Chapter 19

expansion

In the expansion phase, business activity is growing, production and demand are increasing, and *employment is expanding*. At this point, businesses and consumers normally borrow money to expand, which causes *interest rates to rise.*

yield curves

During periods of *easy money* when *interest rates are declining,* yields on *short-term debt securities* will be *lower* than those on *long-term debt securities*. Yield curves will tend to *slope upward from the shorter to the longer maturities,* as illustrated by the normal yield curve diagram shown in notebook. On the other hand, during periods of *tight money*, the yield curve may *invert.* This means that *short-term interest rates will be higher than long-term rates*. As illustrated by the inverted yield curve diagram shown in notebook.

If the economy is experiencing rising inflation, this will generally lead to: A. A decrease in bond prices B. An increase in bond prices C. No change in bond prices D. Volatility in bond prices

*A. A decrease in bond prices* Rising inflation will usually lead to the FRB increasing short-term rates. This increase in rates will cause outstanding bond prices to decrease.

In the past 18 months, the CPI has been rising steadily. Under this circumstance, which of the following events is likely? A. Bond prices are falling. B. Bond prices are rising. C. Gold prices are falling. D. Deflation is accelerating.

*Bond prices are falling.* When the consumer price index (CPI) is steadily rising, the economy is operating under inflationary expectations. When inflation picks up, interest rates usually rise. When interest rates rise, prices fall. Gold and other precious metals would typically rise in value during inflationary times. Deflation (falling prices) is the opposite of inflation (rising prices).

Money received by a corporation when it sells its stock above its par value is called: A. Excess capital B. Earned surplus C. Paid-in Capital D. Stockholders' capital

*C. Paid-in Capital* Money received by a corporation when it sells its stock above its par value is called capital surplus or paid-in capital. This is different from earned surplus (retained earnings), which is profits that have been retained by the company and have not been paid as dividends.

Coincident Economic Indicators

*Coincident* indicators usually *mirror the movements of the business cycle*. The composition of the coincident economic indicators includes the following *four* components: --Employees on non-agricultural *payrolls* --*Personal income less transfer payments* (Transfer payments represent aid for individuals in the form of Medicare, Social Security, and veterans' benefits, etc.) --The *Index of Industrial Production* --*Manufacturing and trade sales* (leading is more orders, coincident is more actual sales)

Which of the following will occur if U.S. imports are increasing? A. The dollar will weaken B. Yields will decrease C. The money supply will increase D. GDP will decrease

*D. GDP will decrease* When imports exceed exports, it means that more money is being spent than received. This typically leads to a decrease in the production of U.S. goods (i.e., a decrease in GDP). Monetary policy may then be implemented to use strategies designed to strengthen the dollar, increase yields, and decrease the money supply.

A significant decline in the general level of prices is referred to as: A. Inflation B. Deflation C. Disinflation D. Expansion

*Deflation* A significant decline in the general level of prices is referred to as deflation. On the other hand, inflation is an increase in the level of prices, while disinflation is a slowing down of the increase in the level of prices. Expansion is the phase of the business cycle during which inflation is a characteristic.

When interest rates are trending upward, the economy will normally be in which phase of the business cycle? A. Expansion B. Contraction C. Trough D. Peak

*Expansion* Increasing interest rates, along with increased costs and lower unemployment, are frequently associated with an expanding economy where there is an increasing demand for goods. As demand overtakes supply, prices begin to rise due to the scarcity of goods. This rise in prices is known as inflation. The Federal Reserve will look to raise interest rates in an attempt to curb demand and combat inflation.

balance of payments

*Foreign exchange rates also have an impact on foreign trade.* If a county's *exports* (the goods sent overseas) *exceed its imports* (the goods received from overseas), the country is considered to have a *trade surplus.* Conversely, if *imports exceed exports*, a country is operating under a *trade deficit.* To *correct a trade deficit, the dollar should weaken*, which will cause U.S. goods to become *cheaper (more competitive) abroad* and *foreign goods to become more expensive in the United States.* This leads to *more U.S. exports and fewer U.S. imports*, which should help to alleviate the trade imbalance. Essentially, *U.S. importers (and consumers) prefer a strong dollar*, while *U.S. exporters (producers) prefer a weak dollar.*

All of the following characteristics would be associated with a growth company, EXCEPT that it has a: A. High price/earnings ratio B. High dividend payout ratio C. High amount of research and development costs D. Wide trading range for the price of its stock

*High dividend payout ratio* Growth companies will normally retain most of their earnings to enable them to continue their growth. They would typically have low dividend payout ratios, high research and development expenses, and high price/earnings ratios, as well as a wide trading range for the stock.

If an investment's distribution increases by 3% while inflation has increased by 3%, what's the impact on the investment's purchasing power?

*It stays the same* When an investment's distribution increases by the same amount as inflation, the purchasing power remains the same. If inflation outpaces an investment's return, the purchasing power will decrease. If the rate of inflation is lower than an investment's return, the purchasing power will increase.

leading economic indicators

*Leading* economic indicators *precede* the upward and downward movements of the business cycle and may also be used to *predict* the *near-term* activity of the economy. The *government index of 10 leading economic indicators* is released *monthly.* The components of the index include: --Average *weekly hours, manufacturing* --Average weekly *initial claims for unemployment* insurance --Manufacturing *new orders*, consumer goods and materials --ISM Index of *New Orders* (this reflects the level of new orders from customers) --Manufacturers' *new orders*, non-defense capital goods excluding aircraft orders --*Building permits*, private housing units --The *prices for the S&P 500 Index* common stocks --Leading *Credit Index* (This index consists of six financial indicators based on various yields) --*Interest-rate spreads*, 10-year Treasury bonds less federal funds --Average *consumer expectations* for business conditions

Which of the following choices is considered a leading economic indicator? A. Manufacturing new orders B. Industrial Production C. Average duration of unemployment D. Commercial and industrial loans outstanding

*Manufacturing new orders* Manufacturing new orders is considered a leading economic indicator. Industrial production is considered a coincident indicator, while average duration of employment and commercial and industrial loans outstanding are lagging indicators.

Which of the following choices is NOT a leading economic indicator? A. Building permits B. Consumer expectations C. Prime rate D. Stock prices

*Prime rate* The prime rate is the rate that banks charge their most creditworthy customers, typically corporations. The prime rate is considered a lagging economic indicator, while the other three choices are all considered leading economic indicators.

components of the income statement (fundamental analysis)

*Sales (revenues)* represent the total money received and the amounts billed (although not yet collected) from the company's primary source of business. Sales are reduced by day-to-day operating expenses to arrive at *operating income.* *"Operating expenses"* reflect the daily costs of doing business and include the amount claimed for the depreciation of fixed assets. *"Operating income"* is adjusted for other forms of income (or expenses) that are not generated by normal operations, leaving earnings before interest expense and taxes (*EBIT*). "*Other income*" usually represents income generated by investments (*dividends and interest*). However, other income may also reflect non- recurring or extraordinary items, such as earnings from the sale of assets or losses incurred by discontinuing a part of the business. To determine a company's net income (or net loss), EBIT is first *reduced by bond interest* and then by *taxes*. Many financial professionals use earnings before interest expense, taxes, *depreciation, and amortization (EBITDA)* as a *measure of a company's cash flow.* Although depreciation is subtracted from income, it's actually a non-cash expense because it's based on the theoretical wear and tear of assets (there's no cash outlay).

During periods of easy money when interest rates are declining, yield curves tend to: A. Slope upward from the shorter to the longer maturities B. Slope downward from the shorter to the longer maturities C. Remain flat D. Slope downward from shorter to intermediate and then upward to longer maturities

*Slope upward from the shorter to the longer maturities* During periods of easy money when interest rates are declining, yields on shorter maturities will be less than yields on longer maturities. Yield curves tend to slope upward from the shorter to the longer maturities.

Which of the following items is considered a coincident economic indicator? A. The industrial production index B. The S&P index C. Housing starts D. Expenditures for capital goods

*The industrial production index* Economic indicators are classified as leading, coincident, or lagging. Leading indicators precede the change in the economy as a whole. Coincident indicators change with the economy as a whole and lagging indicators change after the economy as a whole. Industrial production comprises a large part of the economy and, therefore, changes at the same time as the whole economy. The other choices are examples of leading indicators.

The Federal Reserve Board's Open Market Committee (FOMC) buys and sells which of the following securities most often to accomplish its aims? A. Agency bonds B. Treasury Bonds C. Treasury notes D. Treasury bills

*treasury bills* The Federal Reserve Board's Open Market Committee (FOMC) purchases and sells U.S. government securities in the open market to accomplish the Federal Reserve Board's aims of influencing the money supply. The securities most often used are Treasury bills.

business cycle indicators

Although the economy tends to follow a general pattern, it's often difficult to determine the *actual direction* at any given time. Economists use *three types of indicators* that provide *monthly data* on the movement of the economy as the business cycle enters its different phases. The three economic indicators are *leading, coincident, and lagging.* Although there are different definitions of these terms, this manual uses the most well-recognized version from *The Conference Board*—a global, independent research association.

if interest rates are lower in the US than they are overseas, this will result in US investors investing more in overseas investments, which will result in:

A decreased demand for the dollar, which will result in a weaker US dollar and foreign goods being less attractive. (A weaker dollar makes foreign goods less attractive)

repurchase agreement (FRB Open market operation)

A repurchase agreement (also referred to as a *repo*) is a *contract that's entered into by the Federal Reserve to purchase U.S. government securities at a fixed price* from dealers with provisions for their *resale back to the dealer at the same price plus a negotiated rate of interest*. When the FRB executes a repo, it's *lending money and, therefore, increasing bank reserves (an easing of the money supply).* A *reverse repo* (also referred to as a *matched sale*) occurs when the FRB *sells* securities to dealers with the intention of *buying* the securities back at a future date. This has the *short-term effect of absorbing funds from the money supply (a tightening of the money supply).*

value stocks

A value stock is one that tends to *trade at a lower price* relative to the issuing company's fundamentals (i.e., *dividend yield, earnings per share, sales, price-to-earnings ratio, market price-to-book value*) and is therefore considered *undervalued* by a value investor. These companies tend to have *high dividend yields,* *low price-to-book ratios, and/or low price-to-earnings ratios.* The risk of purchasing a value stock is that there may be a valid reason as to why it's undervalued and why investors keep ignoring this security, which results in a price that doesn't rise. A term used to describe value investors is *contrarian,* since they purchase stocks which are *not popular* with other investors.

Market Capitalization (Market Cap)

Another method of categorizing a stock is according to the *total value of the issuing company's outstanding common shares*, which is also referred to as its market capitalization. To calculate a company's market capitalization, *its total number of outstanding common shares is multiplied by its current price*. For example, if XYZ Co. has 10,000,000 shares of outstanding common stock and the shares are selling for $25 per share, XYZ's market capitalization is $250,000,000 (10,000,000 x $25). A company's outstanding shares* include* shares that are held by institutions, retail investors, as well as the restricted shares held by insiders, but doesn't include treasury shares (i.e., shares that have been repurchased by the company). Remember, a *company's outstanding shares are found by subtracting the number of treasury shares from the number of shares that the company has issued.* The following table lists the main categories and their commonly applied capitalization values: (table in notebook) The boundaries between the categories are neither officially defined, *nor clear-cut.* Over time, a stock's *category can change as its market value rises and falls.* Small-cap stocks are generally the equities of *newer, less-established companies*, while more well- established issuers typically have mid-cap or large-cap valuations. *Small-caps* tend to be *more volatile* than large- or mid-cap stocks, but also often include companies that are *growing faster and have more potential for capital appreciation.* The *micro-cap* category includes companies with very small capitalization ($50 million to $300 million). These companies typically have a low price-per-share and are *extremely volatile and risky.* Lastly, the newest *unofficial* category is nano-cap. These stocks are of companies with capitalizations of less than $50 million. Nano-caps have a low price-per-share and are *extremely volatile and risky.*

contraction

As *prices rise*, *demand diminishes* and *economic activity begins to decrease.* At this point, the cycle then enters the contraction (recession) phase. As business activity contracts, employers lay off workers and *unemployment increases*. This usually causes the rate at which prices are rising (*inflation) to decline (disinflation)*. In real terms, the situation in which prices are falling is referred to as *deflation.*

peak

As the cycle moves into the peak, *demand for goods begins to overtake supply*. Since consumers have a large amount of available funds to use for pursuing a limited amount of goods, *prices begin to rise*, thereby creating *inflation*. With the increasing cost of products, the consumer's *purchasing power is reduced*

The effect of the business cycle on securities markets

As the economy moves through the different phases of the business cycle, the *bond and equity markets react to these changes*. Naturally, investors view these changes and take corresponding actions in an attempt to *take advantage of changes* in the economy.

federal funds

Based on deposits, withdrawals, and loan demands, a bank may find itself with either an *excess reserve position* or a *deficit reserve position*. If a bank has excess reserves, it may *lend additional funds to borrowers* (e.g., commercial banks) that are in a deficit reserve position. These *short-term loans of excess reserves* that banks lend to one another are referred to as *federal funds* and the *rate of interest charged on these loans is the federal funds rate.* The *federal funds rate is determined by supply and demand.* Since federal funds are used for *short-term (overnight) purposes*, they're considered *money-market instruments*. Due to the *short duration* of the loan, the fed funds rate is normally considered to be the *most volatile interest rate.* The effective *fed funds rate is published daily* and shows the average rate that was charged the *previous night for federal funds.* Although the *FRB doesn't directly set the fed funds rate*, it does set a *target or range.* The FRB's *open market operations* are designed to maintain the fed funds rate within this prescribed target.

buying securities (FRB open market operation)

By *purchasing* securities through its open market operations, the FRB is *injecting money into the banking system* in order to *stimulate* investment and business activity. When the FRB buys securities, it *pays for these securities with funds that are subsequently deposited in commercial banks*. This action causes *deposits at banks to increase, reserves to increase,* and adds to the funds that are *available for loans*. At this point, money becomes more available and *interest rates tend to move downward.* This is referred to as an *easing of the money supply.* Since buying securities increases the money supply, this action may lead to *inflation.*

Recession vs depression

By definition, a *recession occurs when Real GDP declines for two successive quarters (six months)*. On the other hand, a *depression* occurs when *Real GDP declines for a more prolonged period.*

exchange rates

Changes in interest rates affect not only the domestic economy, but also international economic activity. If interest rates in the U.S. are higher than interest rates overseas, *foreign investors who want to earn the higher rate may need to invest in the U.S.* However, in order to invest in the U.S., foreign investors must first *convert their funds into dollars.* If an investor intends to immediately exchange currencies (e.g., British Pounds for U.S. dollars), the conversion is based on the *spot rate.* The spot rate is the current value of a base currency compared to a counter currency (or other asset). The name spot rate is derived from the fact that it's the price a person can get "on the spot." As *demand for dollars increases*, the *price of dollars (the exchange rate) will increase.* Therefore, when U.S. interest rates are *higher* than foreign rates, it may lead to a *stronger dollar.* Conversely, a *decline* in U.S. interest rates will likely cause a *weakening of the dollar.*

commodities as an inflation hedge

Commodities, such as *gold and silver,* tend to perform *well* during *inflationary* periods. Customers are able to *gain exposure to these asset* classes through *direct investments* in the commodities or through *futures or derivative products, such as mutual funds and ETFs.*

deflation

Deflation is characterized by a persistent and appreciable *decline* in the general level of *prices.* Deflation may be caused by the *supply* of goods and services *exceeding the demand* for those items, resulting in producers *lowering their prices to compete for the limited demand.* *Deflation should not be confused with disinflation.* Again, *deflation is a drop in prices*, while *disinflation is a reduction in the rate of inflation.*

Deflation is a *decrease in Interest rates* (not a decrease in the level of inflation)

Deflation is considered a reduction in the general level of prices. Deflation leads to lower interest rates, which results in higher bond prices. Equities tend to perform well during periods of inflation, not deflation.

Measuring national output

Economists typically attempt to measure the relative economic health of a given country. *Two of the most significant measures* of U.S. economic activity are the *Gross National Product* and *Gross Domestic Product.* *gross national product (GNP)*: GNP measures the *total value of all of the goods and services that are produced by a national economy*. For the U.S., GNP includes the goods and services being produced overseas by a U.S. company. *gross domestic product (GDP)*: GDP has *replaced GNP as the most important measure of output and spending within the U.S.* The reason for its importance is that *GDP includes the output of all of the goods and services that are produced by labor and property located in the U.S., without regard to the origin of the producer.* For example, in the U.S., GDP includes a Toyota plant in Columbus, Ohio. *Components of GDP include consumer spending, investments, government spending, and net exports.* The most useful variation of GDP is *real* GDP. *Real GDP is adjusted for inflation* using constant dollars and is considered the *key measure of aggregate economic activity.* Rising GDP signifies economic growth and potential *inflation.*

growth stocks

Growth stocks are related to companies whose sales and earnings are *growing at a faster rate than the overall economy.* These companies often reinvest most of their earnings in order to keep *expanding* and therefore *pay little or no dividends to their shareholders*. On average, these stocks are *riskier* than other stocks, but also offer *greater potential for capital appreciation*. For investors with an *objective* of *capital appreciation*, rather than *current income*, these stocks are an appropriate *long-term* investment. From an analytical point of view, growth stocks have *high price-to-earnings (P/E) ratios* and *low dividend payout ratios*. *To calculate the P/E ratio, the stock's current market price is divided by its earnings per share.* For example, if ABC is trading at $180 per share and its earnings are $10 per share, then its P/E ratio is 18. To calculate the dividend payout ratio, the *dividends per share being paid to shareholders is divided by the earnings per share.* Therefore, if ABC paid a $2.00 dividend, its dividend payout ratio is 20% ($2 ÷ $10).

selling securities (FRB open market operation)

If the FRB wishes to *tighten (reduce) the money supply*, it will *sell securities to banks and securities dealers*. The banks and dealers will *pay* for these securities by withdrawing the money from their *demand (checking) accounts*. The withdrawal of money from the banks will *decrease* the amount of money *available for loan*s and will have a *tightening effect* on the money supply, causing *interest rates to rise*. Since selling securities reduces the money supply, this action may *curb inflation.*

Fixed-income investors fear inflation

In *comparison to equities*, *fixed-income securities are more vulnerable to inflation.* Inflation actually represents a *dual risk for bondholders*—(1) rising interest rates will cause the *market prices* of their holdings to *fall*, and (2) the *purchasing power* of their *interest payments* will *decrease*. If *higher rates are anticipated*, bond investors will make adjustments to *shorten their maturities* (i.e., *decrease portfolio duration*) in order to *minimize the effect of downward pricing pressure.* Some bondholders may also attempt to protect their portfolios by *purchasing inflation-indexed bonds, such as Treasury Inflation Protected Securities (TIPS).*

tools of the federal reserve board

In an effort to implement its monetary policy, the FRB has the following tools at its disposal: --Setting *reserve requirements* --Setting the *discount rate* --Implementing *open market operations* --Setting *margin requirements* --Using *moral suasion* The following cards explain how the FRB uses these tools

Inflation

Inflation is defined by a persistent and appreciable *rise in the general level of prices*. Inflation occurs when the *demand* for goods and services in the market *increases at a faster rate than the supply* of these items. In other words, inflation is when there's *too much money chasing too few goods.*

classifications of common stocks

Market professionals classify *common stocks* into various categories that are *based on how they perform* during various economic conditions, their *market capitalization*, as well as their potential for *short-term or long-term capital gains*. Although basic descriptions for many of these classifications were given in Chapter 3, this section will provide more detailed information on them. The classifications include: *cyclical, defensive, growth, value, and market capitalization* stocks.

reserve requirements

Member *banks* are required to keep a *portion of their deposits on reserve* with the FRB. By adjusting the amount that banks *must* keep on reserve, the FRB is able to either *tighten or ease the money supply.* If reserve requirements are *lowered*, the banks are able to *extend more credit,* which causes the *money supply to increase* and *interest rates to fall.* The opposite effect occurs if there's an *increase* in reserve requirements. Changing the reserve requirement will have the greatest impact on the money supply. After meeting its reserve requirement, a bank will seek to *lend the remaining funds to borrowers.* The amount of funds that a bank has above the reserve requirement is referred to as its *excess reserves*. The money spent by borrowers may eventually be deposited in another bank. This process continues as money is deposited from one bank to another, thereby creating a *multiplier effect* on deposits. In other words, the *multiplier effect* is the *rate at which banks can create new money by re-lending deposits and, in turn, creating new deposits.*

Monetary theory/monetary policy

Monetary policy *attempts to control the supply of money and credit in the economy.* Monetary policy is controlled by the *Federal Reserve* The adjustments will *affect interest rates* and cause an *increase or decrease in economic activity.* The Federal Reserve System implements monetary policy in the U.S. and primarily focuses on *controlling inflation.*

cyclical stocks

The *performance* of cyclical stocks is often *parallel* to the changes in the economy. If the economy is in a period of prosperity, these companies prosper; however, as the economy falters, cyclical stocks decline. The common stock of a machine tool company is an example of a cyclical stock. As the economy expands, new orders for machinery increase and the stocks of machine tool companies perform well. Other examples of cyclical stocks include *basic industries* (e.g., rubber, steel, and cement), construction firms, transportation, automotive, and energy companies, as well as homebuilders and manufacturers of durable goods.

money supply

Money is the unit of value by which goods and services are measured and is the medium of exchange through which business is transacted. *The Federal Reserve Board attempts to control the money supply and credit to maintain a stable, growing economy with the aim of combating inflation.* However, before getting into specifics, let's define several measures of money supply: table in notebook *M1* is currency in circulation, plus demand deposits, plus other checkable deposits *M2* is M1, and in addition, money market deposit accounts (MMDAs), plus savings and relatively small time deposits, plus balances at money funds, plus overnight repurchase agreements at banks (i think these are also called repos) Shifts in economic conditions will influence the FRB's focus on the money supply figures. *Each week* the FRB compiles and publishes figures on the size of the money supply according to the *M1 measure.* On a *monthly basis*, the FRB publishes figures on M2.

the business cycle

Over time, a pattern has emerged of the economic ebb and flow and it's the business cycle that represents this repetitive succession of changes in economic activity. The business cycle has *four phases*—*1. expansion* (recovery), *2. peak,* *3. contraction* (recession), and *4. trough*. (Visual aid in notebook)

Effects of the FRB's activities

Table in notebook As with any product, when the *supply increases*, the *price* of that product will *decrease*. Conversely, if the *supply contracts, the price will increase*. The *price of money is the interest rate that lenders charge borrowers;* therefore, as the FRB changes the *supply of money, the price of money (interest rates) must also change*. As interest rates change, the FRB will adjust its monetary policy in order to influence the various sectors of the economy. Any method or tool that *creates additional money for the banking system is potentially inflationary.* On the other hand, any tool or method that shrinks the amount of money available to the banking system is potentially *deflationary*. The FRB will use each of its tools to influence inflation and deflation.

Consumer Price Index (CPI)

The *Consumer Price Index* is widely considered to be the *most important measure of inflation.* CPI measures the *prices of a fixed basket of goods that are bought by typical consumers.* If the prices of these goods are *rising*, then the economy is experiencing *inflation.* *Inflationary periods are typically characterized by rising interest rates*. Along with *bonds, interest-rate-sensitive stocks*, such as those issued by utilities and financial service companies, also have *significant reactions to changes in interest rates*. Since utility companies are *highly leveraged*, it becomes more *expensive* for these companies to *raise money when interest rates increase*. Increasing interest charges cause a drain on earnings, which results in a *decline in the prices of these securities.*

margin requirements

The *Securities Exchange Act of 1934* provided the Federal Reserve Board with the power to *determine the amount of credit that may be extended to purchase securities*. The provisions are established under *Regulation T* and apply to *brokerage firms*, while the provisions of *Regulation U* apply to *banks and all other lenders.* By *increasing margin requirements*, the FRB *reduces* the amount of money that brokers and banks may lend, causing the *money supply to tighten.* Changing the margin requirement is the *least effective method* the FRB has to control credit since it *affects only securities market transactions.*

interest-rate changes

The *level and direction* of *interest rates* will influence numerous investments and may indicate *inflationary* trends. Therefore, *interest rates and the effects of inflation* will be important factors for investors to consider when choosing their investments. Since *bond* investors are concerned with the possibility of inflation eroding the purchasing power of their interest and principal payments, it's important that they earn a *rate of return that out-performs the rate of inflation.* For this reason, an investor may choose to calculate the *real interest rate on his investment.* Numerous interest rates are published each day in *The Wall Street Journal.* Some of the most important rates include (In order from highest to lowest): --1. *Prime Rate*: The prime rate is what commercial banks charge their best (*prime*) corporate clients. --2. *Call Rate*: The call rate is what commercial banks charge on *coll*ateralized loans to broker-dealers (for margin purposes). --3. *Discount Rate*: The discount rate is what the depository institutions are charged when they *borrow* from the Federal Reserve. --4. *Federal Funds Rate*: The fed funds rate is what's charged on an *overnight loan* of reserves between member banks.

easing or tightening of money

The *method that the FRB uses to accomplish its goals is to ease or tighten money supply.* When implemented by the FRB, an *easy* money policy involves *increasing the money supply and lowering of rates*, both of which should eventually stimulate the economy. On the other hand, when adopting a *tight* money policy, the FRB *reduces the money supply and raises rates*, both of which should diminish economic activity and *control inflation.*

measuring profitability

The *operating profit margin* is used as a measurement of a *corporation's profitability.* The calculation for *operating profit margin is net operating income divided by sales.* Another formula that requires the income statement is the *bond coverage ratio, which is calculated by dividing EBIT (or EBITDA) by the interest expense.*

Real interest rate

The *real interest rate* is the *rate of interest that a bond investor expects to receive after allowing for the decline in his purchasing power due to inflation*. The formula for computing the real rate is the *bond's yield minus the inflation rate.* For example, if an investor buys a 5% bond while the rate of inflation is 2%, he expects to earn a real interest rate of 3%. This is one of the reasons why *bond investors demand higher returns during an inflationary period.* Essentially, they're factoring in the decline of the purchasing power of their future interest payments.

discount window

The FRB was originally established to *aid the banking system* by acting as a *banker's banker in emergency* situations. The FRB *always* stands ready to *lend money* to its members and fulfills that function through its *discount window*. As described earlier, the *rate charged by the FRB for the loans that are made to its members is referred to as the discount rate.* When members of the FRB borrow funds through the use of the discount window, *new money is injected into the system* (which then is expanded by the *multiplier effect*). The *FRB can encourage or discourage borrowing from the FRB's discount window by changing the rate of interest it charges for those loans.* By *decreasing the discount rate*, the FRB *encourages borrowing*, which leads to the *expansion of money supply*. Conversely, the money supply will contract with an *increase* in the discount rate. Any change in the discount rate is usually seen as a *very strong sign that monetary policy has shifted.* The discount rate is the *only rate that's directly set by the FRB*. Although it's largely *symbolic*, it acts as a *benchmark* off of which other *key interest rates* are set, such as the *fed funds rate.*

The balance sheet (fundamental analysis)

The balance sheet (also called a *statement of financial condition*) represents the financial picture of a company as of a specific date. The balance sheet is divided into *three* major sections—*Assets, Liabilities, and Stockholders' Equity.* The term balance sheet is used since the *total assets must always equal the total liabilities plus the stockholders' equity*. Therefore, the basic formula is: *Assets = liabilities + stockholders' equity (Net Worth)* Assets represent all of the items that are *owned by a corporation*, while the liabilities section contains all of the items that are *owed* by the corporation. The difference between a corporation's total assets and its total liabilities is stockholders' equity (also referred to as net worth).

What is the basic balance sheet equation?

Total Assets = Total Liabilities + Stockholders' Equity

trough

The cycle finally enters the *trough* at the *bottom of the economy's decline.* *Lower prices* will eventually *stimulate demand* and cause the economy to move into a renewed period of *expansion that's referred to as a recovery.* At times, the economic decline may be pronounced. By definition, a *recession occurs when Real GDP declines for two successive quarters (six months)*. On the other hand, a *depression* occurs when *Real GDP declines for a more prolonged period.*

what is a call rate

The discount rate is the rate that the Federal Reserve charges when its lends money to a member bank. The prime rate is the rate that commercial banks charge their best corporate clients. The federal funds rate is the rate charged for overnight loans between member banks. The call rate is what commercial banks charge on loans to broker-dealers for margin purposes.

Measurement of economic activity

The following table summarizes some of the more common measurements of economic activity that students may encounter on the SIE Exam: Note: In many cases throughout the regulatory examination, an acronym (e.g., GDP, CPI) may be used in place of the full name. Table in notebook

lagging economic indicators

The index of *lagging* indicators represents items that *change after* the economy has moved through a given stage of the business cycle. The index of lagging indicators should *confirm the economic condition* portrayed by previous leading and coincident indexes. Lagging indicators include the following components: --Average *duration of unemployment* --*Ratio of manufacturing and trade inventories to sales* --Change in *labor cost per unit of output* for manufactured goods --The average *prime rate charged by banks* --Commercial and industrial *loans outstanding* --*Ratio of consumer installment credit to personal income* --Change in the *Consumer Price Index* for services

The liabilities section (fundamental analysis)

The liabilities section identifies the company's *debts*. Some of the debts must be paid in a *short period (current liabilities*), while others are not required to be repaid for *many years (long-term liabilities*). *current liabilities*: Current liabilities are debts that become due in less than one year and are easily identified by the word *payable*. Included in this section are accounts payable (the amount a company owes for goods and services that are purchased on credit), dividends payable, interest payable, notes payable, and taxes payable. *Long-term liabilities*: Long-term liabilities are debts that are incurred by a corporation which become payable in *one year or more*, such as bonds and long-term bank loans.

The income statement (fundamental analysis)

The other significant financial document used in fundamental analysis is the *income statement*—also referred to as the *profit and loss statement.* The income statement shows a company's financial performance during a *specified period* and provides detailed information about the company's *revenues and expenses*. If revenues exceed expenses, the difference represents the company's *net income*. However, if expenses exceed revenues, the result for the company is a *net loss.*

economics

The performance of an investment is influenced by the performance of the economy. An impending *recession* may *reduce demand for equity securities*, while the effects of *inflation or deflation* may interfere with *anticipated returns* across many asset classes. The *fear of rising interest rates (and falling bond prices*) may cause fixed-income investors to *shorten their maturities*. *Currency instability* may cause investors to *rebalance the global exposure* of their portfolios. Essentially, when *formulating an overall investment strategy, numerous economic factors must be considered.*

moral suasion

The pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed. There are times when the FRB attempts to influence bank lending policies through moral suasion (i.e., *jawboning*). The FRB exerts its influence through the *public media* or through the *examiners* who are sent to member banks. Its efforts to control the money supply by these means are limited by the extent to which they're able to *elicit cooperation from these institutions.*

The stockholders' equity section (fundamental analysis)

The stockholders' equity section represents the *company's net worth* and also indicates the shareholders' *ownership interest*. The items listed in this section include the different classes of stock, retained earnings, and capital surplus. *Capital surplus, or paid-in capital*, is the amount of premium above the par value that's paid by investors who purchase the shares from the issuing corporation.

defensive stocks

The stocks of defensive companies have a *smaller reaction to changes in the business cycle* than cyclical stocks. Examples of defensive companies include *utility, tobacco, alcohol, cosmetic, pharmaceutical, and food companies*. Since people *need basic services to exist*, these companies are the *last* to be negatively affected as the economy moves through difficult periods. Generally, the *demand* for the products/services that are provided by defensive companies is *not diminished* by a downturn in the economy.

Components of the balance sheet-- Assets

There are *three* basic subsections to the asset category—*current assets, fixed assets, and intangible assets.* 1.) *Current assets:* Current assets represent cash and other items that can be converted into cash within a short period (usually *one year)*. The assets that may be converted into cash include marketable securities, accounts receivable, and inventories. 2.) *Fixed assets*: Fixed assets are items that are used by the company in its day-to-day operations to create its products. This section includes the company's physical property, such as land, buildings, equipment, and furniture. 3.) *Intangible assets*: Although intangible assets don't have physical value, they add substantial value to a company. Some intangible assets differentiate the company from its competitors and are proprietary, such as patents, intellectual property, trademarks, franchises, and copyrights. Goodwill is another intangible asset and represents the amount that was paid above the fair market value to acquire an asset (or a company).

international economic factors

These include exchange rates and balance of payments and whether they weaken or strengthen the US dollar

open market operations

While the *reserve requirements and the discount window* involve very *public* moves on the part of the FRB, *open market operations may be implemented very quietly and without significant disruption to the financial markets.* The *Federal Open Market Committee (FOMC)* oversees the FRB's buying and selling of *U.S. government securities in the secondary markets*. FOMC operations are the FRB's *most effective and frequently used tool of monetary control.* For the FRB, it's also the *most flexible* tool and the easiest to *reverse.* Open market operations typically involve the *purchase and sale of U.S. government securities*—primarily *Treasury bills*. However, the FRB also trades *government notes and bonds*. These trades are executed through *primary government dealers*, which are the nation's *largest banks and brokerage firms* that have been *appointed* by the FRB.

Financial Statements/ Fundamental analysis

While there's no doubt that the level of overall economic activity is an important factor to consider when making investment decisions, *fundamental analysis* is much more specific. This discipline focuses on *analyzing individual companies and their industry groups.* Important items for a *fundamental analyst* include a *company's financial statements (e.g., its balance sheet and income statement*), details regarding the company's *product line*, the *experience and expertise* of the company's *management*, and the *outlook* for the company's *industry.* Obviously, the general condition of the economy will affect the prospects for a given company.

Keynesian theory

aka fiscal policy Keynesian economic theory states that *government intervention in the economy is necessary for sustained economic growth and stability*. As introduced by British economist John Maynard Keynes, this theory further states that the *government should use fiscal policies* (i.e., *tax and spend programs*) to *combat the effects of inflation and deflation*, as well as to influence economic activity.

fiscal policy

goes hand-in-hand with Keynesian theory Fiscal policy involves the *government's use of taxation and expenditure programs to maintain a stable, growing economy*. For example, if the economy is in a recession or trough, the government may *increase its spending to stimulate demand.* Alternatively, it may *cut taxes* to increase the disposable income of consumers. These actions would (indirectly) stimulate demand. On the other hand, if the economy is overheated (i.e., exhibiting too much demand), the government may *cut its spending or increase taxes.* Fiscal policy is set by the *President and Congress*; therefore, some decisions may be based on *political motives*, rather than those that are purely economic. However, the primary focus of fiscal policy is on economic growth and *high employment*. Conversely, *monetary* policy is controlled by the *Federal Reserve*—a body that's *theoretically independent of the political process.*

Equities as an inflation hedge

historically, *equity securities or other related products*, such as *equity mutual funds, equity ETFs, and variable annuities*, have provided the *best protection against inflation*. Securities which provide payments that are *set at the time of issuance and remain unchanged regardless of the inflation rate* are most susceptible to *inflation risk (also referred to as purchasing-power risk).*

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utility stock is a defensive stock

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Influencing the economy -- monetary and fiscal policy

there are many theories as to why the economy moves in a cyclical fashion and what may be done to control that cycle. Let's review *two* of the more popular economic theories—*Keynesian and Monetary.*