Understanding Products & Their Risks Flashcards
1
Q
Common Stock
A
- only has a claim to the residual value of a company, meaning what’s left over after all credit facilities, short-term debt, long-term debt, loans, and other senior obligations of the company are paid (in event of liquidation)
- right to:
inspect records
evaluate assets
sue manager and officers
transfer and sell shares
recover residual value in event of liquidation
receive equal share of dividends (pro rata dividends)
vote on all issues affecting the corporation
purchase additional shares before the general public (preemptive right) - most corporations allow one vote per share
2
Q
Preemptive Right
A
- the granted to some shareholders to purchase new shares before the general public
- typically occurs after an IPO when a second round of shares issued
- meant to ensure the company’s original investors maintain their ownership percentage of the company
3
Q
Limited Liability
A
- an owner is liable only for their initial investment
- if a company loses all of its equity value and still has debts, the owners are not required to repay the debt
4
Q
Preferred Stock
A
- dividends paid in full prior to common stockholders
- does not typically have voting rights
5
Q
Cumulative Preferred Stock
A
accumulates dividends in arrears
6
Q
Non-cumulative Preferred Stock
A
just like common stock, missed dividends don’t accrue and won’t be paid if there aren’t earnings to do so
7
Q
Participating Preferred Stock
A
used when special measures are needed to attract new investors; receive dividends and give stockholders the right to receive additional dividends along with common stock shareholders
8
Q
Non-participating Preferred Stock
A
only pays stipulated dividends
9
Q
Convertible Preferred Stock
A
- grants the shareholder the right to convert into a specific number of shares within a specific time period
- often carry a rating like a traditional bond
10
Q
Callable Preferred Stock
A
- give the issuer the right to call the shares back at a specified price over a specified time (as stated in the prospectus)
- this is advantageous to the issuing company if finance conditions become more favorable (i.e. interest rates are lower)
11
Q
Sinking Fund
A
- accrues a balance that’s used to redeem bonds or preferred stock
- this means that the company must retire a specified amount of debt on an annual basis
PRO: it creates liquidity for the bonds
CON: means that funds will be invested at a lower rate
12
Q
Adjustable rate stock
A
- pays a dividend that’s adjusted on a quarterly basis
- typically tied to the change in Treasury rates or some other index rate
- price of these securities is typically more stable as it does not need to adjust to compensate investors for the rate of return they require given changes in the interest rate
13
Q
Rights Offering
A
- allows existing stockholders to buy newly issued shares at a discount before the general public
- typically involve an investment bank having the right to buy any offered shares if the existing investors don’t purchase all available shares
14
Q
Warrants
A
- contracts attached to the ownership of a bond or preferred stock
- grant the holder the right to purchase additional stock over a specified time and at a set price (the “exercise price”)
- creates an incentive for the warrant holder should the market price rise above the set price
- essentially a “sweetener” when debt is issued by a company
- when a company wants to issue debt at a lower interest rate than the market dictates (given the company’s risk profile), so this compensates the investor for buying the debt at a lower rate
- tradeable
- can be separated from the instrument to which they were attached
- experiences a “time decay” as it gets closer to its expiration date
- sometimes have an anti-dilution provision
15
Q
Basket Warrants
A
mirror the performance of an industry
16
Q
Index Warrants
A
value is determined by the performance of an index
17
Q
Anti-Dilution Provision
A
allows existing shareholders to purchase new shares on a pro rata bases
18
Q
Convertible bond value
A
Equal to the bond’s straight value plus the value of the warrant
19
Q
American Depository Receipts (ADRs)
A
- securities that allow U.S. citizens to purchase shares of foreign companies in the U.S. markets without having to make the purchase on a foreign stock exchange
- denominated in U.S. dollars
- help reduce the administrative costs incurred with international transactions
- do not eliminate currency or economic risks associated with investments in foreign companies
20
Q
Securities Act Rule 144A
A
- allows for easier trading of restricted securities by QIBs (buyers with $100M in assets)
- induced foreign companies to sell restricted securities in the U.S. capital markets
- essentially provides a safe harbor from the registration requirements of the Securities Act of 1933
- NASDAQ offers a compliance review process that grants access to securities falling under this exemption
- NOT to be confused with Rule 144, which permits public (as opposed to private) unregistered sales
21
Q
Qualified Institutional Buyers (QIBs)
A
- buyers with at least $100M in assets
22
Q
U.S. Debt Instruments
A
- Treasury bills, Treasury notes, Treasury bonds, Zero- coupon bonds (STRIPS), Treasury Inflation-Protected Securities (TIPS)
- backed by the full faith and credit of the U.S. government
- income from these securities is tax exempt at state ad local levels, but is taxable at the federal level
- T-bills mature in 1 year or less
- T-notes: 1-10 years
- T-bonds: 10-30 years
23
Q
Treasury bills
A
- the primary instrument used by the Federal Open Market Committee (FOMC) to regulate the supply of money
- minimum denomination of $1,000 then in $5k increments, max of $5M
- is a short-term debt obligation backed by the U.S. Treasury Department with a maturity of one year or less.
- the longer the maturity date, the higher the interest rate that the T-Bill will pay to the investor.
24
Q
Treasury Inflation Protected Securities
A
- have their principal amount adjusted for inflation as calculated by the Consumer Price Index (CPI)
- these bonds compensate investors for inflation
- their breakeven rate (i.e. the difference between the yield on TIPS and regular Treasury notes or bonds) is sometimes used to gauge the inflation that financial markets expect
25
Q
Treasury Note
A
- a U.S. government debt security with a fixed interest rate and maturity between two and 10 years.
- available either via competitive bids, in which an investor specifies the yield, or non-competitive bids, in which the investor accepts whatever yield is determined.
- just like a Treasury bond, except that they have different maturities—T-bond lifespans are 20 to 30 years
26
Q
Treasury bonds (T-bonds)
A
- are fixed-rate U.S. government debt securities with a maturity range between 10 and 30 years.
- pay semiannual interest payments until maturity, at which point the face value of the bond is paid to the owner.
- along with Treasury bills, Treasury notes, and Treasury Inflation-Protected Securities (TIPS)
- one of four virtually risk-free government-issued securities
- after they have been sold at auction by the U.S. government, they trade on the secondary market
27
Q
Treasury Markets
A
- highly liquid due to significant trading by both institutional and retail investors in treasury bonds
- actually the largest security market in the world
28
Q
Treasury Notes & Bonds Point Increments
A
- Notes and bonds are quoted on the secondary market at the percentage of par in 1/32 point increments
- each 1/32nd is referred to as a tick
- each percentage point or basis point is a bip
- the spread is the difference between the yields of 2 different bonds
ex: if a 10-year bond is trading with a yield of 5% and
the 5-year bond is trading at 4% the spread would be
1% (5%-4%=1%) - traders typically look at spreads when deciding which bonds offer the most value
29
Q
Government Sponsored Entities (GSEs)
A
- private corporations that are granted government charters because their activities are deemed important to public policy
- backed by full faith and credit of the U.S. government, thus their agency bonds risk is virtually as low as Treasury bonds
30
Q
Asset-backed securities (ABS)
A
- backed by the receivables a bank or servicer is owed on loans for everything from automobiles, credit cards, and mortgages to company inventory and student loans
- originated by a bank or finance company, then packaged and sold to investors
- have different tranches with varying levels of risk
more senior tranches receive interest and principal
first while the riskiest, equity-like tranches only
receive the residual payment on the riskiest loans
31
Q
Collateralized Mortgage Obligation (CMO)
A
- refers to a type of mortgage-backed security that contains a pool of mortgages bundled together and sold as an investment
- organized by maturity and level of risk
- receive cash flows as borrowers repay the mortgages that act as collateral on these securities
32
Q
Collateralized Debt Obligation (CDO)
A
- a complex structured finance product that is backed by a pool of loans and other assets
- these underlying assets serve as collateral if the loan goes into default.
- though risky and not for all investors, area viable tool for shifting risk and freeing up capital
33
Q
Mortgage-backed securities (MSBs)
A
- turn a bank into an intermediary between the homebuyer and the investment industry
- the bank handles the loans and then sells them at a discount to be packaged to investors as a type of collateralized bond
- for the investor, is as safe as the mortgage loans that back it up
34
Q
Government National Mortgage Association (GNMA)
A
- Ginnie Mae
- issues bonds backed by the full faith and credit of the U.S. government
- guarantees principal and interest on MBS backed by loans insured by the Federal Housing Administration & the Department of Veteran Affairs
35
Q
Federal National Mortgage Association (FNMA)
A
- Fannie Mae
- issues a variety of debt securities with maturities across the yield curve to fulfill its ongoing needs
- issues both short and long-term debt
- can either be callable or noncallable
36
Q
Callable bond
A
- can be called away by the issuer before the maturity date, making them riskier than noncallable bonds.
- compensate investors for their higher risk by offering slightly higher interest rates.
- face reinvestment risk, which is the risk that investors will have to reinvest at lower interest rates if the bonds are called away.
- a good investment when interest rates remain unchanged
- typically called when interest rates decline and the company can find less expensive financing
- also called a redeemable bond
37
Q
Noncallable bond
A
- a financial security that cannot be redeemed early by the issuer except with the payment of a penalty
- the issuer subjects itself to interest rate risk because, at issuance, it locks in the interest rate it will pay until the security matures. If interest rates decline, the issuer must continue paying the higher rate until the security matures.
38
Q
Securitization
A
- pools of securities (typically mortgages) that are sold as a single security
39
Q
Corporate bond
A
- issued by corporations
- taxable securities
- set maturity (usually pay the full principal at maturity, some amortize like mortgages and asset-backed securities)
- typically set par value of $1,000
- trade on major exchanges, but sometimes OTC
- accrues interest in the same manner as Treasury bonds (except when “traded flat”)
40
Q
Bond indenture
A
- formal agreement between the bond issuer and the investor
KEY ITEMS: - the form of the bond
- total dollar amount in the bond issuance
- the property pledged behind the bond (not always is there property)
- any protective covenants
- redemption rights and call privileges
41
Q
Covenants
A
- acts that must be or cannot be performed by the issuer
e. g. working capital requirements, debt-equity ratio requirements, and restrictions on dividend payments
42
Q
Traded flat
A
- when a buyer doesn’t have to pay the accrued interest on a bond to the seller
- usually occurs when the bonds are in default since there is no guarantee that the buyer will received the entire interest payment that’s due
