difference is the call premium. A $1,000 bond with a call price of $1,100 has a $100 call premium payable to the investor if the bond is called

Participating Preferred Stock

Participating preferred stock allows investors to receive extra dividends when the company exceeds some predetermined financial goals. Investors will always receive their regular dividend but may also participate in a company's accelerated growth. Participating preferred also often receives a greater claim during liquidation than non-participating preferred. For example, participating preferred may receive 120% of its invested value rather than 100% of its invested value. Participating preferred stock is extremely rare. Most preferred stock is non-participating.

Preferred Stock

Preferred stock, which like common stock, represents an ownership share in a company, is an equity security that looks in many ways like a debt security (bond). Like a debt security, preferred shares generate income from a fixed, regular monetary payment rather than a share in the company's financial gains. Also like a bond, a preferred stock's market price fluctuates with interest rates and creditworthiness, rather than with a company's earnings and losses. As a result, preferred stock is less risky than common stock, but it offers less growth potential. It is more risky than debt, because companies can miss their regular dividend payments without being in default. Preferred stock is "preferred" in the sense that dividend payments are distributed to preferred stockholders before any dividends are paid to common stockholders. Preferred stock also has a higher claim on a corporation's dividends and residual assets during bankruptcy than common stock. If a company is forced to liquidate, preferred stockholders have first claim to its remaining assets compared to other equity holders. The price for these enhanced privileges is that preferred stocks generally come without voting rights and have no real share in the company's profits.

What is the price of preferred stock primarily dependent on?

Preferred stocks trade in the secondary market, but price fluctuations are caused by changing interest rates rather than increases and decreases in company earnings. As with bonds, preferred stock appreciates in value with falling interest rates and decreases with rising interest rates. When interest rates fall, the price of the preferred stock will usually rise above par, and when interest rates rise, the price of the preferred stock will fall below par. Since they behave more like bonds, preferred stocks tend not to fluctuate as dramatically in price as common stocks.

Protective Provisions

Protective provisions are a relatively standard feature of preferred stocks, often written into a company's certificate of incorporation. Protective provisions permit preferred shareholders to veto certain actions by the company, such as the sale or merger of the company and the raising of capital. They are designed to protect the preferred stockholders, which are almost always the minority shareholders, from the dilution of their investment by the common shareholding majority.

Registered Bonds

Registered bonds are certificates issued to the bondholder with the owner's name printed on them and no coupons attached. Instead, the issuer's transfer agent sends the bondholder interest when payments are due and the redeemed principal at maturity. Registered bonds can be transferred to another individual only after the owner signs off and presents the endorsed certificate to the transfer agent. The transfer agent will then cancel the certificate and issue a new one to the new owner.

Book-Entry Bonds and Beneficial Ownership

Registered bonds have largely been supplanted by book-entry bonds. Owners of a book-entry bond do not receive a physical certificate. Instead, each bond issue has only one master certificate, which is kept at a securities depository. Ownership of book-entry bonds is recorded by computer at a central depository. When the bonds are held in street name, the brokers or dealers are listed as owners rather than their clients. The clients are said to have beneficial ownership, because they maintain all the benefits of ownership, such as transfer and voting rights.

Revenue Anticipation Notes (RANs)

Revenue anticipation notes (RANs) are issued to finance the current operations of a project backed by a revenue bond, in anticipation of fees from the completed project to repay the notes.

Revenue Bonds

Revenue bonds are bonds that finance projects in which principal and interest payments to the bondholder are paid from the revenue generated by those projects. Issuers of revenue bonds may be municipal governments, government agencies, or public authorities (such as the New York City Housing Authority or the Chicago Transit Authority). Public authorities are formed to promote the public interest by financing, building, and operating public facilities. Revenue bonds finance airports, mass transit systems, roads and bridges, libraries, and hospitals. Income from concessions, tolls, or user fees is put into a revenue fund. The project's expenses are paid first out of the fund, with the remaining money going to bondholders. Revenue might also be generated by rental or lease payments. A state may create a nonprofit authority to build a school and then lease the facility to a local government. Since these projects only serve those in the community who use the services, users of these services are asked to pay for them, as opposed to the general taxpayer.

Secured Bonds

Secured bonds are bonds backed by property or some other real asset, such as physical equipment, which serves as collateral for the loan. In the event of default, the property can be foreclosed and sold off to repay the bond. Secured bonds are considered high grade, safe investments, because they are paid off first, ahead of all other bondholders. Because they are a safer investment, they generally pay a lower yield.

Standby Underwriter

Shareholders are not required to exercise their rights to buy the discounted stock. If not all shareholders exercise their subscription rights, the issuer may enter into an agreement with a standby underwriter, which agrees to purchase any shares that were not bought in the rights offering in a firm commitment. This is called a standby underwriting.

Employee Stock Option Plans

Similar to stock appreciation rights are employee stock options plans. These too are an option on the common stock of a company, but they are granted to employees as part of their compensation package. They are used as an incentive to get employees to stay and to improve a company's share price and performance.

Sovereign Bonds

Sovereign bonds are bonds issued by foreign governments. They are called "sovereign" bonds, because they are issued by entities (countries) that have "sovereign" or paramount power. Sovereign bonds tend to be less risky than other types of foreign bonds, because governments can raise taxes or lower spending to make their interest payments. That said, certain government debt is considered more risky and therefore pays higher coupon rates than other government debt. Politically stable governments have lower rates than less stable governments. Sovereign debt may be issued in the country's local currency or in a foreign currency. Investing in sovereign debt involves currency risk if the investment is made in a foreign currency.

Tax Anticipation Notes (TANs)

Tax anticipation notes (TANs) are issued to finance a project's current operations in anticipation of future tax receipts. TANs have first claim on any tax collections before they are otherwise disbursed.

Term Bonds

Term bonds are those in which the entire issue is scheduled to reach maturity on the same date and offers a single interest rate. A corporation that issues $20 million of term bonds with a maturity of 10 years must repay the entire $20 million principal when the bond comes due

What is the current yield of a 6% bond purchased at discount for $960?

The annual coupon payment is 6% times its par value (0.06 x $1,000 = $60). The annual coupon payment, $60, divided by the purchase price of $960 is 0.0625. Thus, the current yield is 6.25%.

Conversion Period

The conversion period is the time during which a convertible bond may be converted to stock or other assets. It generally extends for the life of the bond. If it expires after a shorter period, the issuer may choose to extend it.

Conversion Value and Conversion Parity

The decision to convert a bond will depend on its conversion value and the current market value of the bond. The conversion value, which is the bond's value if it were to be converted at the present moment, is the conversion ratio times the current market price of the stock. Suppose a convertible bond has a conversion ratio of 50 and the issuer's stock is currently selling at $24. The conversion value of the bond is 50 x $24 = $1,200. If the bond happens to be selling at $1,200, it is said to be at conversion parity.

Bid-Ask Spread

The difference between the price at which investors are willing to buy bonds and the price at which investors are willing to sell them is called the bid-ask spread. The bid price is the maximum price a buyer is willing to pay, and the ask price is the minimum price a seller is willing to accept. A dealer who quotes a price of 99 1/8 - 99 7/8 is indicating a willingness to buy at $991.25 and sell at $998.75. The spread represents the dealer's profit. The bid-ask spread is a key indicator of the liquidity of a security. A bond that trades at a smaller spread is generally one that trades more frequently (it is more liquid) than one that has a larger spread (it is less liquid).

Trustee

The issuer must appoint an independent trustee to protect the bondholders' rights as stated in the indenture. This third party trustee, usually a bank or trust company, is responsible for authenticating the bonds and ensuring that the issuer complies with all of the covenants specified in the indenture. The trustee also has the right to seize the bond issuer's assets to protect the bondholders' rights to their investment if the issuer becomes insolvent. The bond indenture is a contract between the issuer and the trustee, who is representing the interests of the bondholders. The bond indenture must be signed by both the issuer and the trustee.

Securitization

The practice of backing a bond or other security with many kinds of debt, including residential mortgages, commercial mortgages, auto loans, and credit card debt obligations, with the intent of lowering the risk associated with the security.

Par Value

The principal that is printed on a bond certificate is called its par value. This is the amount the investor lends to the borrower (the issuing entity) when the investor buys the bond, and this is what the investor will be repaid at the bond's maturity. Corporate bonds are normally issued in $1,000 denominations.

Why does the government have enterprises and agencies that facilitate the MBS market?

The underlying philosophy is that mortgage-backed securities increase the ability of the average person to purchase a home, and home ownership is thought to be good for the nation. Here's how it works. Mortgage-backed securities allow lending banks to sell off the debt they hold. Once the new mortgage-backed securities are sold on the secondary market to investors, the banks that granted the original mortgages are able to remove them from their balance sheets, decreasing their debt. These lending banks are then able to issue new mortgages at lower interest rates. They then sell off these new mortgages by issuing more MBSs and can issue more new loans. This process allows more people to become homeowners, who, according to conventional wisdom, now have a greater stake in society. Mortgage-backed securities facilitate homeownership by shifting the risk of mortgages from banks to investors.

Yield to Call (YTC)

The yield for a callable bond, since it is likely to be redeemed at a call date before maturity, is called yield to call (YTC). Yield to call is always higher than yield to maturity for a discount bond and usually lower for a premium bond, depending on the call price. If a bond is held to maturity, then YTC will always be higher than YTM for discount bonds and will always be lower than YTM for premium bonds. If you are asked to order these yields for the exam, assume that the bond is held to maturity (unless the exam says otherwise).

Yield to Worst (YTW)

The yield to worst calculation is important to investors who want to know the minimum yield they could possibly receive from their bond investments. Yield to worst is the lowest yield of the yield to maturity, yield to every possible call date, and yield to every possible put date.

Government National Mortgage Association (Ginnie Mae)

There is another important player in the mortgage-backed securities world—the Government National Mortgage Association, more commonly known as Ginnie Mae.

Subordinated Debentures

These are debentures that will be repaid only after other corporate debts, including unsubordinated debentures, have been satisfied. Subordinated debentures are generally issued by companies that have already borrowed a lot of money and need to borrow more. They have a high credit risk and, thus, pay out higher yields.

What risks are MBS owners susceptible to?

Thus, MBS owners are subject to prepayment risk (they get their money back sooner than expected, which may happen when interest rates fall) and extension risk (they get their money back slower than expected, which may happen when interest rates rise).

Trust/Bond Indenture

To issue a corporate bond, an issuer must prepare a formal written document called a bond indenture, also called a trust indenture, and file it with the SEC. The bond indenture is the legal document that specifies the scope and features of the bond and holds the issuer to its terms. Specifically, the indenture must identify: • Purpose of the bond issue and its features • Conditions under which the bonds may be redeemed before maturity • Covenants or promises that the issuing company makes with respect to its obligations over the life of the bond • Procedures and remedies should the issuer default • Rights and duties of the trustee

TIPS (Treasury Inflation-Protected Securities)

Treasury Inflation-Protected Securities (TIPS) are inflation-adjusted securities issued by the U.S. Treasury. With TIPS, the principal is adjusted according to the Consumer Price Index (CPI), and at maturity, the investor receives the inflation-adjusted principal or the original principal, whichever is greater. TIPS offer a fixed interest rate that is calculated twice a year by multiplying half the interest rate (because it is paid semiannually) by the principal. The principal is adjusted daily by the change in the CPI and is, thus, "inflation-protected." Therefore, inflation will affect how much in annual interest the TIPS pay. Like the interest on all Treasury securities, TIPS interest income is exempt from state and local taxes. Any gain on the principal, while not realized until maturity, is still considered taxable income to the IRS and is recorded at year-end on the form 1099. In the event of deflation or declining prices, the principal will decline in value. Even so, at maturity, the Treasury will pay the investor back her initial principal if the initial principal was greater than the CPI-adjusted principal. So TIPS provide deflation protection as well as inflation protection!

Treasury Bills

Treasury bills (T-bills) are a discount bond having a maturity of one year or less. They are sold in denominations of $100 up to $5 million; common maturities are 1 month (4 weeks), 3 months (13 weeks), 6 months (26 weeks), and a year. As opposed to coupon bonds, which pay periodic interest, Treasury bills are issued at a discount to par. They pay out no interest and are redeemed on maturity at par (or face) value. An investor who buys $1 million in one-year T-bills at a 5% yield will pay approximately $950,000 for the purchase and receive $1 million at maturity. T-bills are exempt from state and local taxes. T-bills are the shortest term securities issued by the Treasury and are considered to be the safest. Their yield is considered to be a risk-free return, and T-bills are the common proxy for a riskless rate of return.

Treasury Bonds (T-Bonds)

Treasury bonds are coupon securities having maturities from 10 to 30 years. They are issued in denominations that range from $100 to $5 million and pay interest semiannually. Unlike Treasury notes, Treasury bonds may have a call feature. Prior to 1985 the Treasury issued bonds with a 5- or 10-year call feature, and while it has not done so since, it is not precluded from doing so in the future.

Treasury Notes (T-Notes)

Treasury notes are coupon bonds having a maturity ranging from 2 to 10 years. They are issued in denominations of $100 to $5 million and pay interest semiannually. Treasury notes are non-callable, guaranteeing the holder the stated yield to maturity.

U.S. Savings Bonds (I Bonds and EE Bonds)

U.S. savings bonds were created in 1935 to broaden citizen participation in government financing by making bonds available in small denominations. Savings bonds offer a fixed rate of interest over a fixed period of time (30 years), with face values ranging from $25 to $10,000. They are non-callable, nontransferable, and nonnegotiable. They cannot be sold in the secondary market; they can only be sold by redeeming them to the U.S. government. There are two types of U.S. savings bonds, I bonds and Series EE bonds. I bonds pay a guaranteed interest rate that may be adjusted upward when inflation rises; EE bonds earn a fixed rate of return. With both, interest payments are accrued over the life of the bond and paid out with the principal at maturity. In other words, the investor receives no interest until the bonds are redeemed.

How does Ginnie Mae compare to Fannie Mae and Freddy Mac

Unlike Freddie Mac and Fannie Mae, Ginnie Mae is not a GSE; instead, it is a public government agency. It does not buy or sell mortgages or issue mortgage-backed securities. Instead, Ginnie Mae securities are often issued by private companies, such as banks. Ginnie Mae guarantees the timely payment of interest and principal of certain mortgage-backed securities, and it has the full faith and credit of the U.S. federal government to do so. Therefore, if an investor buys a Ginnie Mae mortgage-backed security, it is buying a security whose interest payments are backed by the full faith and credit of the U.S. government. Despite their differences, mortgage-backed securities issued by Fannie Mae and Freddie Mac and those backed by Ginnie Mae are all referred to as agency securities.

How is CMOs different than other traditional MBSs?

Unlike a traditional MBS that has one coupon rate and maturity date, a CMO offers a range of coupon rates and maturity dates for investors to choose from. The monthly payments from the CMO will be a combination of varying amounts of both interest and principal. Therefore, the CMO investor's principal is returned over the life of the security rather than repaid in a single lump sum at maturity as with other types of debt securities. As the principal is repaid or prepaid by the mortgage holders, interest payments become smaller, because they are based on a lower amount of outstanding principal.

Current Refunding vs. advance refunding and pre-refunding

When an issuer uses the proceeds from the refunding bonds to retire the old debt right away (within 90 days), it is called a current refunding. A refunding in which the old issue remains outstanding for a period longer than 90 days after the issuance of the refunding bonds is called an advance refunding or pre-refunding.

Refunding of Bonds

When interest rates fall, the homeowner refinances to replace her current mortgage with a new mortgage at a lower rate. Similarly, when interest rates fall, a company may issue new bonds, called refunding bonds, at a lower rate. The proceeds of the refunding bonds have the sole purpose of being used to retire an existing issue, the refunded bonds. When an issuer uses the proceeds from the refunding bonds to retire the old debt right away (within 90 days), it is called a current refunding.

What is the difference between GOs and Revenue bonds?

While GO bonds are unsecured and revenue bonds are secured, GO bonds are generally viewed as less risky than revenue bonds, because the municipality is obligated to raise taxes to pay the bondholders if need be. Because they are thought of as safer, GO bonds typically pay lower interest rates than revenue bonds.

A discount bond quoted at 97 1/8 - what is the market price of par and the dollar amount?

Will have a market price of 97.125% of par, or $971.25 ($1,000 x 0.97125). Another way of calculating this is first thinking that 97 bond points equals $970. An eighth of a bond point is equal to an eighth of $10, or $1.25. So $970 + $1.25 = $971.25.

A discount bond quoted at 97.5 - what is the market price of par and the dollar amount?

Will have a market price of 97.5% of par, or $975 ($1,000 x 0.975).

Yankee Bonds

Yankee bonds are U.S. dollar denominated bonds issued in the U.S. by a foreign issuer. Yankee bonds may be issued by foreign governments, but more often they are issued by corporations and other private entities.

Yield Spread

Yield spread is the difference in yields between a bond's yield and some benchmark. The most common spread compares the yield of a bond against the yield of a U.S. Treasury security of a similar maturity. For example, you may want to compare the yield of a 10-year corporate bond with a 10-year Treasury note. If the 10-year Treasury note currently yields 1% and the 10-year corporate bond yields 5%, the yield spread is 4%. This means investors currently demand a risk premium of 4%, or 400 basis points, for the corporate bond, because of its higher perceived risk.

Yield to Maturity (YTM)

Yield to maturity (YTM) is the anticipated yield of a bond that is bought and held to maturity. It is essentially the rate of return over the life of the bond based on its current value in the market. It differs from current yield in that its calculation includes the coupon rate, the price, and the maturity.

Suppose when you buy 10 bonds of Hot Box Lunches Corporation, you receive 10 warrants for Hot Box Lunches stock. The stock is currently trading at $20/share, and your warrants have $50 strike prices. Ten years later, Hot Box Lunches stock has risen to $200 per share. If you exercise your warrants, how much would you make in the interaction?

You exercise your warrants and purchase 10 shares of Hot Box Lunches at $50 per share. If you sell the stock at that price, you will have made $1,500 ($2,000 - $500).

Callable Bond

a bond that can be paid off or redeemed prior to its maturity date. Callable bonds generally pay a higher coupon rate than non-callable bonds.

Conversion Ratio

the number of common shares for which each convertible security can be exchanged. If the ratio is 2.0, that means that each convertible security can be converted into two shares of common stock.

Nominal Yield

the stated interest rate for a bond.

A premium bond quoted at 101 3/8 - what is the market price of par and the dollar amount?

will have a market price of 101.375% of par, or $1,013.75 ($1,000 x 1.01375).