Chapter 11 | Corporations and their Financial Statements

1. CORPORATIONS AND THEIR STRUCTURE

Sole proprietorships Or partnerships:

ADVANTAGES OF INCORPORATION

• Limited shareholder liability

• Continuity of existence

• Transfer of ownership

• Ability to finance

• Growth

• Professional management

DISADVANTAGES OF INCORPORATION

• Inflexibility

• Taxation

• Expense

• Capital withdrawal

PRIVATE AND PUBLIC CORPORATIONS

• Private corporations have charters that restrict the right of shareholders to transfer shares, limit the number of shareholders to no more than 50, and prohibit members from inviting the public to subscribe for their securities.

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

CORPORATE BY-LAWS

VOTING RIGHTS

SHAREHOLDERS’ MEETINGS

VOTING BY PROXY

VOTING TRUSTS

THE CORPORATE STRUCTURE

• Directors

• Chairman of the board

• President

• Vice-Presidents

• Officers

2. FINANCIAL STATEMENTS OF A CORPORATION

International Financial Reporting Standards (IFRS)

STATEMENT OF FINANCIAL POSITION

• Assets consist of what the company owns and what is owed to it.

• Equity represents the shareholders’ interest in the company.

• Liabilities are what the company owes.

CLASSIFICATION OF ASSETS

ITEMS 1–3: NONCURRENT ASSETS

-Noncurrent assets include property, plant, and equipment (PP&E); goodwill and other intangible assets; and investments in associates.

-Two commonly used methods of calculating depreciation are the straight-line method and the declining-balance method.

ITEMS 5–8: CURRENT ASSETS

-Inventory, prepaid expenses, and trade receivables

• The weighted average method uses the average of the total cost of the goods purchased over the period on a per unit basis.

• The first-in-first-out (FIFO) method implies that items acquired earliest are assumed to be used or sold first.

CLASSIFICATION OF EQUITY

ITEM 11: SHARE CAPITAL

ITEM 12: RETAINED EARNINGS

ITEM 13: NON-CONTROLLING INTEREST

CLASSIFICATION OF LIABILITIES

ITEMS 15 AND 16: NON-CURRENT LIABILITIES

ITEMS 18–21: CURRENT LIABILITIES

• Current portion of long-term debt due in one year

• Taxes payable to the government in the near term

• Trade payables (unpaid bills for items such as raw materials and supplies)

• Short-term borrowings from financial institutions

STATEMENT OF COMPREHENSIVE INCOME

• Where earnings come from

• Where earnings go

• The adequacy of earnings, both to assure the successful operation of the company and to provide income for the holders of its securities

STRUCTURE OF THE STATEMENT OF COMPREHENSIVE INCOME

ITEMS 24–26: REVENUE, COST OF SALES, AND GROSS PROFIT

ITEM 27: OTHER INCOME

ITEMS 28 TO 31: GENERAL EXPENSES

• Distribution costs, including such expenses as advertising costs and salaries and commissions to sales personnel

• Administrative expenses, including office salaries, accounting staff salaries, and office supplies

• Other expenses not directly related to the company’s normal operating activities, including expenses associated with the sale of PP&E

• Finance costs in the form of interest payments on debtholders’ securities or loans to the company

ITEM 32: SHARE OF PROFIT OF ASSOCIATES

ITEM 33: INCOME TAX EXPENSE

ITEM 34: PROFIT

• Actuarial gains and losses on defined benefit plans

• Gains and losses from currency translations relating to the financial statements of a foreign operation

STATEMENT OF CHANGES IN EQUITY

RETAINED EARNINGS

TOTAL COMPREHENSIVE INCOME

STATEMENT OF CASH FLOWS

STRUCTURE OF THE STATEMENT OF CASH FLOWS

• Operating Activities • Financing Activities • Investing Activities

ITEMS 34 TO 37: OPERATING ACTIVITIES

• Trade receivables • Inventories • Trade payables • Interest payable • Taxes payable

ITEMS 38 TO 41: FINANCING ACTIVITIES

• If the company has issued new share capital (item 38) or debt (item 40), cash flows into the company. • If the company repays debt (item 39) or pays dividends to the shareholders (item 41), cash flows out of the company.

ITEMS 42 TO 44: INVESTING ACTIVITIES

ITEMS 45 AND 46: THE CHANGE IN CASH FLOW

3.THE ANNUAL REPORT

NOTES TO THE FINANCIAL STATEMENTS

THE AUDITOR’S REPORT

5. PUBLIC COMPANY DISCLOSURES AND INVESTOR RIGHTS

CONTINUOUS DISCLOSURE

STATUTORY RIGHTS OF INVESTORS

-RIGHT OF WITHDRAWAL

-RIGHT OF RESCISSION

-RIGHT OF ACTION FOR DAMAGES

5.TAKEOVER BIDS AND INSIDER TRADING

TAKEOVER BIDS

EARLY WARNING DISCLOSURE

INSIDER TRADING

INSIDER REPORTING

Chapter 10 | Derivatives

Derivatives

1. THE ROLE OF DERIVATIVES

Underlying asset

Two basic types: options and forwards. Both types are contracts between two parties: a buyer and a seller.

• The buyer in an option contract has the right, but not the obligation, to buy or sell a specified quantity of the underlying asset in the future at a price agreed upon today. The seller of the option is obliged to complete the transaction if called upon to do so. An option that gives its owner the right to buy the underlying asset is a call option; one that gives the right to sell the underlying asset is a put option.

• With forward contracts both parties oblige themselves to trade the underlying asset in the future at a price agreed upon today. Neither party has given the other any right; they are both obliged to participate in the future trade.

FEATURES COMMON TO ALL DERIVATIVES

• They are contractual agreements between two parties (often called counterparties): a buyer and a seller. The agreements spell out the rights (if any) and the obligations of each party.

• They have a price upon which the buyer and seller must agree; buyers try to buy them for as little as possible, whereas sellers try to sell them for as much as possible.

• They have an expiration date. Both parties must fulfill their obligations or exercise their rights under the contract on or before the expiration date. After that date, the contract is automatically terminated.

When a derivative contract is drawn up, it includes a price, or formula for determining the price, of an asset to be bought and sold in the future, either on or before the expiration date.

• With forwards, no up-front payment is required. Sometimes one or both parties make a performance bond or good-faith deposit, which gives the party on the other side of the transaction a higher level of assurance that the terms of the forward will be honoured.

• With options, the buyer makes a payment to the seller when the contract is drawn up. This payment, known as a premium, gives the buyer the right to buy or sell the underlying asset at a preset price on or before the expiration date.

DERIVATIVE MARKETS

• OTC derivatives : contracts can be custom designed to meet specific needs

EXCHANGE-TRADED DERIVATIVES

Derivative exchanges evolved in response to OTC issues, including concerns around standardization, liquidity, and default risk.

The Montréal Exchange (or Bourse de Montréal) lists options on stocks, indexes, and U.S. currency, as well as exchange-traded forwards (futures) on bonds, bankers’ acceptances, and indexes.

DEFAULT RISK

Canadian Derivatives Clearing Corporation (CDCC)

Exchange-Traded

• Traded on an exchange

• Standardized contract

• Transparent (public)

• Easy termination prior to contract expiry

• Clearinghouse acts as third-party guarantor ensuring contract’s performance to both trading parties

• Performance bond required, depending on the type of derivative

• Gains and losses accrue on a day-to-day basis (marking to market)

• Heavily regulated

• Delivery rarely takes place

• Commission visible

• Used by retail investors, corporations and institutional investors

Over-the-Counter

• Traded largely through computer and/or phone lines

• Terms of the contract agreed to between buyer and seller

• Private • Early termination more difficult

• No third-party guarantor

• Performance bond not required in most cases

• Gains and losses generally settled at the end of the contract, rather than marking to market

• Much less regulated

• Delivery or final cash settlement usually occurring

• Fee usually built into price

• Used by corporations and financial institutions

2. TYPES OF UNDERLYING ASSETS

Commodity futures and options are commonly used by producers, merchandisers, and processors of commodities to protect themselves against fluctuating commodity prices.

Financial derivatives

-Equity is the underlying asset of a large category of financial derivatives.

-Exchange-traded interest rate derivatives

-currency derivatives

3. THE USERS OF DERIVATIVES

• Individual investors

• Institutional investors

• Businesses and corporations

• Derivative dealers

INDIVIDUAL INVESTORS

exchange-traded derivatives only

INSTITUTIONAL INVESTORS

• Market entry and exit

• Arbitrage

• Yield enhancement

4. OPTIONS

Call Option

Holder (Long Position)

• PAYS premium to the writer

• Has the RIGHT to BUY the underlying asset at the predetermined price

• Expects the price of the underlying asset to RISE

Put Option

Holder (Long Position)

• PAYS premium to the writer

• Has the RIGHT to SELL the underlying asset at the predetermined price

• Expects the price of the underlying asset to FALL

Call Option

Writer (Short Position)

• RECEIVES premium from the buyer

• Has the OBLIGATION to SELL the underlying asset at the predetermined price, if called upon to do so

• Expects the price of the underlying asset to REMAIN THE SAME OR FALL

Put Option

Writer (Short Position)

• RECEIVES premium from the buyer

• Has the OBLIGATION to BUY the underlying asset at the predetermined price, if called upon to do so

• Expects the price of the underlying asset to REMAIN THE SAME OR RISE

OPTIONS TERMINOLOGY

• Strike price

• Option premium

• Expiration date

• Trading unit

• Americanstyle and Europeanstyle options

• Long-Term Equity AnticiPation Securities

• Opening transaction

• In-the-money

• Out-of-themoney and Atthe-money

• Intrinsic value

• Time value

BUYING CALL OPTIONS

Investors buy call options with either of two investment strategies in mind: to speculate in the hope of earning a profit or to manage risk.

WRITING CALL OPTIONS

Investors write call options primarily for the income they provide in the form of the premium.

BUYING PUT OPTIONS

A popular reason for buying put options is to profit from an expected decline in the price of the stock.

WRITING PUT OPTIONS

Investors write put options primarily for the income they provide in the form of the premium.

5. FORWARDS AND FUTURES

• Financial futures are contracts with a financial asset as the underlying asset. Common underlying assets include: Stocks Bonds Currencies Interest rates Stock Indexes

• Commodity futures are contracts with a physical asset as the underlying asset. Common underlying assets include: Precious and base metals Crude oil and natural gas Grains and oilseeds Meats and dairy Lumber

CASH-SETTLED FUTURES

Many financial futures are based on underlying assets that are difficult or even impossible to deliver. For these types of futures, delivery involves an exchange of cash from one party to the other.

MARGIN REQUIREMENTS AND MARKING TO MARKET

The Montréal Exchange lists financial futures.

BUYING FUTURES TO SPECULATE

BUYING FUTURES TO MANAGE RISK

6. RIGHTS AND WARRANTS

RIGHTS

A right is a privilege granted to an existing shareholder to acquire additional shares directly from the issuing company. There is no cost for shareholders to acquire these rights.

• subscription price or offering price

• record date

• ex-rights

• cum rights

Intrinsic Value of Rights

(S-X)/n

S = The market price of the stock X = The exercise or subscription price of the rights n = The number of rights needed to buy one share

WARRANTS

A warrant is a security that gives its holder the right to buy shares in a company from the issuer at a set price for a set period of time. In this sense, warrants are similar to call options. The primary difference between the two is that warrants are issued by the company itself, whereas call options are issued (i.e., written) by other investors.

Sweetener

1. THE ROLE OF DERIVATIVES

Underlying asset

Two basic types: options and forwards. Both types are contracts between two parties: a buyer and a seller.

• The buyer in an option contract has the right, but not the obligation, to buy or sell a specified quantity of the underlying asset in the future at a price agreed upon today. The seller of the option is obliged to complete the transaction if called upon to do so. An option that gives its owner the right to buy the underlying asset is a call option; one that gives the right to sell the underlying asset is a put option.

• With forward contracts both parties oblige themselves to trade the underlying asset in the future at a price agreed upon today. Neither party has given the other any right; they are both obliged to participate in the future trade.

FEATURES COMMON TO ALL DERIVATIVES

• They are contractual agreements between two parties (often called counterparties): a buyer and a seller. The agreements spell out the rights (if any) and the obligations of each party.

• They have a price upon which the buyer and seller must agree; buyers try to buy them for as little as possible, whereas sellers try to sell them for as much as possible.

• They have an expiration date. Both parties must fulfill their obligations or exercise their rights under the contract on or before the expiration date. After that date, the contract is automatically terminated.

When a derivative contract is drawn up, it includes a price, or formula for determining the price, of an asset to be bought and sold in the future, either on or before the expiration date.

• With forwards, no up-front payment is required. Sometimes one or both parties make a performance bond or good-faith deposit, which gives the party on the other side of the transaction a higher level of assurance that the terms of the forward will be honoured.

• With options, the buyer makes a payment to the seller when the contract is drawn up. This payment, known as a premium, gives the buyer the right to buy or sell the underlying asset at a preset price on or before the expiration date.

DERIVATIVE MARKETS

• OTC derivatives : contracts can be custom designed to meet specific needs

EXCHANGE-TRADED DERIVATIVES

Derivative exchanges evolved in response to OTC issues, including concerns around standardization, liquidity, and default risk.

The Montréal Exchange (or Bourse de Montréal) lists options on stocks, indexes, and U.S. currency, as well as exchange-traded forwards (futures) on bonds, bankers’ acceptances, and indexes.

DEFAULT RISK

Canadian Derivatives Clearing Corporation (CDCC)

Exchange-Traded

• Traded on an exchange

• Standardized contract

• Transparent (public)

• Easy termination prior to contract expiry

• Clearinghouse acts as third-party guarantor ensuring contract’s performance to both trading parties

• Performance bond required, depending on the type of derivative

• Gains and losses accrue on a day-to-day basis (marking to market)

• Heavily regulated

• Delivery rarely takes place

• Commission visible

• Used by retail investors, corporations and institutional investors

Over-the-Counter

• Traded largely through computer and/or phone lines

• Terms of the contract agreed to between buyer and seller

• Private • Early termination more difficult

• No third-party guarantor

• Performance bond not required in most cases

• Gains and losses generally settled at the end of the contract, rather than marking to market

• Much less regulated

• Delivery or final cash settlement usually occurring

• Fee usually built into price

• Used by corporations and financial institutions

2. TYPES OF UNDERLYING ASSETS

Commodity futures and options are commonly used by producers, merchandisers, and processors of commodities to protect themselves against fluctuating commodity prices.

Financial derivatives

-Equity is the underlying asset of a large category of financial derivatives.

-Exchange-traded interest rate derivatives

-currency derivatives

3. THE USERS OF DERIVATIVES

• Individual investors

• Institutional investors

• Businesses and corporations

• Derivative dealers

INDIVIDUAL INVESTORS

exchange-traded derivatives only

INSTITUTIONAL INVESTORS

• Market entry and exit

• Arbitrage

• Yield enhancement

4. OPTIONS

Call Option

Holder (Long Position)

• PAYS premium to the writer

• Has the RIGHT to BUY the underlying asset at the predetermined price

• Expects the price of the underlying asset to RISE

Put Option

Holder (Long Position)

• PAYS premium to the writer

• Has the RIGHT to SELL the underlying asset at the predetermined price

• Expects the price of the underlying asset to FALL

Call Option

Writer (Short Position)

• RECEIVES premium from the buyer

• Has the OBLIGATION to SELL the underlying asset at the predetermined price, if called upon to do so

• Expects the price of the underlying asset to REMAIN THE SAME OR FALL

Put Option

Writer (Short Position)

• RECEIVES premium from the buyer

• Has the OBLIGATION to BUY the underlying asset at the predetermined price, if called upon to do so

• Expects the price of the underlying asset to REMAIN THE SAME OR RISE

OPTIONS TERMINOLOGY

• Strike price

• Option premium

• Expiration date

• Trading unit

• Americanstyle and Europeanstyle options

• Long-Term Equity AnticiPation Securities

• Opening transaction

• In-the-money

• Out-of-themoney and Atthe-money

• Intrinsic value

• Time value

BUYING CALL OPTIONS

Investors buy call options with either of two investment strategies in mind: to speculate in the hope of earning a profit or to manage risk.

WRITING CALL OPTIONS

Investors write call options primarily for the income they provide in the form of the premium.

BUYING PUT OPTIONS

A popular reason for buying put options is to profit from an expected decline in the price of the stock.

WRITING PUT OPTIONS

Investors write put options primarily for the income they provide in the form of the premium.

5. FORWARDS AND FUTURES

• Financial futures are contracts with a financial asset as the underlying asset. Common underlying assets include: Stocks Bonds Currencies Interest rates Stock Indexes

• Commodity futures are contracts with a physical asset as the underlying asset. Common underlying assets include: Precious and base metals Crude oil and natural gas Grains and oilseeds Meats and dairy Lumber

CASH-SETTLED FUTURES

Many financial futures are based on underlying assets that are difficult or even impossible to deliver. For these types of futures, delivery involves an exchange of cash from one party to the other.

MARGIN REQUIREMENTS AND MARKING TO MARKET

The Montréal Exchange lists financial futures.

BUYING FUTURES TO SPECULATE

BUYING FUTURES TO MANAGE RISK

6. RIGHTS AND WARRANTS

RIGHTS

A right is a privilege granted to an existing shareholder to acquire additional shares directly from the issuing company. There is no cost for shareholders to acquire these rights.

• subscription price or offering price

• record date

• ex-rights

• cum rights

Intrinsic Value of Rights

(S-X)/n

S = The market price of the stock X = The exercise or subscription price of the rights n = The number of rights needed to buy one share

WARRANTS

A warrant is a security that gives its holder the right to buy shares in a company from the issuer at a set price for a set period of time. In this sense, warrants are similar to call options. The primary difference between the two is that warrants are issued by the company itself, whereas call options are issued (i.e., written) by other investors.

Sweetener

Chapter 9 | Equity Securities: Equity Transactions

1. CASH ACCOUNTS AND MARGIN ACCOUNTS

• Clients with regular cash accounts are expected to make full payment for purchases or full delivery for sales on or before the settlement date. The settlement date is specified in the contract, generally according to the following industry rules: Government of Canada Treasury bills—on the day that the transaction takes place All other securities—two business days after the transaction takes place

• In contrast, margin accounts are used by clients who wish to buy or sell securities on partial credit. In such cases, the client pays only a portion of the purchase price and the investment dealer lends the balance to the client, charging interest on the loan.

2. MARGIN ACCOUNT TRANSACTIONS

• A long margin position allows investors to partially finance the purchase of securities by borrowing money from the dealer. Investors buy on margin with the expectation that the price of the security will rise.

• A short margin position allows investors to sell borrowed securities in the expectation that the price will fall, allowing the investor to buy back the shares at a lower price for a profit.

This requirement to deposit additional money is known as a margin call.

MARGIN RISKS

• Margin increases market risk

• Loan and interest must be repaid

• Margin calls must be paid without delay

SHORT MARGIN ACCOUNTS

Short selling

There is no limit on the amount of time that a short sale position

COVERING A SHORT POSITION

DECLARING A SHORT SALE

sell-order ticket Short (or S)

RISKS OF SHORT SELLING

• Borrowing shares

• Adequate margin

• Liability

• Buy-in requirements

• Insufficient information

• Price action

• Unlimited risk

• Regulatory risk

TRADING AND SETTLEMENT PROCEDURES

bid-ask spread

HOW SECURITIES ARE BOUGHT AND SOLD

TYPES OF ORDERS

• market order

• limit order

• day order

• good through order

• stop loss order

• stop buy order

• professional (PRO) order

Chapter 8 | Equity Securities: Common and Preferred Shares

1. COMMON SHARES

BENEFITS

• Potential for capital appreciation

• The right to receive any common share dividends paid by the company

• Voting privileges, including the right to elect directors, approve financial statements and auditor’s reports, and vote on important issues

• Favourable tax treatment in Canada of dividend income and capital gains

• Marketability—the shareholdings of most public companies can easily be increased, decreased, or sold

• The right to receive copies of the annual and quarterly reports, as well as other mandatory information pertaining to the company’s affairs

• The right to examine certain company documents, including its by-laws and its register of shareholders, at specified times

• The right to question management at shareholders’ meetings

• Limited liability

RISK

• The issuer has no obligation to pay dividends.

• Common shareholders generally have very little influence over the day-to-day operations of the company.

• Common share prices can be volatile, and price changes can lead to investors losing money.

• In terms of claims to assets, common shareholders fall behind creditors, bondholders, and preferred shareholders in the case of bankruptcy or dissolution.

CAPITAL APPRECIATION

retained earnings

REGULAR AND EXTRA DIVIDENDS

EX-DIVIDEND AND CUM DIVIDEND

Without dividend or with dividend

DIVIDEND REINVESTMENT PLANS

Dollar cost averaging

VOTING PRIVILEGES

Voting rights

RESTRICTED SHARES

• Non-voting shares carry no right to vote, except in certain limited circumstances.

• Subordinate voting shares carry a right to vote, if another class of shares is outstanding and those shares carry a greater voting right on a per share basis.

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

STOCK EXCHANGE REGULATIONS OF RESTRICTED SHARES

• Restricted shares must be identified by the appropriate restricted share term.

• Disclosure documents—including information circulars, annual reports, and financial statements sent to voting shareholders—must also be sent to holders of restricted shares, and the documents must describe the restrictions on their voting rights.

• Restricted shares must be identified in the financial press with a code.

• Dealer and advisor literature must properly describe restricted shares.

• Trade confirmations must identify restricted shares.

• Holders of restricted shares must be given notice of shareholders’ meetings. They must also be invited to attend and be permitted to speak at the meetings.

• Minority approval is required for any corporate action that would result in the creation of new restricted shares.

STOCK SPLITS AND CONSOLIDATIONS

Stock split or reverse stock split (or consolidation)

2. PREFERRED SHARES

THE PREFERRED SHAREHOLDER’S CLAIM TO ASSETS

Pari passu

PREFERRED ISSUE VERSUS DEBT ISSUE

• It is not feasible for the company to market a new debt issue because existing assets are already heavily mortgaged.

• Market conditions are temporarily unreceptive to new debt issues.

• The company has enough short- and long-term debt outstanding (i.e., its debt-to-equity ratio is high). Preferreds would increase the equity component

• The directors are reluctant to assume the legal obligations to pay interest and principal.

• The directors decide that paying preferred dividends will not be onerously expensive.

PREFERRED SHARE FEATURES

• Cumulative feature – Non-cumulative feature

• Callable feature – Non-callable feature

• Voting privileges

• Purchase fund

• Sinking fund

STRAIGHT PREFERRED SHARES

• They provide greater safety than common shares through preference to dividend and asset entitlements

• For individuals, they provide a tax advantage through the dividend tax credit.

• For corporations, they provide a tax advantage through preferred dividends received from taxable Canadian companies on a tax-exempt basis.

• They provide less safety than a debt investment because dividends are not a legal obligation. • They do not provide voting privileges (unless a stated number of dividend payments is in arrears).

• They have no maturity date.

• They are less marketable than common shares because there are usually fewer preferreds than common outstanding.

• They have limited potential for price appreciation compared to common shares. The price at which the preferreds could be redeemed by the issuer places a limit on any appreciation that might occur as a result of a decline in interest rates.

CONVERTIBLE PREFERRED SHARES

• They provide a two-way security because the holder is in a more secure position than the common shareholder, and yet the holder can realize a capital gain if the market price of the common shares rise sufficiently.

• They usually provide a higher yield than the underlying common shares.

• They provide the right to obtain common shares through conversion without paying a commission.

• They usually provide a lower yield than a comparable straight preferred.

• They sometimes convert into less (or more) than a standard trading unit of common shares, which in turn may be more difficult to sell than a standard trading unit.

• They revert to straight preferreds when the conversion period expires, if conversion has not taken place.

RETRACTABLE PREFERRED SHARES

• They provide a predetermined date and price at which to tender shares for retraction. The shorter the time interval to the retraction date, the less vulnerable the stock’s market price is to increases in interest rates. A straight preferred declines in price as interest rates rise, whereas a retractable preferred will not fall significantly below its retraction price as the retraction date approaches.

• They provide a capital gain if purchased at a discount from the retraction price and subsequently tendered at the retraction price.

• They sell above the retraction price and at least as high as the call price when interest rates decline sufficiently.

• They do not retract automatically; the retraction privilege expires if no action is taken by the holder during the election period.

• They become straight preferred shares if they are not retracted when the election period expires. If this occurs in a period of high or rising interest rates, the stock’s market value declines. The shares sell on a straight yield basis after the retraction privilege expires.

FLOATING-RATE PREFERRED SHARES

variable-rate preferred

• They are issued during periods in the market when a straight preferred is hard to sell and the issuer does not want to make the issue convertible or retractable. (Making the issue convertible could potentially dilute shareholder equity, whereas making it retractable allows holders to potentially force redemption at an inopportune time.)

• They are also issued when the issuer believes that interest rates will not go much higher than the rate on the new issue date. (The company is prepared to pay a higher dividend if interest rates rise, but if interest rates decline, of course, the issuer will pay a smaller dividend—subject, in most cases, to a guaranteed minimum rate.)

• They provide higher income if interest rates rise, but lower income if interest rates fall.

• They provide a variable amount of annual income that is difficult to predict accurately, but which reflect prevailing interest rate levels.

• As an investment, their market price is less sensitive to changes in interest rates compared to the market prices of straight preferred shares. The dividend payout of variable-rate preferreds is tied to changes in interest rates on a predetermined basis.

FOREIGN-PAY PREFERRED SHARES

3. STOCK INDEXES AND AVERAGES

• Gauge the overall performance and directional moves in the stock market.

• Enable portfolio managers and other investors to measure their portfolio’s performance against a commonly used yardstick within the stock market.

• Create index mutual funds.

• Serve as underlying interests for options, futures, and exchange-traded funds.

• S&P/TSX Composite Index

• S&P/TSX 60 Index

• S&P/TSX Venture Composite Index

• DJIA – THE DOW JONES INDUSTRIAL AVERAGE

• THE S&P 500

Chapter 7 | Fixed-Income Securities: Pricing and Trading

1. CALCULATING PRICE AND YIELD OF A BOND

PV=Cn+FV/(1+r)n

THE DISCOUNT RATE

The discount rate is the rate at which you would discount a future value to determine the present value.

CALCULATING THE FAIR PRICE OF A BOND

The fair price of a bond is the present value of the bond’s principal and the present value of all coupon payments to be received over the life of the bond.

Yield to maturity (YTM)

REINVESTMENT RISK

Because interest rates fluctuate, the interest rate prevailing at the time of purchase is unlikely to be the same as the interest rate prevailing at the time the investor reinvests cash flows from each coupon payment.

2. TERM STRUCTURE OF INTEREST RATES

• The general level of interest rates at any particular time

• The level of interest rates at different terms to maturity

Fisher Effect:

• The real rate of return

• The inflation rate

Because inflation reduces the value of a dollar, the return that is received, called the nominal rate, must be reduced by the inflation rate to arrive at the real rate of return.

Nominal Rate = Real Rate + Inflation Rate

THE YIELD CURVE

Yield curve is a curve showing several yields to maturity or interest rates across different contract lengths for a similar debt contract.

-Expectations theory : The expectations theory says that current long-term interest rates foreshadow future short-term rates.

-Liquidity preference theory : Investors prefer short-term bonds because they are more liquid and less volatile in price.

-Market segmentation theory : Yield curve represents the supply of and demand for bonds of various terms, which are primarily influenced by the bigger players in each sector.

3. FUNDAMENTAL BOND PRICING PROPERTIES

THE RELATIONSHIP BETWEEN BOND PRICES AND INTEREST RATES

When interest rates rise, bond yields also rise but bond prices fall; when interest rates fall, bond yields also fall but bond prices rise.

THE IMPACT OF MATURITY

The next important relationship to recognize is that longer-term bonds are more volatile in price than shorter-term bonds.

THE IMPACT OF THE COUPON

Lower-coupon bonds are more volatile in price percentage change than high-coupon bonds.

THE IMPACT OF YIELD CHANGES

The relative yield change is more important than the absolute yield change.

DURATION AS A MEASURE OF BOND PRICE VOLATILITY

• The value of a bond changes in the opposite direction to a change in interest rates: as interest rates rise, bond prices fall; as interest rates fall, bond prices rise.

• Given two bonds with the same term to maturity and the same yield, the bond with the higher coupon is usually less volatile in price than the bond with the lower coupon.

• Given two bonds with the same coupon rate and same yield, the bond with the longer term to maturity is usually more volatile in price than the bond with the shorter term to maturity.

4. BOND MARKET TRADING

THE SELL SIDE

• Investment banker

• Trader

• Sales representative

THE BUY SIDE

• Portfolio manager

• Trader

ROLE OF INTER-DEALER BROKERS

These brokers act solely as agents, bringing together institutional buyers and sellers in matching trades.

THE TRADE TICKET

• Specific details of the counterparties to the trade

• Full identification of the bond

• The bond’s Committee on Uniform Security Identification Procedure (CUSIP)

• The nominal

• The price

• The settlement date

• The name of the custodian

• The total settlement amount

CLEARING AND SETTLEMENT

Bearer bonds

Registered bonds

Bonds registered in book-based format

CALCULATING ACCRUED INTEREST

Accrued Interest = par amount X (coupon rate/100) X (Time Period/365)

5. BOND INDEXES

• As a guide to the performance of the overall bond market or a segment of that market

• As a performance measurement tool, to assess the performance of bond portfolio managers

• To construct bond index funds

CANADIAN BOND MARKET INDEXES

FTSE Global Debt Capital Markets offers a comprehensive set of Canadian bond indexes.

GLOBAL INDEXES

• Global bond indexes

• U.S. bonds

• Government bonds

• Emerging market bonds

• High-yield bonds

Chapter 6 | Fixed-Income Securities: Features and Types

1. THE FIXED-INCOME MARKETPLACE

• To finance operations or growth

• To take advantage of financial leverage

2.THE BASIC FEATURES AND TERMINOLOGY OF FIXED-INCOME SECURITIES

BOND TERMINOLOGY

• Par value

• Coupon rate

• Maturity date

• Term to maturity

• Bond price

• Yield to maturity

Liquidity, negotiability, and marketability

STRIP BONDS

Zero coupon bond is high-quality bonds separates future-dated interest coupons from the rest of the bond (bond residue).

CALLABLE BONDS

Redemption feature : Bond issuers often reserve the right, but not the obligation, to pay off the bond before maturity.

STANDARD CALL FEATURES

Allows the issuer to call bonds for redemption at a specified price on either specific dates.

EXTENDIBLE AND RETRACTABLE BONDS

-Option to extend the investment

-Option to redeem early

CONVERTIBLE BONDS

Option of exchanging the bond for common shares

FORCED CONVERSION

• It relieves the issuer of the obligation to make interest payments on debt once investors convert their debt into equities.

• It can free up room for new debt financing, if needed.

SINKING FUNDS AND PURCHASE FUNDS

• Sinking funds are sums of money that are set aside out of earnings each year to provide for the repayment of all or part of a debt issue by maturity.

• A fund is set up to retire a specified amount of the outstanding bonds or debentures through purchases in the market

PROTECTIVE PROVISIONS OF CORPORATE BONDS

• Security

• Negative pledge

• Limitation on sale and leaseback transactions

• Sale of assets or merger

• Dividend test

• Debt test

• Additional bond provisions

• Sinking or purchase fund and call provisions

3. GOVERNMENT OF CANADA SECURITIES

BONDS

Government of Canada issues marketable bonds in its own name.

TREASURY BILLS

T-bills are short-term government obligations.

CANADA SAVINGS BONDS AND CANADA PREMIUM BONDS

(CSBs) and (CPBs) were a secure savings product fully guaranteed by the Government of Canada.

REAL RETURN BONDS

Coupon payments and principal repayment are adjusted for inflation to provide a fixed real coupon rate.

4. PROVINCIAL AND MUNICIPAL GOVERNMENT SECURITIES

GUARANTEED BONDS

PROVINCIAL SECURITIES

• They can be purchased only by residents of the province.

• They can be purchased only at a certain time of the year.

• They are redeemable every six months (or, in Quebec, at any time).

MUNICIPAL SECURITIES

Instalment debenture (serial bond). Part of this bond matures in each year of its term.

5. TYPES OF CORPORATE BONDS

MORTGAGE BONDS

Agreement to pledge land, buildings, or equipment as security for a loan.

FLOATING-RATE SECURITIES

Variable-rate securities are a type of corporate issue that automatically adjusts to changing interest rates.

DOMESTIC, FOREIGN, AND EUROBONDS

Domestic bonds are issued in the currency and country of the issuer.

Foreign bonds are issued outside of the issuer’s country and denominated in the currency of the country in which they are issued.

Eurobonds are international bonds issued in a currency other than the currency of the country where the bond is issued.

• Collateral trust bond

• Equipment trust certificates

• Subordinated debentures

• Corporate notes

• High-yield bonds

6. OTHER FIXED-INCOME SECURITIES

BANKERS’ ACCEPTANCES

BA is a commercial draft drawn by a borrower for payment on a specified date.

COMMERCIAL PAPER

Either an unsecured promissory note issued by a corporation or an asset-backed security backed by a pool of underlying financial assets.

TERM DEPOSITS

Offer a guaranteed rate for a short-term deposit.

GUARANTEED INVESTMENT CERTIFICATES

GIC offer fixed rates of interest for a specific term. Both principal and interest payments are guaranteed.

Types of Guaranteed Investment Certificates:

• Escalating-rate GIC

• Laddered GIC

• Instalment GIC

• Index-linked GIC

• Interest-rate linked GIC

FIXED-INCOME MUTUAL FUNDS AND EXCHANGE-TRADED FUNDS

7. BOND QUOTES AND RATINGS

DBRS, Moody’s, and S&P provide independent rating services for many debt securities.

Chapter 5 | Economic Policy

1. FISCAL POLICY

SPENDING

-government spending on infrastructure can have a stimulative effect on the whole economy.

TAXATION

-the government may increase taxation to lower inflation, making it more difficult for consumers and businesses to spend.

2. THE BANK OF CANADA

-Monetary policy

-The Canadian financial system

-Physical currency

-Funds management

3. MONETARY POLICY

-Inflation

Interest Rates

The Bank raises interest rates.

• Borrowing becomes more expensive.

• Borrowing decreases and consumption and business investment therefore decrease.

Money Supply

The Bank reduces the money supply.

• Interest rates rise in response.

• Borrowing becomes more expensive.

• Borrowing decreases and consumption and business investment thus decrease.

-Recession

• reverse

IMPLEMENTING MONETARY POLICY

• Target overnight rate: operating band that is 50 basis points wide

• Open market operations : Special Purchase and Resale Agreements (SPRA), commonly called Specials, and Sale and Repurchase Agreements (SRA)

• Drawdowns and redeposits

4. THE CHALLENGES OF GOVERNMENT POLICY

Timing lags, Political considerations, Future expectations, Coordination of federal and provincial policies, High federal debt, Impact of international economies

Fiscal and Monetary Economic Policy

-recession

• Increase government spending • Decrease taxes

Increase money supply • Decrease interest rates

-High inflation

• reverse

Chapter 4 | Overview of Economics

THE ECONOMY

1. DEFINING ECONOMICS

-microeconomics: individual markets of goods and services

-macroeconomics: employment levels, interest rates, inflation, recessions, government spending

THE DECISION MAKERS

consumers, businesses, and governments

DEMAND, SUPPLY, AND MARKET EQUILIBRIUM

2.MEASURING ECONOMIC GROWTH

GROSS DOMESTIC PRODUCT (GDP)

The total market value of all the final goods and services produced in a country over a given period.

-Income approach: adds up all of the income generated by this economic activity.

-Expenditure approach: add up everything that consumers, businesses, and governments spend money.

GDP = c+i+g+(x-m)

REAL AND NOMINAL GROSS DOMESTIC PRODUCT

-Nominal gross domestic product (nominal GDP) is the dollar value of all goods and services produced.

-real gross domestic product (real GDP). This measure removes the changes in output that are attributable to inflation.

PRODUCTIVITY

key factors contribute to gains in productivity: Technological advances, Population growth, Improvements in training, education, and skill

3.THE BUSINESS CYCLE

PHASES OF THE BUSINESS CYCLE

-expansion, peak, contraction, trough, and recovery

ECONOMIC INDICATORS

• Leading indicators: Housing starts, Manufacturers’ new orders, Commodity prices, Stock prices, The money supply

• Coincident indicators: Personal income, GDP, Industrial production, Retail sales

• Lagging indicators: Unemployment, Inflation rate, Labour costs, Private sector, plant and equipment spending, Business loans

IDENTIFYING RECESSIONS

Depth, Duration, Diffusion

4. THE LABOUR MARKET

15 years of age and older

• Those who are unable to work • Those who are not working by choice • The labour force

LABOUR MARKET INDICATORS

• Participation rate • Unemployment rate

TYPES OF UNEMPLOYMENT

Cyclical unemployment, Seasonal unemployment, Frictional unemployment, Structural unemployment

5. THE ROLE OF INTEREST RATES

DETERMINANTS OF INTEREST RATES

• Demand and supply of capital

• Default risk

• Foreign interest rates and the exchange rate

• Central bank credibility

• Inflation

HOW INTEREST RATES AFFECT THE ECONOMY

• They reduce business investment

• They encourage saving

• They reduce consumption

-Real interest rate is the nominal interest rate minus the expected inflation rate.

6. THE IMPACT OF INFLATION

MEASURING INFLATION

The Consumer Price Index (CPI) is a widely used measure of inflation.

THE COSTS OF INFLATION

• erode the standard of living

• reduces the real value of investments

• distorts the price signals sent to market participants

• rising interest rates and a recession

THE CAUSES OF INFLATION

-demand-pull inflation

-cost-push inflation

Phillips curve

• Lower unemployment is achieved in the short run by increasing inflation at a faster rate.

• Lower inflation is achieved at the cost of possibly increased unemployment and slower economic growth.

7. INTERNATIONAL FINANCE AND TRADE

BALANCE OF PAYMENTS

-Current account: records the import and export of goods and services between Canadians and foreigners

– Capital and financial account: records financial flows between Canadians and foreigners

DETERMINANTS OF EXCHANGE RATES

Commodities, Inflation, Interest rates, Trade, Economic performance, Public debts and deficits, Political stability

Chapter 3 | The Canadian Regulatory Environment

1. REGULATORS

-CANADIAN SECURITIES ADMINISTRATORS (CSA)

Umbrella organization of Canada’s ten provincial and three territorial securities regulators designed to improve, coordinate and harmonize regulation of the Canadian capital markets.

-SELF-REGULATORY ORGANIZATIONS (SRO)

Canadian SROs include the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association (MFDA).

-THE INVESTMENT INDUSTRY REGULATORY ORGANIZATION OF CANADA (IIROC)

IIROC oversees all investment dealers and trading activity on debt and equity marketplaces in Canada.

Financial compliance, Business conduct compliance, Registration, Enforcement, Market surveillance

-THE MUTUAL FUND DEALERS ASSOCIATION (MFDA)

The MFDA is the mutual fund industry’s SRO responsible for regulating the distribution and sales of mutual funds by its members in Canada

-THE OFFICE OF THE SUPERINTENDENT OF FINANCIAL INSTITUTIONS (OSFI)

independent agency of the Government of Canada designed to contribute to the safety and soundness of the Canadian financial system.

-INVESTOR PROTECTION FUNDS

The securities industry offers the investing public protection against loss as a result of the financial failure of any firm in the self-regulatory system.

-CANADIAN INVESTOR PROTECTION FUND (CIPF)

The primary role of the CIPF is investor protection; its secondary role is overseeing the self-regulatory system.

-MUTUAL FUND DEALERS ASSOCIATION INVESTOR PROTECTION CORPORATION (MFDA IPC)

Provide protection for eligible customers of insolvent MFDA member firms.

-CANADA DEPOSIT INSURANCE CORPORATION (CDIC)

Federal Crown Corporation that provides deposit insurance and contributes to the stability of Canada’s financial system.

-PROVINCIAL INSURANCE CORPORATIONS

Protect the deposits of credit union members.

2. REGULATION AND SUPERVISION

-REGULATION

Consumer protection, Fairness, Economic stability, Social objectives

-PRINCIPLES-BASED REGULATION

The regulators set objectives for securities dealers and allow the firms themselves to decide how best to meet those objectives.

-SECURITIES REGULATION IN CANADA

In Canada, there is no federal regulatory body for the securities industry, unlike in the United States, where the national Securities and Exchange Commission (SEC) has considerable regulatory authority.

Protection flows from the SROs, as well as from the provincial and territorial regulatory authorities.

-DISCLOSURE

Full, true, and plain disclosure.

Methods to protect investors:

• Registration of securities dealers and advisors

• Disclosure of facts necessary to make reasoned investment decisions

• Enforcement of the laws and policies

-NATIONAL REGISTRATION DATABASE (NRD)

Web-based system used by investment dealers and employees to file registration forms electronically when applying for approval by a stock exchange, the CSA, or IIROC.

-GATEKEEPER

• Collect and record client information that is accurate and complete.

• Monitor activity in client accounts.

• Report any suspicious transactions or proposed transactions in client accounts.

-KNOW YOUR CLIENT (KYC)

• Learn the essential facts relative to every client and to every order or account accepted.

• Verify that the acceptance of any order for any account is within the bounds of good business practice. • Verify that recommendations made for any account are appropriate for the client’s investment objectives, personal circumstances, and tolerance to risk.

-CLIENT RELATIONSHIP MODEL (CRM)

The objective is increased transparency for investors regarding the fees they pay, the services they receive, potential conflicts of interest, and the performance of their accounts.

-RELATIONSHIP DISCLOSURE

• The types of products and services offered by the firm

• The terms of the account relationship to which the client has consented

• The process used by the firm to assess investment suitability and the client’s KYC information

• The date on which account suitability will be reviewed

• All fees and charges associated with operating, transacting, and holding investments in the account

• The firm’s complaint handling procedures

-CONFLICT OF INTEREST MANAGEMENT

• Avoiding the conflict

• Disclosing the conflict

• Otherwise controlling the conflict situation

-SUITABILITY ASSESSMENT

• A trade is accepted.

• A recommendation is made.

• Securities are transferred or deposited to an account.

• There is a change of representative or portfolio manager responsible for the account.

• There is a material change to the KYC information for the account.

3. REMEDIATION

-ARBITRATION

• Attempts have been made to resolve the dispute with the investment dealer.

• The claim does not exceed $500,00

-OMBUDSMAN FOR BANKING SERVICES AND INVESTMENTS (OBSI)

This organization investigates customer complaints against financial services providers, including some banks and other deposit-taking organizations, investment dealers, mutual fund dealers, and mutual fund companies. OBSI is independent of the financial services industry.

4.ETHICAL STANDARDS

EXEMPLES

• Deceiving the public, the buyer, or the vendor as to price of any transaction or the value of any security

• Creating, or attempting to create, a false or misleading appearance of active public trading in a security in an effort to make a profit

• Entering, or attempting to enter, into any arrangement to sell and repurchase a security in an effort to manipulate the market

• Making a fictitious trade that involves no change in the beneficial ownership of a security in an effort to mislead the public

• Using high-pressure or otherwise undesirable selling techniques

• Violating any statute applicable to the sale of securities

• Misleading a client as to the risk involved in purchasing a specific security

• Trading in one’s own account before effecting the same trade for a client (a practice known as front running)

• Conducting oneself in a way that would bring the securities business, the exchanges, or IIROC into disrepute

-PROHIBITED SALES PRACTICES

Such regulations are designed to curb unethical behaviour, dishonest conduct, and high-pressure selling tactics.

NATIONAL DO NOT CALL LIST (DNCL)

The DNCL rules prohibit telemarketers and clients of telemarketers from calling any number that has been registered on the DNCL for more than 31 days.

Chapter 2 | The Capital Market

1. INVESTMENT CAPITAL

Characteristic of capital: mobility, sensitivity to its environment, and scarcity

Components of country risk factors: political environment, Economic trends, Fiscal policy, Monetary policy, Investment opportunities, labour force.

Suppliers of capital: Individuals, Non-financial domestic corporations, Governments, Foreign investors

The Sources and Users of Investment Capital

Sources of Capital

-Retail investors are individual clients who buy and sell securities for their personal accounts.

-Institutional investors are organizations, such as pension and mutual fund companies, that trade in large-share quantities or dollar amounts. They typically have a steady flow of money to invest.

-Foreign direct investment in Canada tends to concentrate in manufacturing, petroleum, natural gas, mining, and smelting. Some industries have restrictions on foreign investment.

Users of Capital

-Individuals need capital to finance large purchases such as houses, cars, and major appliances. They usually obtain it in the form of personal loans, mortgage loans, and charge accounts.

-Businesses require massive sums of capital to finance day-to-day operations, renew and maintain plants and equipment, and expand and diversify their activities. They generate much of that capital internally, in the form of profits retained in the business. They borrow from financial intermediaries for other needs, and they raise the remainder in securities markets.

-Governments are major issuers of securities in public markets, either directly or through guaranteeing the debt of their Crown corporations. When revenues fail to meet expenditures, or when they undertake large capital projects, governments must borrow.

2. THE FINANCIAL INSTRUMENTS

The Different Types of Financial Instruments

-Fixed-income securities (also called debt securities) formalize a relationship in which the issuer promises to repay the loan at maturity and, in the interim, makes interest payments to the investor. The term of the loan varies depending on the type of instrument.

-Equity securities (commonly called stocks, equities, or shares) represent some form of ownership stake in the company that issued them. For example, if the value of a company increases, the owner of stock in that company receives a capital gain upon selling it.

-A derivative is a product whose value is derived from the value of an underlying instrument, such as a stock or an index. Unlike stocks and bonds, derivatives are more suited to sophisticated investors.

-Managed products (also called investment funds) are typically pools of capital gathered from investors to buy securities according to a specific investment mandate.

-A structured product is a financially engineered product with the characteristics of debt, equity, and an investment fund.

3. THE FINANCIAL MARKETS

The capital market is made up of many individual financial markets, including stock markets, bond markets, and money markets. Only short-term fixed-income securities with a term of one year or less trade in the money market.

Primary markets and secondary markets

-In the primary market, newly issued securities are sold by companies and governments to investors. IPO

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

Auction market

In an auction market, securities are bought and sold by investors. Investment dealers, who typically act as agents, execute the buy and sell orders on behalf of their clients.

Stock exchanges

A stock exchange is an auction market where buyers and sellers of securities meet to trade with each other and where prices are established according to the laws of supply and demand.

Exchange liquidity

• Frequent trades

• Narrow price spread between bid and ask prices

• Small price fluctuations from trade to trade

Canadian exchanges

• Toronto Stock Exchange (TSX)

• TSX Venture Exchange

• TSX Venture Exchange

• TSX Venture Exchange

• ICE NGX Canada

• Canadian Securities Exchange

• NEO Exchange

Dealer market OTC

OTC consist of a network of banks and investment dealers. Unlike an auction market, where the orders of individual buyers and sellers are entered in a centralized marketplace, a dealer market is a negotiated market where market makers post bid-and-ask quotations via electronic platforms and computer networks. In the OTC market, investment dealers typically act as principals.

-Almost all bonds and debentures are sold through dealer markets.

-Dealer markets are also called unlisted markets.

TRADING IN THE UNLISTED EQUITY MARKET

Investment dealers, who act as market makers, quote their own bids and offers. These market makers hold an inventory of the securities in which they have agreed to make a market.

OVER-THE-COUNTER DERIVATIVES MARKET

They can be custom designed by the buyer and seller, with special features added to the basic properties of options and forwards.

Open 24 hours a day

REPORTING TRADES IN THE EQUITY UNLISTED MARKET

In Canada investment dealers do not have to report unlisted trades except in Ontario.

-web-based system named the Canadian Unlisted Board Inc.

ALTERNATIVE TRADING SYSTEMS ats

Electronic marketplaces that provide automated matching and execution of trades in both the equity and fixed-income markets.

EQUITY ELECTRONIC TRADING SYSTEMS

Alternative trading systems in the equity markets provide automated trade matching and execution of orders from multiple buyers and sellers, a role once performed exclusively by stock exchanges.

FIXED-INCOME ELECTRONIC TRADING SYSTEMS

All bond and money market securities are sold through dealer markets.

• CanDeal

• CBID

• MarketAxess

• CanPX