Canadian Securities Course (CSC) Textbook Vol. 1

Canadian Securities Course Volume 1 Prepared and published by

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Credentials that matter.

Copies of this publication are for the personal use of properly registered students whose names are entered on the course records of CSI Global Education Inc. (CSI)®. This publication may not be lent, borrowed or resold. Names of individual securities mentioned in this publication are for the purposes of comparison and illustration only and prices for those securities were approximate figures for the period when this publication was being prepared.

Notices Regarding This Publication: This publication is strictly intended for information and educational use. Although this publication is designed to provide accurate and authoritative information, it is to be used with the understanding that CSI is not engaged in the rendering of financial, accounting or other professional advice. If financial advice or other expert assistance is required, the services of a competent professional should be sought.

Every attempt has been made to update securities industry practices and regulations to reflect conditions at the time of publication. While information in this publication has been obtained from sources we believe to be reliable, such information cannot be guaranteed nor does it purport to treat each subject exhaustively and should not be interpreted as a recommendation for any specific product, service, use or course of action. CSI assumes no obligation to update the content in this publication.

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© 2013 CSI Global Education Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of CSI Global Education Inc.

ISBN: 978-1-927104-73-6 First printing: 1964 Revised and reprinted: 1967, 1968, 1969, 1970, 1971, 1973, 1974, 1976, 1977, 1978, 1979, 1980, 1981, 1983, 1984, 1985, 1986, 1987, 1988, 1989, 1990, 1991, 1992, 1995, 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2010, 2011, 2013 Copyright © 2013 by CSI Global Education Inc.

Course Introduction

Welcome to the Canadian Securities Course (CSC)! In beginning this course, you are taking an important first step toward a comprehensive financial education. You will be able to apply the knowledge you acquire in this course to an exciting career in the financial services industry, or you can use it simply to make informed financial decisions and maximize your investment potential. The CSC is recognized as an industry benchmark. It covers a diverse range of topics, including financial markets, financial instruments, and financial intermediaries. The course content reflects the ever-changing nature of the securities industry. Ten years ago, for example, exchange-traded funds, principal protected notes, and hedge funds were barely covered in the CSC, because they were of little significance. Today, these types of securities are treated in-depth in the CSC, because they have come to play a vital role in the financial landscape. The dynamic nature of the industry is a compelling reason to take the CSC course, whether you aspire to a career, are already working in the financial services industry or merely want to enhance your investing knowledge. Your challenge is to thoroughly understand the material so you can apply it in the workplace, discuss key concepts with your financial advisor, or use your knowledge to make your own investment decisions. Our challenge is to make the content easy to learn. We created various course components for this purpose, and we highly recommend that you use them all. They include the textbook, online learning activities, post-test questions, discussion boards, Frequently Asked Questions (FAQs), and the CSC Check product.

© CSI GLOBAL EDUCATION INC. (2013)

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COURSE INTRODUCTION

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Tell Us How We’re Doing! Although we make every effort to ensure that what you are learning is accurate, practical, and well written, we recognize that there is always room for improvement. The course is updated regularly, so please let us know what you think. You can submit comments, suggestions or complaints to [email protected]. This edition of the Canadian Securities Course (CSC) textbook was prepared in the Fall of 2012. The CSC textbook is updated and revised regularly to better reflect the rapidly changing financial services industry. We thank those students and industry representatives who helped with the revision process, either through their suggestions or by providing or verifying information for the book.

What You’ll Learn The CSC covers the three central elements of the Canadian securities industry—financial products, financial markets, and the role of financial intermediaries. Intermediaries include Investment Advisors, financial planners, and financial advisors, among others. Our goal is to help you understand the marketplace and introduce you to industry terminology and practices. Our journey begins with an introduction to the Canadian securities industry, the regulatory landscape and the economy. From there, we move to the different types of markets, instruments and methods of analysis. The course ends with a look at the many types of structured or financially engineered products, taxation, ethics and, finally, the financial planning process. Volume 1 provides the tools and knowledge that you will need to apply to the material in Volume 2.

What Is the Big Picture? Think of the capital market as the engine of the economy. By this we mean that the capital market transforms savings into investments, and these investments drive a nation’s growth. This vital economic function is based on a simple process—the transfer of money from those who have it (savers) to those who need it (users). Capital transfer at its simplest occurs when you deposit money into a bank account. Once you make a deposit, the bank can lend it to a business that needs funds. For example, the business may use borrowed funds to expand their operations or to become a publicly-traded company on a stock exchange. In return, the business pays interest on the borrowed funds, and you receive a portion of that interest for the use of your money. Of course, the capital transfer process is more sophisticated in our financial markets, especially as they become increasingly complex. In essence, the financial markets have evolved to work like this: •

Financial instruments, such as stocks and bonds, formalize the transfer of capital.

•

Financial markets provide a forum where capital is transferred in the form of financial instruments.

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Financial intermediaries, such as Investment Advisors, make the transfer process faster and easier.


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CANADIAN SECURITIES COURSE • VOLUME 1

These three components—instruments, markets, and intermediaries—are the key elements of the securities industry. In combination, they facilitate the efficient allocation of capital. For example, a company needs capital to expand its operations. The company raises capital by issuing financial instruments, such as stocks or bonds, into the market through an investment dealer. Investors buy the securities through an intermediary such as a financial advisor. In the process, the investors temporarily transfer their money to the company. In return, they receive securities representing claims on the company’s real assets. If the business does well, it earns a profit. Part of these earnings may be distributed to the investors in the form of dividends or interest, depending on the type of security that was purchased. The price of the security also may rise, yielding a profit or capital gain for the investor when the security is sold in the marketplace. Investors aren’t the only ones to profit, however. Part of the money earned by the company may be reinvested in the business, spurring further economic development. Consequently, securities investments benefit not only the investor and the user of capital, but also the country as a whole.

Key Chapter Features Each chapter includes the following learning features: Chapter Outlines: The chapter outline lets you know what content will be covered in the chapter and will prepare you for the material you are about to read. Learning Objectives: The learning objectives help to focus your studies on important topic areas. Be sure to read each objective before you begin a chapter; the objectives specify precisely what you are expected to know after reading the chapter and studying the material. To highlight their importance, we have linked each objective directly to the chapter’s major headings. Chapter Openers: Each chapter begins with a short overview of the importance and relevance of the material to be covered. The openers set the stage and help to increase your motivation by linking the chapter content to the real world. Key Terms: Understanding the terminology and jargon of the securities industry is an important part of your success in this course. We provide a list of key terms at the start of each chapter. Each key term is boldfaced in the chapter and appears in the glossary included at the end of the textbook. Chapter Summaries: Each chapter closes with a concise summary of the material, organized by learning objective. The summaries will help to reinforce the relationship between the material and the chapter learning objectives. They also help to suggest areas of weakness that require further study.


COURSE INTRODUCTION

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Your Journey Through the Course Although each student will develop an individual technique for studying, some may find the following suggestions helpful. Your registration includes access to online modules that can be used as study guides. They are designed to help reinforce the textbook content and assess your knowledge. Before you read a chapter, we recommend that you log onto the online course and use the modules along with your text. We suggest the following approach: •

Read the Getting Started section and the learning objectives for the chapter.

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Read the chapter in your textbook or the online PDF. Use this first reading to familiarize yourself with the material. Take notes where necessary, especially if there is a concept you don’t understand.

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Complete the learning activities associated with each chapter.

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If you have any questions related to the course material, review the online Frequently Asked Questions section. You may find the answers there.

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Read the chapter slowly a second time. Pay particular attention to those areas you found challenging during your first reading.

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Pay attention to the tables, charts, and exhibits. These will help with the practical aspects of the material.

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Work through all examples and calculations, making sure that you understand how the correct answers were arrived at.

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Complete the post-test for each chapter.

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Read the chapter summary and learning objectives once again to reinforce your learning.

Don’t forget to review the Glossary at the end of the textbook, where the Key Terms from each chapter are defined. Understanding the terminology and jargon used within the industry is an essential part of this course. We particularly recommend a thorough reading of the Glossary for those who are new to the material. In fact, the Glossary provides an excellent means to review the material and prepare for the exam. If you are still in doubt about any concept, use the Index to find a full discussion of that concept in the textbook.


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The Canadian Securities Institute The Canadian Securities Institute (CSI) has been setting the standard for world-class, life-long education for financial professionals for more than 40 years. Our experience training over 700,000 global professionals makes us the preferred partner for individual and corporate financial services education internationally. Our expertise extends from securities to mutual funds, from banking and trust to insurance, from portfolio management to financial planning and wealth management. CSI is a thought leader whose real world training sets professionals apart in their field, by developing them into leaders who are able to excel in their chosen careers. Our focus on leading educational and ethical standards means that our graduates have met the highest level of proficiency and certification. We develop course content based on industry trends and continuous involvement from our worldwide partners to ensure our graduates are the most current in every financial sector. CSI is a partner that works collaboratively with practitioners and industry regulators. This leads to a higher educational standard in an evolving financial services marketplace. By anticipating industry requirements, we are able to develop relevant curriculum and testing for real world application. CSI grants designations that have become a true measure of expertise. We focus on state of the art industry knowledge that is the recognized standard for regulatory authorities, financial organizations and associations in Canada and around the globe. Our graduates come with highly endorsed credentials that are respected throughout the financial services industry. CSI is valued for its expertise in both course content and program delivery. CSI has established professional designations in growing specialties such as financial derivatives and wealth management. These are in addition to our respected and established courses and seminars. We’ve also pioneered the use of the Internet as a powerful tool for teaching and professional development through online courses and study aids. CSI leads innovative, lifelong education for career-minded financial professionals. CSI courses are available on demand in a variety of formats that can be used anywhere and anytime. We are continually adapting to changing technology and to the changing needs of learners and their organizations.


VOLUME I

Contents SECTION I THE CANADIAN INVESTMENT MARKETPLACE

1 The Capital Market ....................................................................1•1 What is Investment Capital? ........................................................................... 1•5 Characteristics of Capital ............................................................................................ 1•5 Why Capital Is Needed............................................................................................... 1•6 Who are the Sources and Users of Capital? .................................................. 1•6 Sources of Capital ....................................................................................................... 1•7 Users of Capital .......................................................................................................... 1•7 What are the Financial Instruments? ............................................................. 1•9 Financial instruments ................................................................................................. 1•9 Private Equity ........................................................................................................... 1•10 What are the Financial Markets? ................................................................... 1•11 Auction Markets in Canada ...................................................................................... 1•12 Dealer Markets ......................................................................................................... 1•14 Other Trading Systems.............................................................................................. 1•16 Fixed-Income Electronic Trading Systems ................................................................. 1•16 Trends in Financial Markets ...................................................................................... 1•17 Summary ...........................................................................................................1•19


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2 The Canadian Securities Industry ...............................................2•1 Overview of the Canadian Securities Industry .............................................. 2•5 What Role do Financial Intermediaries Play? ................................................ 2•6 Types of Firms ............................................................................................................ 2•7 Organization within Firms.......................................................................................... 2•8 Investment Dealers and their Principal or Agency Functions .................................... 2•10 The Clearing System................................................................................................. 2•11 What Roles do Banks Play as Financial Intermediaries? .............................2•12 Schedule I Chartered Banks ...................................................................................... 2•12 Schedule II and Schedule III Banks .......................................................................... 2•13 What are Trust Companies, Credit Unions and Life Insurance Companies? .............................................................................2•14 Trust and Loan Companies ....................................................................................... 2•14 Credit Unions and Caisses Populaires ....................................................................... 2•14 Insurance Companies ............................................................................................... 2•14 What are Investment Funds, Savings Banks, Sales Finance and Consumer Loan Companies, and Pension Plans?.........................................2•16 Summary ...........................................................................................................2•18

3 The Canadian Regulatory Environment......................................3•1 Who are the Regulators?.................................................................................. 3•5 Federal Regulators ...................................................................................................... 3•5 The Provincial Regulators ........................................................................................... 3•6 The Self-Regulatory Organizations ............................................................................. 3•8 Investor Protection Funds ......................................................................................... 3•10 Role of Arbitration.................................................................................................... 3•13 Ombudsman for Banking Services and Investments.................................................. 3•13 What are the Principles of Securities Legislation? ......................................3•14 Full, True and Plain Disclosure ................................................................................. 3•14 Registration .............................................................................................................. 3•14


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The National Registration Database (NRD) ............................................................. 3•16 Know Your Client Rule............................................................................................. 3•16 Client Relationship Model (CRM) ........................................................................... 3•16 What are the Ethics of Trading? .....................................................................3•18 Examples of Unethical Practices ................................................................................ 3•18 Prohibited Sales Practices .......................................................................................... 3•19 What are Public Company Disclosures and Investor Rights? .................... 3•20 Continuous Disclosure ............................................................................................. 3•20 Statutory Rights for Investors ................................................................................... 3•21 Proxies and Proxy Solicitation ................................................................................... 3•22 What are Takeover Bids and Insider Trading? ............................................ 3•22 Takeover Bids ........................................................................................................... 3•23 Insider Trading ......................................................................................................... 3•24 Summary .......................................................................................................... 3•26 SECTION II THE ECONOMY

4 Economic Principles ...................................................................4•1 What is Economics? .......................................................................................... 4•6 Microeconomics and Macroeconomics ....................................................................... 4•6 The Decision Makers .................................................................................................. 4•7 Demand and Supply ................................................................................................... 4•7 How is Economic Growth Measured? ............................................................. 4•9 Measuring Gross Domestic Product ............................................................................ 4•9 Productivity and Determinants of Economic Growth ............................................... 4•11 What are the Phases of the Business Cycle? ................................................4•13 Phases of the Business Cycle ..................................................................................... 4•13 Using Economic Indicators ....................................................................................... 4•16 Identifying Recessions............................................................................................... 4•18


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What are the Key Labour Market Indicators? ............................................. 4•20 Labour Market Indicators ......................................................................................... 4•20 Types of Unemployment........................................................................................... 4•22 What Role do Interest Rates Play?................................................................ 4•23 Determinants of Interest Rates.................................................................................. 4•23 How Interest Rates Affect the Economy ................................................................... 4•24 Expectations and Interest Rates................................................................................. 4•24 What is the Nature of Money and Inflation?................................................ 4•25 The Nature of Money ............................................................................................... 4•25 Inflation.................................................................................................................... 4•25 Disinflation .............................................................................................................. 4•29 Deflation .................................................................................................................. 4•30 How does International Economics Impact the Economy? ....................... 4•30 The Balance of Payments .......................................................................................... 4•30 The Exchange Rate ................................................................................................... 4•31 Summary .......................................................................................................... 4•36

5 Economic Policy .........................................................................5•1 What are the Different Economic Theories? ................................................ 5•5 Rational Expectations Theory ..................................................................................... 5•5 Keynesian Theory ....................................................................................................... 5•5 Monetarist Theory ...................................................................................................... 5•6 Supply-Side Economics .............................................................................................. 5•6 What is Fiscal Policy? ........................................................................................ 5•7 The Federal Budget .................................................................................................... 5•7 How Fiscal Policy Affects the Economy ...................................................................... 5•8 What is the Role of the Bank of Canada? ......................................................5•10 Role of the Bank of Canada ...................................................................................... 5•10 Functions of the Bank of Canada .............................................................................. 5•11


CONTENTS

What is Monetary Policy?................................................................................5•12 Implementing Monetary Policy ................................................................................ 5•13 Open Market Operations.......................................................................................... 5•14 Cash Management Operations.................................................................................. 5•16 What are the Challenges of Government Policy? ........................................5•17 The Consequences of Failed Fiscal Policy.................................................................. 5•18 Summary ...........................................................................................................5•19 SECTION III INVESTMENT PRODUCTS

6 Fixed-Income Securities: Features and Types ...............................6•1 What is the Fixed-Income Marketplace? ....................................................... 6•6 The Rationale for Issuing Fixed-Income Securities ...................................................... 6•6 What are the Basic Features and Terminology of Fixed-Income Securities? ................................................................................. 6•7 Basic Terminology ...................................................................................................... 6•7 Describing Bond Features .......................................................................................... 6•8 Liquid Bonds, Negotiable Bonds and Marketable Bonds ............................................ 6•9 Strip Bonds ............................................................................................................... 6•10 Callable Bonds.......................................................................................................... 6•10 Extendible and Retractable Bonds............................................................................. 6•12 Convertible Bonds and Debentures .......................................................................... 6•13 Sinking Funds and Purchase Funds ........................................................................... 6•15 Protective Provisions of Corporate Bonds ................................................................. 6•16 What are Government of Canada Securities?..............................................6•17 Marketable Bonds ..................................................................................................... 6•17 Treasury Bills ............................................................................................................ 6•18 Canada Savings Bonds .............................................................................................. 6•18 Canada Premium Bonds ........................................................................................... 6•18 Real Return Bonds ................................................................................................... 6•19


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What are Provincial and Municipal Government Securities? .....................6•19 Guaranteed Bonds .................................................................................................... 6•20 Provincial Securities .................................................................................................. 6•20 Municipal Securities ................................................................................................. 6•20 What are Corporate Bonds?...........................................................................6•21 Mortgage Bonds ....................................................................................................... 6•21 Collateral Trust Bonds .............................................................................................. 6•22 Equipment Trust Certificates .................................................................................... 6•22 Subordinated Debentures ......................................................................................... 6•22 Floating-Rate Securities ............................................................................................ 6•22 Corporate Notes ....................................................................................................... 6•22 Domestic, Foreign and Eurobonds ............................................................................ 6•22 Preferred Securities ................................................................................................... 6•23 High-Yield Bonds ..................................................................................................... 6•24 What are some Other Fixed-Income Securities in the Marketplace?...... 6•24 Bankers’ Acceptances ................................................................................................ 6•24 Commercial Paper .................................................................................................... 6•24 Term Deposits .......................................................................................................... 6•25 Guaranteed Investment Certificates .......................................................................... 6•25 Fixed-Income Mutual Funds and ETFs..................................................................... 6•26 How to Read Bond Quotes and Ratings?...................................................... 6•26 Summary .......................................................................................................... 6•29

7 Fixed Income Securities: Pricing and Trading ..............................7•1 How are Price and Yield of a Bond Calculated? ............................................ 7•5 Calculating the Fair Price of a Bond............................................................................ 7•7 Calculating the Yield on a Treasury Bill .................................................................... 7•11 Calculating the Current Yield on a Bond .................................................................. 7•12 Calculating the Yield to Maturity on a Bond ............................................................ 7•12


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What is the Term Structure of Interest Rates?............................................7•15 The Real Rate of Return ........................................................................................... 7•15 The Yield Curve ....................................................................................................... 7•16 What are the Fundamental Bond Pricing Properties? ................................7•19 The Relationship between Bond Prices and Interest Rates......................................... 7•19 The Impact of Maturity ............................................................................................ 7•20 The Impact of the Coupon ....................................................................................... 7•21 The Impact of Yield Changes.................................................................................... 7•22 Duration as a Measure of Bond Price Volatility ......................................................... 7•23 How does Bond Market Trading Work? ....................................................... 7•25 Clearing and Settlement ........................................................................................... 7•25 Calculating Accrued Interest ..................................................................................... 7•26 What are Bond Indexes? ................................................................................ 7•28 Canadian Bond Market Indexes ................................................................................ 7•28 Global Indexes .......................................................................................................... 7•28 Summary .......................................................................................................... 7•30

8 Equity Securities: Common and Preferred Shares ........................8•1 What are Common Shares? ............................................................................ 8•5 Benefits of Common Share Ownership ....................................................................... 8•5 Capital Appreciation ................................................................................................... 8•6 Dividends ................................................................................................................... 8•6 Voting Privileges ......................................................................................................... 8•9 Tax Treatment ........................................................................................................... 8•10 Stock Splits and Consolidations ................................................................................ 8•12 Reading Stock Quotations ........................................................................................ 8•13 What are Preferred Shares? ...........................................................................8•14 The Preferred’s Position ............................................................................................ 8•14 Why Companies Issue Preferred Shares..................................................................... 8•15 Why Investors Buy Preferred Shares .......................................................................... 8•16 Preferred Share Features ............................................................................................ 8•16


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Straight Preferreds..................................................................................................... 8•17 Convertible Preferreds .............................................................................................. 8•18 Retractable Preferreds ............................................................................................... 8•21 Floating-Rate Preferreds ............................................................................................ 8•22 Foreign-Pay Preferreds .............................................................................................. 8•23 Other Types of Preferreds.......................................................................................... 8•23 What are Stock Indexes and Averages? ....................................................... 8•24 Canadian Market Indexes ......................................................................................... 8•25 U.S. Stock Market Indexes........................................................................................ 8•28 International Market Indexes and Averages ............................................................... 8•29 Summary ...........................................................................................................8•31

9 Equity Securities: Equity Transactions .........................................9•1 What are Cash Accounts? ................................................................................ 9•5 Cash Account Rules .................................................................................................... 9•5 Free Credit Balances .................................................................................................. 9•6 What are Margin Accounts? ............................................................................ 9•6 Long Margin Accounts ............................................................................................... 9•6 Margining Long Positions ........................................................................................... 9•7 What is Short Selling? ...................................................................................... 9•9 How Short Selling is Done ....................................................................................... 9•10 Dangers of Short Selling ........................................................................................... 9•14 How do Trading and Settlement Procedures Work? ..................................9•15 Trading Procedures ................................................................................................... 9•15 How are Securities Bought and Sold?............................................................9•18 Types of Orders ........................................................................................................ 9•18 Summary .......................................................................................................... 9•23


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10 Derivatives ................................................................................10•1 What is a Derivative? ...................................................................................... 10•6 Features Common to All Derivatives ........................................................................ 10•6 Derivative Markets.................................................................................................... 10•7 Exchange-Traded versus OTC Derivatives ................................................................ 10•7 What are the Types of Underlying Assets? .................................................10•10 Commodities .......................................................................................................... 10•10 Financials................................................................................................................ 10•10 Who are the Users of Derivatives? ..............................................................10•11 Individual Investors ................................................................................................ 10•11 Institutional Investors ............................................................................................. 10•12 Corporations and Businesses ................................................................................... 10•13 Derivative Dealers................................................................................................... 10•14 What are Options? .........................................................................................10•15 Option Exchanges .................................................................................................. 10•20 Option Strategies for Individual and Institutional Investors .................................... 10•21 Option Strategies for Corporations ......................................................................... 10•29 What are Forwards and Futures? ................................................................10•31 Key Terms and Definitions ..................................................................................... 10•31 Futures Exchanges .................................................................................................. 10•33 Futures Strategies for Investors ................................................................................ 10•33 What are Rights and Warrants? .................................................................. 10•36 Rights ..................................................................................................................... 10•36 Warrants ................................................................................................................. 10•39 Summary ........................................................................................................ 10•41


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SECTION IV THE CORPORATION

11 Financing and Listing Securities ................................................11•1 What are the Different Types of Business Structures? ...............................11•6 What are Incorporated Businesses? ..............................................................11•6 Public and Private Corporations ............................................................................... 11•9 The Structure of the Organization .......................................................................... 11•11 How do Governments and Corporations Finance Themselves? .............. 11•13 Investment Dealer Finance Department ................................................................. 11•13 Canadian Government Issues .................................................................................. 11•14 Provincial and Municipal Issues .............................................................................. 11•15 Corporate Issues ..................................................................................................... 11•16 How does the Corporate Financing Process Work? .................................. 11•18 The Dealer’s Advisory Relationship with Corporations ........................................... 11•19 The Method of Offering ......................................................................................... 11•21 The Prospectus ....................................................................................................... 11•22 After-Market Stabilization ...................................................................................... 11•27 What are the Other Methods of Distributing Securities to the Public?... 11•29 Junior Company Distributions ............................................................................... 11•29 Options of Treasury Shares and Escrowed Shares .................................................... 11•29 Capital Pool Company Program ............................................................................. 11•29 NEX ....................................................................................................................... 11•30 How does the Listing Process Work? ..........................................................11•30 Advantages and Disadvantages of Listing ................................................................ 11•31 Withdrawing Trading Privileges .............................................................................. 11•32 Summary ......................................................................................................... 11•34


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12 Corporations and their Financial Statements .............................12•1 What is the Statement of Financial Position? ..............................................12•5 Classification of Assets .............................................................................................. 12•6 Classification of Equity ........................................................................................... 12•10 Classification of Liabilities ...................................................................................... 12•11 What is the Statement of Comprehensive Income?..................................12•12 Structure of the Statement of Comprehensive Income ............................................ 12•12 What is the Statement of Changes In Equity?............................................12•15 What is the Statement of Cash Flows?........................................................12•16 Operating Activities ................................................................................................ 12•17 Financing Activities (items 38 to 41) ...................................................................... 12•18 Investing Activities (items 42 to 44)........................................................................ 12•18 The Change in Cash Flow (items 45 to 46) ............................................................ 12•18 What is included in the Annual Report? .....................................................12•19 Notes to the Financial Statements ........................................................................... 12•19 The Auditor’s Report .............................................................................................. 12•19 Summary .........................................................................................................12•21 Appendix A – Sample Financial Statements ...............................................12•23

Summary for Volume 1 ....................................................................S•1 Glossary ..........................................................................................G•1 Selected Web Sites .......................................................................Web•1 Index............................................................................................ Ind•1


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VOLUME 2

SECTION V INVESTMENT ANALYSIS

13 Fundamental and Technical Analysis .........................................13•1 What are the Methods of Analysis? .............................................................. 13•5 Fundamental Analysis ............................................................................................... 13•5 Technical Analysis ..................................................................................................... 13•5 Market Theories ....................................................................................................... 13•6 What is Fundamental Macroeconomic Analysis? ........................................13•7 The Fiscal Policy Impact ........................................................................................... 13•8 The Monetary Policy Impact .................................................................................... 13•9 The Flow of Funds Impact...................................................................................... 13•10 The Inflation Impact .............................................................................................. 13•10 What is Fundamental Industry Analysis? .................................................... 13•11 Classifying Industries by Product or Service ............................................................ 13•11 Classifying Industries by Stage of Growth ............................................................... 13•13 Classifying Industries by Competitive Forces .......................................................... 13•14 Classifying Industries by Stock Characteristics ........................................................ 13•14 What are Fundamental Valuation Models?.................................................13•16 Dividend Discount Model ...................................................................................... 13•16 Using the Price-Earnings Ratio ............................................................................... 13•17 What is Technical Analysis? ..........................................................................13•18 Comparing Technical Analysis to Fundamental Analysis ......................................... 13•19 Commonly Used Tools in Technical Analysis .......................................................... 13•19 Summary .........................................................................................................13•27


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14 Company Analysis ....................................................................14•1 What is Company Analysis? ........................................................................... 14•5 Statement of Comprehensive Income Analysis .......................................................... 14•5 Statement of Financial Position Analysis ................................................................... 14•6 Other Features of Company Analysis ........................................................................ 14•8 How are Financial Statements Interpreted? ............................................... 14•9 Trend Analysis ........................................................................................................ 14•10 External Comparisons............................................................................................. 14•11 What is Financial Ratio Analysis? .................................................................14•12 Liquidity Ratios ...................................................................................................... 14•13 Risk Analysis Ratios ................................................................................................ 14•14 Operating Performance Ratios ................................................................................ 14•19 Value Ratios ............................................................................................................ 14•21 How is Preferred Share Investment Quality Assessed? ............................14•27 Investment Quality Assessment............................................................................... 14•27 Selecting Preferreds ................................................................................................. 14•28 Summary .........................................................................................................14•29 Appendix A – Company Financial Statements ...........................................14•31 SECTION VI PORTFOLIO ANALYSIS

15 Introduction to the Portfolio Approach .....................................15•1 What is Risk and Return? ............................................................................... 15•5 Rate of Return .......................................................................................................... 15•6 Risk ........................................................................................................................ 15•10 How are Portfolio Risk and Return Related? ..............................................15•12 Calculating the Rate of Return on a Portfolio ......................................................... 15•12 Measuring Risk in a Portfolio ................................................................................. 15•13 Combining Securities in a Portfolio ........................................................................ 15•14


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What is the Portfolio Management Process? .............................................15•17 What are Investment Objectives and Constraints? ...................................15•18 Return and Risk Objectives .................................................................................... 15•18 Investment Objectives............................................................................................. 15•20 Investment Constraints ........................................................................................... 15•22 What is an Investment Policy Statement? ..................................................15•23 Summary .........................................................................................................15•24

16 The Portfolio Management Process ...........................................16•1 How is an Asset Mix Developed? ................................................................... 16•5 The Asset Mix .......................................................................................................... 16•5 Setting the Asset Mix ................................................................................................ 16•7 What are the Portfolio Manager Styles? ..................................................... 16•11 Equity Manager Styles ............................................................................................ 16•12 Fixed-Income Manager Styles ................................................................................. 16•15 What is Asset Allocation? .............................................................................16•16 Balancing the Asset Classes ..................................................................................... 16•18 Strategic Asset Allocation ........................................................................................ 16•19 Ongoing Asset Allocation ....................................................................................... 16•20 What is Portfolio Monitoring? ......................................................................16•22 Monitoring the Markets and the Client .................................................................. 16•23 Monitoring the Economy ....................................................................................... 16•23 How is Portfolio Performance Evaluated? ..................................................16•24 Measuring Portfolio Returns ................................................................................... 16•24 Calculating the Risk-Adjusted Rate of Return......................................................... 16•25 Other Factors in Performance Measurement ........................................................... 16•26 Summary .........................................................................................................16•27


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SECTION VII ANALYSIS OF MANAGED PRODUCTS

17 Fundamentals of Managed and Structured Products .................17•1 What Factors are Driving the Growth of Managed and Structured Products? .......................................................................................17•5 Recent Industry Developments - Meeting the Evolving Needs of Investors ............... 17•6 Regulatory Considerations ........................................................................................ 17•6 What Are Managed and Structured Products? ............................................17•6 Types of Managed and Structured Products .............................................................. 17•8 How do Managed and Structured Products Compare? ............................17•10 Advantages of Managed Products............................................................................ 17•10 Advantages of Structured Products .......................................................................... 17•11 Disadvantages of Managed Products ....................................................................... 17•12 Disadvantages of Structured Products ..................................................................... 17•13 Risks Involved With Managed and Structured Products.......................................... 17•13 How is the Market Evolving for Managed and Structured Products? ...... 17•14 Outcome Based Investment Solutions..................................................................... 17•14 Changing Compensation Models............................................................................ 17•16 Summary ......................................................................................................... 17•17

18 Mutual Funds: Structure and Regulation ..................................18•1 What is a Mutual Fund? .................................................................................. 18•5 Advantages of Mutual Funds..................................................................................... 18•6 Disadvantages of Mutual Funds ................................................................................ 18•7 What is the Structure of Mutual Funds? ...................................................... 18•8 Mutual Fund Trust Structure .................................................................................... 18•8 Mutual Fund Corporation Structure ......................................................................... 18•9


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Organization of a Mutual Fund ................................................................................ 18•9 Pricing Mutual Fund Units or Shares ...................................................................... 18•11 Charges Associated with Mutual Funds .................................................................. 18•12 What are Labour-Sponsored Venture Capital Corporations? .................18•17 Advantages of Labour-Sponsored Funds ................................................................. 18•17 Disadvantages of Labour-Sponsored Funds ............................................................. 18•18 How are Mutual Funds Regulated?...............................................................18•18 Mutual Fund Regulatory Organizations .................................................................. 18•19 National Instruments 81-101 and 81-102 .............................................................. 18•20 General Mutual Fund Requirements ....................................................................... 18•20 The Simplified Prospectus ...................................................................................... 18•20 What Other Forms and Requirements are Necessary? ........................... 18•22 Registration Requirements for the Mutual Fund Industry ....................................... 18•22 Mutual Fund Restrictions ....................................................................................... 18•24 What is the “Know Your Client” Rule? ...................................................... 18•28 Suitability and Know Your Product ......................................................................... 18•29 The Role of KYC Information in Opening an Account .......................................... 18•30 What are the Requirements when Opening and Updating an Account?....................................................................................18•31 Relationship Disclosure .......................................................................................... 18•31 New Accounts ........................................................................................................ 18•33 Updating Client Information .................................................................................. 18•33 Distribution of Mutual Funds by Financial Institutions .......................................... 18•34 Summary ........................................................................................................ 18•36

19 Mutual Funds: Types and Features ............................................19•1 What are the Different Types of Mutual Funds? ......................................... 19•5 Money Market Funds ............................................................................................... 19•5 Fixed-Income Funds ................................................................................................. 19•6 Balanced Funds......................................................................................................... 19•6 Equity Funds ............................................................................................................ 19•7


CONTENTS

xxiii

Specialty Funds ......................................................................................................... 19•9 Index Funds .............................................................................................................. 19•9 Target-date Funds ................................................................................................... 19•10 Comparing Fund Types .......................................................................................... 19•10 What are the Different Fund Management Styles? ...................................19•12 Indexing and Closet Indexing ................................................................................. 19•12 How are Mutual Fund Units or Shares Redeemed? ...................................19•13 Tax Consequences................................................................................................... 19•13 Reinvesting Distributions ....................................................................................... 19•16 Withdrawal Plans ................................................................................................... 19•17 Suspension of Redemptions .................................................................................... 19•20 How is Mutual Fund Performance Compared? ......................................... 19•20 Reading Mutual Fund Quotes ................................................................................ 19•21 Measuring Mutual Fund Performance..................................................................... 19•22 Issues that Complicate Mutual Fund Performance .................................................. 19•24 Summary .........................................................................................................19•27

20 Segregated Funds and Other Insurance Products .......................20•1 What are the Different Segregated Fund Features? .................................. 20•5 Maturity Guarantees ................................................................................................. 20•6 Death Benefits .......................................................................................................... 20•7 Creditor Protection ................................................................................................... 20•8 Bypassing Probate ..................................................................................................... 20•8 Cost of the Guarantees ............................................................................................. 20•9 Bankruptcy and Family Law ..................................................................................... 20•9 Comparison to Mutual Funds................................................................................... 20•9 How are Segregated Funds Taxed? ..............................................................20•11 Impact of Allocations on Net Asset Values .............................................................. 20•11 Tax Treatment of Guarantees .................................................................................. 20•12 Tax Treatment of Death Benefits ............................................................................. 20•14


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How are Segregated Funds Regulated? ...................................................... 20•14 Monitoring Solvency .............................................................................................. 20•14 The Role Played by Assuris ..................................................................................... 20•15 What are other Insurance Products? ......................................................... 20•15 Guaranteed Minimum Withdrawal Benefit Plans ................................................... 20•16 Portfolio Funds ....................................................................................................... 20•17 Summary ........................................................................................................ 20•18

21 Hedge Funds.............................................................................21•1 How has the Market for Hedge Funds Evolved? ...........................................21•5 Comparisons to Mutual Funds ................................................................................. 21•5 Investing in Hedge Funds ......................................................................................... 21•6 Size of the Hedge Fund Market ................................................................................ 21•8 Tracking Hedge Fund Performance ........................................................................... 21•8 What are the Benefits and Risks of Hedge Funds? ......................................21•9 Benefits ..................................................................................................................... 21•9 Risks ......................................................................................................................... 21•9 Due Diligence......................................................................................................... 21•12 What are the Different Hedge Fund Strategies? ....................................... 21•14 Relative Value Strategies.......................................................................................... 21•15 Event-Driven Strategies........................................................................................... 21•17 Directional Funds ................................................................................................... 21•17 What are Funds of Hedge Funds? ................................................................21•21 Advantages.............................................................................................................. 21•21 Disadvantages ......................................................................................................... 21•22 Summary .........................................................................................................21•24


CONTENTS

xxv

22 Exchange-Listed Managed Products ..........................................22•1 What are Closed-End Funds? ........................................................................ 22•5 Advantages of Closed-End Funds.............................................................................. 22•5 Disadvantages of Closed-End Funds ......................................................................... 22•6 What are Income Trusts? ............................................................................... 22•6 Real Estate Investment Trusts (REITs) ...................................................................... 22•7 Business Trusts .......................................................................................................... 22•8 What are Exchange-Traded Funds? .............................................................. 22•9 Trading ETFs.......................................................................................................... 22•10 Recent Trends in ETFs............................................................................................ 22•11 Regulatory Issues .................................................................................................... 22•14 What is Listed Private Equity? .....................................................................22•15 Structure of Listed Private Equity Companies ......................................................... 22•15 Advantages and Disadvantages of Listed Private Equity .......................................... 22•17 Summary .........................................................................................................22•18

23 Fee-Based Accounts...................................................................23•1 What are the Different Fee-Based Accounts?............................................. 23•4 Managed Accounts ................................................................................................... 23•5 Fee-Based Non-Managed Accounts ........................................................................... 23•6 Advantages and Disadvantages of Fee-Based Accounts .............................................. 23•7 Discretionary Accounts ............................................................................................. 23•7 What are the Different Types of Managed Accounts? ................................ 23•8 Single-Manager Accounts ......................................................................................... 23•8 Multi-Manager Accounts ........................................................................................ 23•10 Private Family Office .............................................................................................. 23•13 Summary .........................................................................................................23•14


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24 Structured Products ..................................................................24•1 What are Principal-Protected Notes? .......................................................... 24•5 PPN Guarantors, Manufacturers and Distributors .................................................... 24•5 The Structure of PPNs.............................................................................................. 24•6 Risks Associated with PPNs ...................................................................................... 24•8 Tax Implications of PPNs ......................................................................................... 24•9 What are Linked Guaranteed Investment Certificates? .......................... 24•10 Structure of Linked GICs ....................................................................................... 24•10 How Returns are Determined ................................................................................. 24•11 Risk Associated with Linked GICs .......................................................................... 24•12 Tax Implications ..................................................................................................... 24•13 What are Split Shares? ..................................................................................24•13 Risks Associated with Split Shares ........................................................................... 24•14 Tax Implications ..................................................................................................... 24•15 What are Asset-Backed Securities?.............................................................24•16 The Securitization Process ...................................................................................... 24•17 Asset-Backed Commercial Paper ............................................................................. 24•18 What are Mortgage-Backed Securities? .................................................... 24•20 Structure and Benefits of MBS................................................................................ 24•21 Summary ........................................................................................................ 24•23 SECTION VIII WORKING WITH THE CLIENT

25 Canadian Taxation ....................................................................25•1 How does the Canadian Taxation System Work? ....................................... 25•5 The Income Tax System in Canada ........................................................................... 25•5 Types of Income ....................................................................................................... 25•6 Calculating Income Tax Payable................................................................................ 25•7


CONTENTS

xxvii

Taxation of Investment Income ................................................................................ 25•7 Tax-Deductible Items Related to Investment Income ................................................ 25•9 How are Investment Gains and Losses Calculated?...................................25•11 Disposition of Shares .............................................................................................. 25•12 Disposition of Debt Securities ................................................................................ 25•14 Capital Losses ......................................................................................................... 25•15 Tax Loss Selling ...................................................................................................... 25•16 What are Tax Deferral Plans? ......................................................................25•17 Registered Pension Plans (RPPs) ............................................................................. 25•17 Registered Retirement Savings Plans (RRSPs) ......................................................... 25•18 Registered Retirement Income Funds (RRIFs) ........................................................ 25•23 Deferred Annuities ................................................................................................. 25•23 Tax-Free Savings Accounts (TFSA) ......................................................................... 25•24 Registered Education Savings Plans (RESPs) ........................................................... 25•25 Pooled Registered Pension Plans (PRPPs) ............................................................... 25•26 What are Tax Planning Strategies? ............................................................. 25•27 Summary ........................................................................................................ 25•29

26 Working with the Retail Client .................................................26•1 What is the Financial Planning Approach? .................................................. 26•5 What are the Steps in Financial Planning Process? .................................... 26•5 Establishing the Client-Advisor Relationship ............................................................ 26•6 Collecting Data and Information .............................................................................. 26•6 Analyzing Data and Information .............................................................................. 26•8 Recommending Strategies to Meet Goals .................................................................. 26•9 Implementing Recommendations ............................................................................. 26•9 Conducting a Periodic Review or Follow-Up ............................................................ 26•9 What is the Life Cycle Hypothesis?..............................................................26•10


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What are Ethics and the Advisor’s Standards of Conducts? ....................26•12 The Code of Ethics ................................................................................................. 26•12 Standards of Conduct ....................................................................................26•13 Summary ........................................................................................................ 26•22 Appendix A .................................................................................................... 26•24 Appendix B – Client Scenarios .................................................................... 26•28

27 Working With the Institutional Client ......................................27•1 Who are Institutional Clients? ...................................................................... 27•4 What are the Suitability Requirements for Institutional Clients? ............ 27•6 Suitability Standards for Institutional Clients............................................................ 27•7 What are the Roles and Responsibilities in the Institutional Market? ..... 27•8 The Role of the Institutional Salesperson .................................................................. 27•9 The Role of the Institutional Trader ........................................................................ 27•12 Summary .........................................................................................................27•14

Summary for Volume 2 ....................................................................S•1 Glossary ..........................................................................................G•1 Selected Web Sites .......................................................................Web•1 Index............................................................................................ Ind•1


SECTION

I

The Canadian Investment Marketplace


Chapter

1

The Capital Market


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1 The Capital Market

CHAPTER OUTLINE What is Investment Capital? • Characteristics of Capital • Why Capital Is Needed Who are the Sources and Users of Capital? • Sources of Capital • Users of Capital What are the Financial Instruments? • Financial instruments • Private Equity What are the Financial Markets? • Auction Markets in Canada • Dealer Markets • Other Trading Systems • Fixed-Income Electronic Trading Systems • Trends in Financial Markets Summary

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LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Define investment capital and describe its role in the economy. 2. Describe how individuals, businesses, governments and foreign agencies supply and use capital in the economy. 3. Differentiate between the types of financial instruments used in capital transactions. 4. Explain the role of financial markets in the Canadian financial services industry, distinguish among the types of financial markets, and describe how auction markets and dealer markets work.

THE CAPITAL MARKET The Canadian securities industry plays a significant role in sustaining and expanding the Canadian economy. The industry grows and evolves to meet the ever-changing needs of Canadian investors, both from domestic and international perspectives. In some way, we are all affected by the securities industry. The vital economic function the industry plays is based on a simple process: the transfer of money from those who have it (savers) to those who need it (users). This capital transfer process is made possible through the use of a variety of financial instruments: money market, stocks, bonds, mutual funds and others. Financial intermediaries, such as banks, trust companies and investment dealers, have evolved to make the transfer process efficient. The first two chapters of this textbook focus on the three central elements of the securities industry: investment markets, products and intermediaries. The emphasis throughout the course, however, is on securities. The text examines the main types of investment products, how to analyze them, how they are sold, and how they are used as part of a well-planned portfolio of investments. For those new to this material, we offer a suggestion: stay informed about the markets and the industry because it will help you better understand the material presented in this textbook. There are countless sources of financial market information, including newspapers, the Internet, books and magazines. The course material will be that much easier to grasp if you can relate it to the activity that unfolds each day in the financial markets. Ultimately, this will help you achieve your goal of becoming an informed and effective participant in the securities industry.


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KEY TERMS Alternative trading systems (ATSs)

Investment fund

Auction market

Market capitalization

Canadian National Stock Exchange (CNSX)

Market makers

Canadian Unlisted Board Inc. (CUB)

Mutual fund

CanDeal

Montreal Exchange (ME)

CanPX

Open-end fund

Capital

Option

CBID

Preferred shares

Common shares

Primary market

Dealer markets

Quotation and trade reporting systems (QTRS)

Debt

Retail investors

Derivative

Secondary market

Equity

Stock exchange

ICE Futures Canada

Toronto Stock Exchange (TSX)

Institutional Investors

TSX Venture Exchange

Investment advisors (IAs)

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ONE • THE CAPITAL MARKET

WHAT IS INVESTMENT CAPITAL? In general terms, capital is wealth – both real, material things such as land and buildings, and representational items such as money, stocks and bonds. All of these items have economic value. Capital represents the invested savings of individuals, corporations, governments and many other organizations and associations. It is in short supply and is arguably the world’s most important commodity. Capital savings are useless by themselves. Only when they are harnessed productively do they gain economic significance. Such utilization may take the form of either direct or indirect investment. Capital savings can be used directly by, for example, a couple investing their savings in a home; a government investing in a new highway or hospital; or a domestic or foreign company paying start-up costs for a plant to produce a new product. Capital savings can also be harnessed indirectly through the purchase of such representational items as stocks or bonds or through the deposit of savings in a financial institution. The indirect investment process is the principal focus of this course. Indirect investment occurs when the saver buys the securities issued by governments and corporations, who in turn use the funds for direct productive investment – equipment, supplies, etc. Such investment is normally made with the assistance of the retail or institutional sales department of the investment advisor’s firm.

Characteristics of Capital Capital has three important characteristics. It is mobile, sensitive to its environment and scarce. Therefore capital is extremely selective. It attempts to settle in countries or locations where government is stable, economic activity is not over-regulated, the investment climate is hospitable and profitable investment opportunities exist. The decision as to where capital will flow is guided by country risk evaluation, which analyzes such things as:

The political environment:

whether the country is involved or likely to be involved in internal or external conflict

Economic trends:

growth in gross domestic product, inflation rate, levels of economic activity, etc.

Fiscal policy:

levels of taxes and government spending and the degree to which the government encourages savings and investment

Monetary policy:

the sound management of the growth of the nation’s money supply and the extent to which it promotes price and foreign exchange stability

Investment opportunities:

opportunities for investment and satisfactory returns on investment when considering the risks to be accepted

Characteristics of the labour force:

whether it is skilled and productive


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Because of its mobility and sensitivity, capital moves in or out of countries or localities in anticipation of changes in taxation, exchange policy, trade barriers, regulations, government attitudes, etc. It moves to where the best use can be made of it and attempts to avoid areas where the above factors are not positive. Thus, capital moves to uses and users that offer the highest risk-adjusted returns. Capital is scarce worldwide and is in great demand everywhere.

Why Capital Is Needed An adequate supply of capital is essential for Canada’s future well-being. Enough new and efficient plant and equipment must be put in place to ensure expanded output capability, improved productivity, increased competitiveness and the development of innovative, soughtafter new products. If capital investment is inadequate, the result will be insufficient output, declining productivity, rising unemployment, decreasing competitiveness in domestic and international markets – in short, lower living standards. The securities industry attaches great importance to the savings and investment process. It is constantly in touch with governments with a view to improving the saving and investment process. The industry advocates changes, when appropriate, in both government policies and the tax system. These proposed changes are designed to encourage more saving and the investment of savings in productive plant and equipment.

WHO ARE THE SOURCES AND USERS OF CAPITAL? The only source of capital is savings. When revenues of non-financial corporations, individuals, governments and non-residents exceed their expenditures, they have savings to invest. Non-financial corporations, such as steel makers, food distributors and machinery manufacturers, have historically generated the largest part of total savings mainly in the form of earnings, which they retain in their businesses. These internally generated funds are usually available only for internal use by the corporation and are not normally invested in other companies’ stocks and bonds. Thus, corporations are not important providers of permanent funds to others in the capital market. Individuals may decide, especially if given incentives to do so, to postpone consumption now in order to save so that they can consume in the future. Governments that are able to operate at a surplus are “savers” and able to invest their surpluses. Other governments are “dis-savers” and must borrow in capital markets to fund their deficits. Non-residents, both corporations and private investors, have long regarded Canada as a good place to invest. Canada has traditionally relied on savings for both direct plant and equipment investment in Canada and portfolio investment in Canadian securities.


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Sources of Capital Retail, institutional, and foreign investors are a significant source of investment capital.

Retail investors:

Retail investors are individual investors who buy and sell securities for their own personal accounts, and not for another company or organization.

Institutional investors:

Institutional investors are organizations, such as a pension fund or mutual fund company, that trade large volumes of securities and typically have a steady flow of money to invest. Retail investors generally buy in smaller quantities than larger, institutional investors.

Foreign investors:

Foreign investors also are a significant source of investment capital. Historically, Canada has depended upon large inflows of foreign investment for continued growth. Foreign direct investment in Canada has tended to concentrate in particular industries: manufacturing, petroleum and natural gas, and mining and smelting. Some industries also have restrictions with respect to foreign investment.

Users of Capital Based on the simplest categorization, the users of capital are individuals, businesses and governments. These can be both Canadian and foreign users. The ways in which these groups use capital are described below. INDIVIDUALS

Individuals may require capital to finance housing, consumer durables (e.g., automobiles, appliances) or other types of consumption. They usually obtain it through incurring indebtedness in the form of personal loans, mortgage loans or charge accounts. Since individuals do not issue securities to the public and the focus of this text is on securities, individual capital users are not discussed further. Just as foreign individuals, businesses or governments can supply capital to Canada, capital can flow in the other direction. Foreign users (mainly businesses and governments) may access Canadian capital by borrowing from Canadian banks or by making their securities available to the Canadian market. Foreign users will want Canadian capital if they feel that they can access this capital at a less expensive rate than their own currency. Access to foreign securities benefits Canadian investors, who are thus provided with more choice and an opportunity to further diversify their investments. BUSINESSES

Canadian businesses require massive sums of capital to finance day-to-day operations, to renew and maintain plant and equipment as well as to expand and diversify activities. A substantial part of these requirements is generated internally (e.g., profits retained in the business), while some is borrowed from financial intermediaries (principally the chartered banks). The remainder is raised in securities markets through the issuance of short-term money market paper, medium- and longterm debt, and preferred and common shares.


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GOVERNMENTS

Governments in Canada are major issuers of securities in public markets, either directly or through guaranteeing the debt of their Crown corporations.

Federal Government

When revenues fail to meet expenditures and/or when large capital projects are planned, the federal government must borrow. The government makes use of four main instruments: treasury bills (T-bills), marketable bonds, Canada Savings Bonds (CSBs) and Canada Premium Bonds (CPBs).

Provincial Governments

Like the federal government, the provinces issue debt directly themselves. When revenues fail to meet expenditures and/or when large capital projects are planned, provinces must borrow. They may issue bonds to the federal government or borrow funds from Canada Pension Plan (CPP) assets (or the Québec Pension Plan in the case of Québec). Alternatively, a province may issue debt domestically through a syndicate of investment dealers who sell the issue to financial institutions or to retail investors. In addition to conventional debt issues, some provinces issue their own short-term treasury bills and, in some cases, their own savings bonds similar to CSBs issued by the federal government.

Municipal Governments

Municipalities are responsible for the provision of streets, sewers, waterworks, police and fire protection, welfare, transportation, distribution of electricity and other services for individual communities. Since many of the assets used to provide these services are expected to last for twenty or more years, municipalities attempt to spread their cost over a period of years through the issuance of instalment debentures (or serial debentures).

Complete the following Online Learning Activity Sources and Users of Capital What is capital used for and where does it come from? Assess your understanding of the Sources and Users of Capital.


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WHAT ARE THE FINANCIAL INSTRUMENTS? Transferring money from one person to another may seem relatively straightforward. Why then do we need formal financial instruments called securities? As a way of distributing capital in a large, sophisticated economy, securities have many advantages. Securities are formal, legal documents, which set out the rights and obligations of the buyers and sellers. They tend to have standard features, which facilitates their trading. Furthermore, there are many types of securities, enabling both investors (buyers) and users (sellers) of capital to meet their particular needs.

Financial instruments Much of this text deals with the characteristics of different financial instruments. The following brief discussion of instruments is included here to remind the reader that financial instruments (products) are one of the three key components of the securities industry. Financial instruments, along with the other two components, financial markets and financial intermediaries, will be covered in subsequent chapters.

Debt Instruments:

Debt instruments 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 ranges from very short to very long, depending on the type of instrument. Bonds, debentures, mortgages, treasury bills and commercial paper are all examples of debt instruments (also referred to as fixed-income securities).

Equity Instruments:

Equities are usually referred to as stocks or shares because the investor actually buys a “share” of the company, thus gaining an ownership stake in the company. As an owner, the investor participates in the corporation’s fortunes. If the company does well, the value of the company may increase, giving the investor a capital gain when the shares are sold. In addition, the company may distribute part of its profit to shareowners in the form of dividends. Unlike interest on a debt instrument, however, dividends are not obligatory. Different types of shares have different characteristics and confer different rights on the owners. In general, there are two main types of stock: common and preferred.

Investment Funds:


An investment fund is a company or trust that manages investments for its clients. The most common form is the open-end fund, also known as a mutual fund. The fund raises capital by selling shares or units to investors, and then invests that capital. As unitholders, the investors receive part of the money made from the fund’s investments.

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Derivatives:

Unlike stocks and bonds, derivatives are suited mainly for more sophisticated investors. Derivatives are products based on or derived from an underlying instrument, such as a stock or an index. The most common derivatives are options and forwards.

Other Financial Instruments:

In the past few years, investment dealers have used the concept of financial engineering to create structured products that have various combinations of characteristics of debt, equity and investment funds. Two of the most popular are linked notes and exchange-traded funds (ETFs).

Private Equity Private equity is the financing of firms unwilling or unable to find capital using public means – for example, via the stock or bond markets. The term “private equity” is a bit of a misnomer as this asset class really encompasses debt and equity investment. Long term returns on private equity typically exceed most other asset classes. But in exchange for these returns, private equity also exposes investors to far higher risks. Private equity plays a specific role in financial markets, in Canada and in other markets worldwide. It complements publicly traded equity by allowing businesses to obtain financing when issuing equity in the public markets may prove difficult or impossible. A good example is venture capital. Venture capital finances businesses at a time when they produce little or no cash flows, invest most or all revenue in more or less unproven technologies or production processes, and have little or no assets to offer as collateral. In such situations, firms must typically turn to investors that are ready to take substantially more risk against significantly higher profit prospects if the venture is successful. There are several means by which private equity investors finance firms.

Leveraged Buyout:

This is the acquisition of companies financed with equity and debt. Buyouts are one of the most commonly used forms of private equity.

Growth Capital:

The financing of expanding firms for their acquisitions or high growth rates.

Turnaround:

Investments in underperforming or out of favour industries that are in either financial need or operating restructuring.

Early Stage Venture Capital:

Investments in firms that are in the infancy stages of developing products or services in high growth industries such as health care or technology. These firms usually have a limited number of customers.

Late stage Venture Capital:

The financing of firms which are more established but still not profitable enough to be self-sufficient. Revenue growth is still very high.

Distressed debt:

This is the purchase of debt securities of private or public companies that are trading below par due to financial troubles at the firm.



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SIZE OF THE PRIVATE EQUITY MARKET

The growth of private equity has been remarkable over the last 25 years. Investment minimums in the private equity market tend to be relatively high compared to the general retail market. As a result, investments in private equity cater mostly to individuals and organizations with sizeable portfolios and resources. For this reason, private equity investors are typically: •

Public pension plans

•

Private pension plans

•

Endowments

•

Foundations

•

High net worth investors

Given the features of private equity and the differences it shows with other assets typically held in investor portfolios, its role is one of return enhancement and to a certain extent, of portfolio diversification. Return enhancement is the reward for accepting much lower liquidity typical of private equity, particularly when compared to investing in the common shares of highly liquid stocks like large banks or oil companies.

WHAT ARE THE FINANCIAL MARKETS? Securities are a key element in the efficient transfer of capital from savers to users, benefiting both. Many of the benefits of investment products, however, depend on the existence of efficient markets in which these securities can be bought and sold. A well-organized market provides speedy transactions and low transaction costs, along with a high degree of liquidity and effective regulation. Like a farmers’ market, a securities market provides a forum in which buyers and sellers meet. But there are important differences. In the securities markets, buyers and sellers do not meet face to face. Instead, intermediaries, such as investment advisors (IAs) or bond dealers, act on their clients’ behalf. Unlike most markets, a securities market may not manifest itself in a physical location. This is possible because securities are intangible – at best, pieces of paper, and often not even that. Of course, some securities markets do have a physical component. Other securities markets, such as the bond market, exist in “cyberspace” as a computer- and telephone-based network of dealers who may never see their counterparts’ faces. In Canada, all exchanges are electronic. The capital market or securities market is made up of many individual markets. For example, there are stock markets, bond markets and money markets. In addition, securities are sold on primary and secondary markets. •

In the primary market new securities are sold by companies and governments to investors for the first time. Companies can raise capital by selling stocks or bonds to investors while governments raise capital by selling bonds. In this market, investors purchase securities directly from the issuing company or government. When a company issues stocks for the very first time in the primary market, the sale is known as an initial public offering (IPO).


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•

In the secondary market investors trade securities that have already been issued by companies and governments. In this market, buyers and sellers trade among each other at a price that is mutually beneficial to both parties. The security is then transferred from the seller to the buyer. The issuing company does not receive any of the proceeds from transactions in the secondary market - the issuer received payment when the securities were first issued in the primary market.

Auction Markets in Canada Markets can also be divided into auction and dealer markets. In an auction market, buyers enter bids and sellers enter offers for a stock. The price at which a stock is traded represents the highest price the buyer is willing to pay and the lowest price the seller is willing to accept. These orders are than channelled to a single central market and compete against each other. There are a number of important terms you need to understand when talking about trading stocks. •

The bid is the highest price a buyer is willing to pay for the security being quoted.

•

The offer (or ask) is the lowest price a seller will accept.

•

The spread is the difference between the bid and ask prices.

•

The last price is the price at which the last trade on that stock took place. This price can fluctuate back and forth between the bid price and the ask price as buying and selling orders are filled. The last price is also referred to as the market price. It is important to understand that the last price may not reflect the price for which you can currently buy or sell the stock, and only reflects the latest price at which a purchase or sale occurred.

Let’s see how this terminology is used on the Toronto Stock Exchange. EXHIBIT 1.1

AUCTION MARKETS IN ACTION

Let’s say there are three investors who want to buy a share of ABC and they enter the following bids on the stock: $5, $5.03 and $5.06. On the other side of the trade, there are three investors that want to sell their share in ABC. These sellers submit offers to sell their ABC stock at the following prices: $5.06, $5.07, and $5.11. The trade is executed and settles only when there is a match in the bid and offer prices. On the ABC trade, the investor who entered the bid and the seller who entered the offer of $5.06 will have their orders executed. The other bid/offers will not be immediately executed. In fact, the price of $5.06 becomes the last price (or market price) of ABC.

CANADIAN STOCK EXCHANGES

A stock exchange is a marketplace 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. On Canadian exchanges, trading is carried on in common and preferred shares, rights and warrants, listed



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options and futures contracts, instalment receipts, exchange-traded funds (ETFs), income trusts, and a few convertible debentures. On some U.S. and European exchanges, bonds and debentures are traded along with equities. Liquidity is fundamental to the operation of an exchange. A liquid market is characterized by: •

Frequent sales

•

Narrow price spread between bid and ask prices

•

Small price fluctuations from sale to sale

Canada’s stock exchanges are auction markets. During trading hours, Canada’s exchanges receive thousands of buy and sell orders from all parts of the country and abroad. Canada has five exchanges: the Toronto Stock Exchange (TSX) and the TSX Venture Exchange, the Montreal Exchange (MX, also known as the Bourse de Montréal), owned by the TMX Group Inc., the Canadian National Stock Exchange (CNSX), and the ICE Futures Canada. Each exchange is responsible for the trading of certain products. •

The TSX lists senior equities, some debt instruments that are convertible into a listed equity, income trusts and Exchange-Traded Funds (ETFs).

•

The TSX Venture Exchange trades junior securities and a few debenture issues.

•

CNSX trades securities of emerging companies.

•

The Montreal Exchange trades all financial and equity futures and options.

•

ICE Futures Canada trades agricultural futures and options. EXHIBIT 1.2

CHANGES TO THE CANADIAN EXCHANGES

Securities trading has existed in Canada since 1832. Over the years there have been many changes. The late 1990s saw radical changes to securities trading in Canada. In March 1999, Canada’s four major stock exchanges announced that they had reached an agreement to restructure along lines of market specialization. The restructuring was intended to ensure a strong and globally competitive market system, and this resulted in three specialized exchanges: • The Toronto Stock Exchange became Canada’s senior equities market and gave up its participation in derivatives trading and the junior equity market. • The Alberta Stock Exchange, the Winnipeg Stock Exchange and the Vancouver Stock Exchange merged to create a single, national junior equities market, called the Canadian Venture Exchange (CDNX). This new market also consolidated the operations of the Canadian Dealing Network (CDN) as of October 2000. • The Montréal Exchange became the exclusive exchange for financial futures and options in Canada. Responsibility for all equities once traded on Montréal transferred to the TSX or the TSX Venture Exchange.


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EXHIBIT 1.2

CHANGES TO THE CANADIAN EXCHANGES – Cont’d

The CDNX became a wholly owned subsidiary of the Toronto Stock Exchange in 2001. In April 2002, the Toronto Stock Exchange rebranded its abbreviated name from the TSE to TSX, while CDNX was renamed the TSX Venture Exchange. These changes were part of a rebranding initiative as the TSX and its subsidiaries prepared to go public in the fall of 2002. Under the rebranding program, the TSX, TSX Venture Exchange and TSX Markets Inc. (the arm of the TSX that sell market information and trading services) are collectively known as the TSX Group of companies. In November 2002, the TSX Group Inc. went public, becoming the first listed stock exchange in North America. In 2004, the CNSX gained recognition as a stock exchange by the Ontario Securities Commission. The intent of CNSX is to provide an alternative market to the TSX Venture Exchange for emerging companies. Trading on CNSX is also regulated by IIROC in the same way as the other Canadian exchanges and must therefore follow the Universal Market Integrity Rules (UMIR). In 2007, the Winnipeg Commodity Exchange became a wholly-owned subsidiary of ICE and became ICE Futures Canada. This exchange trades options and futures of agricultural commodities such as Canola, Barley, and Wheat. In 2008, the TSX and the Montreal Exchange merged to form the TMX Group. In 2012, the Maple Group acquired the TMX Group Inc. As a result, the Maple Group was renamed TMX Group Limited.

There are over 80 stock exchanges in over 60 countries around the world. Including the auction markets in Canada, North America has 10 exchanges, Europe has in excess of 35, Central and South America, around 10, and the balance are in Africa, Asia and Australia.

Dealer Markets Dealer markets are the second major type of market on which securities trade. They consist of a network of dealers who trade with each other, usually over the telephone or over a computer network. Unlike auction markets, where the individual buyer’s and seller’s orders are entered, a dealer market is a negotiated market where only the dealers’ bid and ask quotations are entered by those dealers acting as market makers in a particular security.

Market makers work for investment dealers and must be approved by the exchange to carry out market making duties on assigned stocks. The responsibilities include monitoring the opening of trading to ensure that orders are properly executed, maintaining a continuous two-sided market at an agreed upon maximum spread throughout the day (e.g., $0.10 between the bid and ask), and executing all tradable orders that meet a maximum number of shares as agreed upon with the exchange. By making a market, the market maker assists in creating fair and orderly markets and contributes to market liquidity for all parties who want to participate in the buying and selling of stocks.



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Almost all bonds and debentures are sold through dealer markets. These dealer markets are less visible than the auction markets for equities, so many people are surprised to learn that the volume of trading (in dollars) on the dealer market for debt securities is significantly larger than the equity market. Dealer markets are also referred to as over-the-counter (OTC) or as unlisted markets - securities on these markets are not listed on an organized exchange as they are on auction markets. THE UNLISTED EQUITY MARKET

The volume of unlisted equity business is much smaller than the volume of stock exchange transactions. The exact size of Canadian OTC dealings cannot be measured because complete statistics are not available. Many junior issues trade OTC, but so too do the shares of a few conservative industrial companies whose boards of directors have for one reason or another decided not to seek stock exchange listing for one or more issues of their equities. The unlisted market does not set listing requirements for the stocks traded on its system (hence the term “unlisted market”) nor does it attempt to regulate the companies. Many of the stocks sold on the unlisted market are more speculative, and in most cases offer lower liquidity, than listed securities.

TRADING IN THE UNLISTED MARKET

Over-the-counter trading in equities is conducted in a similar manner to bond trading. One veteran described the OTC market as a “market without a market place.” In the OTC market, individual investors’ orders are not entered into the market or displayed on the computer system. Instead, dealers, who are acting as market makers, enter their bid and ask quotations. These market makers hold an inventory of the securities in which they have agreed to “make a market.” They sell from this inventory to buyers and add to the inventory when they acquire securities from sellers. The market makers post their individual bid (the highest price the maker will pay) and ask (the lowest price the maker will accept) quotations. The willingness of the market makers to quote bid and ask prices provides liquidity to the system (although the market makers do have the right to refuse to trade at these prices). When an investor wishes to buy or sell an unlisted security, the broker consults the bid/ask quotations of the various market makers to identify the best price, and then contacts the market maker to complete the transaction. The broker charges a commission for this service. OVER-THE-COUNTER DERIVATIVES MARKET

Derivatives also trade in dealer or OTC markets. The OTC derivative market is dominated by financial institutions, such as banks and brokerage houses, who trade with other corporate clients and other financial institutions. This market has no trading floor and no regular trading hours. Traders do not meet in person to negotiate transactions and the market stays open 24 hours a day. One of the attractive features of OTC derivative products is that they can be custom designed by the buyer and seller. As a result, these products tend to be somewhat more complex, as special features are added to the basic properties of options and forwards.


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REPORTING TRADES IN THE UNLISTED MARKET

In most of Canada, there is no requirement for firms to report unlisted trades. Ontario is the exception. The Ontario Securities Commission (OSC) requires that trades of unlisted securities be reported through the Canadian Unlisted Board Inc. (CUB). CUB was launched as an automated system after the reorganization of the equity markets in Canada. It offers an Internet web-based system for dealers to report completed trades in unlisted and unquoted equity securities in Ontario, as required under the Ontario Securities Act.

Other Trading Systems Over time, different trading systems emerged to meet changing investor needs. Examples include quotation and trade reporting systems and alternative trading systems (ATSs). QUOTATION AND TRADE REPORTING SYSTEMS

Quotation and trade reporting systems (QTRS) are entities, other than an exchange or registered dealer, that disseminate price quotations for the purchase and sale of securities and report completed transactions to the applicable securities commission. A QTRS must be recognized by a provincial securities regulatory authority. ALTERNATIVE TRADING SYSTEMS

Alternative trading systems (ATSs) are privately owned computerized trading facilities that match buy and sell orders for securities traded outside of recognized exchanges. ATSs can be owned by individual brokerage firms or by groups of brokerage firms. These systems compete with the exchanges because a brokerage firm operating an ATS can match orders directly from its own inventory, or act as an agent in bringing buyers and sellers together, thus bypassing the stock exchange. Since there is one less intermediary, more of the commission charged to the client is kept by the dealer. Most client users of these systems are institutional investors who can reduce transaction costs considerably and avoid the market impact of their trades if the orders were instead traded through a regular exchange. Some non-brokerage-owned ATSs even allow buyers and sellers to contact each other directly and negotiate a price.

Equity ATSs now in operation in Canada include CNSX’s Pure Trading, Bloomberg Tradebook Canada, OMEGA ATS, Chi-X Canada, Instinet Canada Cross ICX, Liquidnet Canada, and MATCH Now, operated by TriAct Canada Marketplace LP.

Alternative trading systems have the potential, however, to threaten market stability due to lessened market transparency, cross-border trading issues and technological glitches such as insufficient system capacity. In Canada, ATSs are members of the Investment Industry Regulatory Organization of Canada (IIROC). The trading activity of ATS is also regulated by IIROC.

Fixed-Income Electronic Trading Systems With the exception of a few debentures listed on the TSX and TSX Venture Exchanges, all bond and money market securities are sold through dealer markets. Three fixed-income electronic trading systems launched in Canada include:


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CAN D EAL

CanDeal, a member of IIROC, is a joint venture between Canada’s six largest investment dealers, and is operated by the TMX Group. It is recognized as both an ATS and an investment dealer. It offers institutional investors access to Government securities and to money market instruments. CBID

CBID, also a member of IIROC and an ATS, operates two distinct fixed-income marketplaces: retail and institutional. The retail fixed-income marketplace is accessible by registered dealers on behalf of retail clients. The institutional fixed-income marketplace is accessible by registered dealers, institutional investors, governments and pension funds. CAN PX

CanPX is a joint venture of Investment Industry Association of Canada (IIAC)/IIROC dealer member firms. The CanPX system is an information processor for government and corporate debt securities that provides investors with real-time bid and offer prices and hourly trade data. The service covers Government of Canada bonds, treasury bills, and provincial bonds, and a select list of corporate bonds from major industrial issuers.

Complete the following Online Learning Activity Auction and Dealer Markets You have read about the differences between dealer markets and auction markets. Use this exercise to assess your understanding of the features of these markets. Complete the Auction and Dealer Markets activity that outlines the features of these markets.

Trends in Financial Markets There have been many changes to global capital markets over the last several years: •

ATSs are taking market share away from traditional stock exchanges.

•

Exchanges are merging and taking over other exchanges to meet the challenge of globalization. Ten years ago, there were over 200 exchanges in the world; today there are fewer than 100.

•

In addition to mergers and takeovers, exchanges are forming alliances, partnerships and electronic links with exchanges in other countries to foster global trading.

Most of these changes were driven by increased global trading, aggressive competition, the ease of electronic communication, improved computer technology and the increased mobility of capital. The speed of innovative computer technology and the globalization and integration of financial marketplaces are likely to increase.


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Complete the following Online Learning Activity What’s the Difference? After you have read the chapter, test whether you can differentiate between some common terms used in the securities industry. Complete the What’s the Difference? activity to test yourself.



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SUMMARY After reading this chapter, you should be able to: 1.

2.

3.

Define investment capital and describe its role in the economy. •

Investment capital is available and investable wealth (e.g., real estate, stocks, bonds and money) that is used to enhance the economic growth prospects of an economy.

•

In direct investment, an individual or company invests directly in an item (e.g., house, new plant or new road); indirect investment occurs when an individual buys a security and the issuer invests the proceeds.

•

Capital has three characteristics: it is mobile, it is sensitive, and it is in short supply.

Describe how individuals, businesses, governments and foreign agencies supply and use capital in the economy. •

Individuals generate investment capital through savings and use capital to finance major purchases or for consumption.

•

Retail investors are individuals who buy and sell securities for their personal accounts; institutional investors are companies and other organizations.

•

Businesses use capital to finance day-to-day operations, to renew and maintain plant and equipment, and to expand and diversify activities.

•

Governments use capital when expenditures exceed revenue and to finance large projects.

•

Foreign investors invest in Canada to access returns on investment not perceived to be available in other countries. Foreign investors will use Canadian capital if they can borrow at a more advantageous rate in Canada than elsewhere.

Differentiate between the types of financial instruments used in capital transactions. •

Debt (bonds or debentures): the issuer promises to repay a loan at maturity, and in the interim makes payments of interest or interest and principal at predetermined times. The term to maturity of a debt instrument can be either short (less than five years) or long (more than ten years).

•

Equity (stocks): the investor buys a share that represents a stake in the company.

•

Investment funds (mutual funds, segregated funds): a company or trust that manages investments for its clients.

•

Derivatives (options, futures, rights): products derived from an underlying instrument such as a stock, financial instrument, commodity or index.

•

Other investment products (linked notes, exchange-traded funds): investments that are relatively new and do not fit into any of the standard categories.


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4.

•

Private equity is the financing of firms unwilling or unable to find capital using public means – for example, via the stock or bond markets.

•

Private equity complements publicly traded equity by allowing businesses to obtain financing when issuing equity in the public markets may prove difficult or impossible.

•

Public and private pension plans, endowments, foundations, and wealthy individuals are the main investors in the private equity market.

Explain the role of financial markets in the Canadian financial services industry, distinguish among the types of financial markets, and describe how auction markets and dealer markets work. •

The financial markets facilitate the transfer of capital between investors and users through the exchange of securities.

•

The exchanges do not deal in physical movement of securities; they are simply the venue for agreeing to transfer ownership.

•

The primary market is the initial sale of securities to an investor.

•

The secondary market is the transfer of already issued securities among investors.

•

Dealer markets are network of dealers that trade with each other directly on a negotiated market with market makers. Most bonds and debentures trade on these markets.

•

In an auction market, clients’ bid and ask quotations for a stock are channelled to a single central market (stock exchanges) and compete against each other.

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Chapter

2

The Canadian Securities Industry


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2 The Canadian Securities Industry

CHAPTER OUTLINE Overview of the Canadian Securities Industry What Role do Financial Intermediaries Play? • Types of Firms • Organization within Firms • Investment Dealers and their Principal or Agency Functions • The Clearing System What Roles do Banks Play as Financial Intermediaries? • Schedule I Chartered Banks • Schedule II and Schedule III Banks What are Trust Companies, Credit Unions and Life Insurance Companies? • Trust and Loan Companies • Credit Unions and Caisses Populaires • Insurance Companies What are Investment Funds, Savings Banks, Sales Finance and Consumer Loan Companies, and Pension Plans? Summary

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LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Summarize the state of the Canadian securities industry today. 2. Distinguish among the three categories of securities firms, explain how they are organized, and compare and contrast dealer, principal and agency transactions. 3. Describe the roles of the chartered banks in the capital market. 4. Describe the roles of trust companies, credit unions and insurance companies in the capital market. 5. Describe the roles of investment funds, savings banks, loan companies and pension plans in the capital market.

PARTICIPANTS IN THE SECURITIES INDUSTRY What do the following individuals have in common? A couple needs to borrow money to finance the purchase of a home. An entrepreneur needs to raise funds to help with financing the development of a new product. An investor would like to set up a regular savings program to save for her children’s education. The common strand is that all of these individuals require some form of intermediary to help meet their goals. Simply described, savers (lenders) give funds to a financial intermediary (such as a bank) that in turn gives those funds to spenders (borrowers) in the form of loans or mortgages, among other products. Alternatively, the intermediary can play a direct role in bringing a new issue of securities to financial markets. More specifically for our purposes, a typical example occurs when a company needs money to operate or expand its business. One way to generate the necessary capital is by issuing securities, such as stocks and bonds. A financial intermediary, or investment dealer, can help the company issue the securities and sell them to investors. By buying the securities, the investors temporarily transfer their money to the company and, in return, receive securities representing claims on the company’s real assets. If the firm does well, it earns a profit. Its securities may rise in value, yielding a profit for the investor when the security is sold in the marketplace. But investors are not the only ones to profit. Part of the money earned by the company may be reinvested in the firm, spurring further economic development.


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In the previous chapter, we learned about the various financial markets and instruments that have evolved to meet the expanding needs of users of capital. The focus here is the role played by the financial intermediaries, the last piece of the capital transfer puzzle. Their role is important because they have established efficient and reliable methods of channelling funds between lenders and borrowers.

KEY TERMS Agent

Primary distribution

Broker

Principal

CDS Clearing and Depository Services Inc. (CDS)

Self-Regulatory Organizations (SROs)

Closed-End funds

Underwriting

Open-End Funds

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TWO • THE CANADIAN SECURITIES INDUSTRY

OVERVIEW OF THE CANADIAN SECURITIES INDUSTRY The Canadian securities industry is a regulated industry. Provinces have the power to create and to enforce their own laws and regulations through securities commissions (also called securities administrators in some provinces). Securities commissions delegate some of their powers to self-regulatory organizations (SROs), which establish and enforce industry regulations to protect investors and to maintain fair, equitable, and ethical practices. In that capacity, SROs are responsible for setting rules governing many aspects of investment dealers’ operations, including sales, finance, and trading. The major participants in the industry and their relationships are illustrated in Chart 2.1. The chart highlights the workings of the industry by showing the major participants and their relationships with one another. Investors and users of capital trade financial instruments through the various financial markets (stock exchanges, money markets, etc.). Brokers and investment dealers act as intermediaries by matching investors with the users of capital and each side of a transaction will have its own broker or dealer who matches the trades through the markets. Trades and other transactions are settled through organizations like CDS Clearing and Depository Services Inc. and banks. The SROs monitor the markets to ensure fairness and transparency, and they set and enforce rules that govern market activity. Organizations like the Canadian Investor Protection Fund (CIPF) provide insurance against insolvency while provincial regulators oversee the markets and the SROs. Organizations like CSI provide education for industry participants. CHART 2.1

SECURITIES INDUSTRY FLOWCHART Market Flow Ancillary Services

Brokers & Investment Dealers

Users of Capital

Markets

Clearing & Settlement

CSI Global Education Inc.

Canadian Investor Protection Fund

Provincial Regulator

Industry Educator

Industry Insurance Fund

Investors

Self-Regulatory Organizations Investment Industry Regulatory Organization of Canada Mutual Funds Dealers Association


Securities Commission

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According to the Investment Industry Association of Canada, there were 201 firms at the end of 2011 in the securities industry that were members of the Investment Industry Regulatory Organization of Canada (IIROC). Together, these firms employed more than 40,000 people. Still, the industry is small compared to other segments of the financial services sector or even to some companies operating within competing segments. For instance, Canada’s largest bank, Royal Bank of Canada, employed over 68,000 people in 2011 and had total assets of $751 billion. The entire Canadian securities industry is likewise eclipsed in size by several individual U.S. and Japanese securities houses. In spite of its comparatively small size, the industry has provided Canada with a capital market that is one of the most sophisticated and efficient in the world. These qualities are measured in terms of the variety and size of new issues brought to the market and the depth and liquidity of secondary market trading. In 2011 alone, more than $320 billion in new financing was issued through Canadian securities markets, including more than $201 billion in new federal, provincial and municipal debt securities, $77 billion in corporate debt securities, and $42 billion in corporate equities. In 2011, more than $2,380 billion in equity securities and more than $9,340 billion in debt securities changed hands in Canada’s secondary markets (source: Investment Industry Association of Canada website, September 2012). Today the industry is highly competitive and becoming increasingly so. It calls for a high degree of specialized knowledge about securities issuers, investors and constantly changing securities markets. An entrepreneurial spirit of innovation and calculated risk-taking are among its hallmarks. Change and volatility are frequently the norm.

Complete the following Online Learning Activity Canadian Securities Industry Overview In this activity you’ll review the characteristics of intermediaries and learn about the structure of the Canadian securities industry. Learn more about these intermediaries in the Canadian Securities Industry Overview w activity.

WHAT ROLE DO FINANCIAL INTERMEDIARIES PLAY? Intermediaries are a key component of the financial system. The term “intermediary” is used to describe any organization that facilitates the trading or movement of the financial instruments that transfer capital between suppliers and users. We will discuss intermediaries such as banks and trust companies, which concentrate on gathering funds from suppliers in the form of saving deposits or GICs and transferring them to users in the form of mortgages, car loans and other lending instruments. Other intermediaries, such as insurance companies and pension funds, collect funds and then invest them in bonds, equities, real estate, etc., to meet their customers’ needs for financial security.



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Investment dealers serve a number of functions, sometimes acting on their clients’ behalf as agents in the transfer of instruments between different investors, at other times acting as principals. Investment dealers sometimes are known by other names, such as brokerage firms or securities houses. Investment dealers play a significant role in the securities industry’s two main functions. •

First, investment dealers help to transfer capital from savers to users through the underwriting and distribution of new securities. This takes place in the primary market in the form of a primary distribution.

•

Second, investment dealers maintain secondary markets in which previously issued or outstanding securities can be traded.

Investors’ confidence in Canadian financial institutions is high. It is based upon a long record of integrity and financial soundness reinforced by a legislative framework that provides close supervision of their basic activities. It is not surprising that deposit-taking and savings institutions have experienced strong growth. In today’s financial environment, most banks own a number of other corporations, such as investment dealers and trust companies, as well as operating in the insurance market through subsidiaries. These activities are becoming more and more integrated. An investor, for example, can walk into a bank today and receive advice on purchasing mutual funds and other securities. In the same visit, a mortgage can be arranged, and life insurance can be offered. Overall, the expansion of chartered bank assets has been facilitated by several factors. These include: • • • •

much greater international activity changes in the Bank Act permitting the banks to compete vigorously in new sectors of the financial services industry the creation of more banks, notably the foreign-owned Schedule II and Schedule III banks the purchase of many major trust companies by banks

Types of Firms Three categories of firms make up the Canadian securities industry: integrated firms, institutional firms and retail firms. Integrated firms offer products and services that cover all aspects of the industry, including full participation in both the institutional and the retail markets. Most underwrite all types of federal, provincial, municipal and corporate debt and corporate equity issues, actively trade in secondary markets including the money market, trade on all Canadian and some foreign stock exchanges, and provide many ancillary services to securities issuers and large and small investors. Such services include economic, industry, corporate and securities research and advice, portfolio evaluation and management, merger and acquisition advice, tax counselling, loans to investors with margin accounts and safekeeping of clients’ securities. Many smaller securities dealers or “investment boutiques” specialize in such areas as stock trading, bond trading, research on particular industries, trading only with institutional clients, unlisted stock trading, arbitrage, portfolio management, underwriting of junior mines, oils and industrials, mutual funds distribution, and tax-shelter sales. © CSI GLOBAL EDUCATION INC. (2013)

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More than 70 foreign and domestic institutional firms serve institutional clients exclusively. Foreign firms account for about one-third of total institutional firms and include affiliates of many of the major U.S. and European securities dealers. Retail firms account for the remainder of the industry. Retail firms include full-service firms and discount brokers. Full-service retail firms offer a wide variety of products and services for the retail investor. Discount brokers execute trades for clients at reduced rates but do not provide advice. Discount brokers are more popular with those investors who are willing to research individual companies themselves in exchange for lower commission rates.

Organization within Firms The operational structure of securities firms varies widely in the industry. A typical configuration divides a securities firm into different departments, each of them focusing on a specific task. While the organization structure is flexible, a larger, integrated firm might be organized into the following departments. MANAGEMENT

Senior management usually include a chairman, a president, an executive vice-president, vicepresidents, some of whom are also directors, and other directors, including, in a few firms, directors from outside the securities industry. Most senior officers work at head office, but some may be in charge of regional branch offices in Canada or abroad. THE FRONT, MIDDLE AND BACK OFFICE

In order to manage client portfolios, be in compliance with regulatory requirements, and process trades efficiently, the organizational structure of a securities firm is generally separated into three departments, the front, middle and back office. Front Office

The front office usually includes all staff functions pertaining directly to portfolio management activities. Accordingly, all portfolio management, trading, and sales and marketing staff would be part of the front office. The primary objective of the portfolio management team is to earn a competitive rate of return on the investor’s assets with an amount of risk that is acceptable to the investor. The primary responsibility of a trader is to execute effectively and efficiently the firm’s security trading activities. The primary challenge for security trading is to buy or sell the requisite amount of securities at a price that is as close as possible to the currently quoted bid or ask price. The success of a securities firm rests largely on profits generated by its sales department, which is usually the largest and most geographically dispersed unit in a firm. Typically, the sales department is divided into institutional and retail divisions. Institutional salespeople deal mainly with traders at major financial institutions and larger nonfinancial companies. Working with their firm’s underwriting department, they help sell new securities issues to institutional accounts. In co-operation with the firm’s trading department, they help generate day-to-day trading in outstanding securities with such accounts.



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EXAMPLES OF INSTITUTIONAL CLIENTS

Traditionally, institutional investors have been grouped as follows: • pension plans • mutual funds • insurance companies • endowments • charitable foundations • family trusts/estates • corporate treasuries Despite the popular use of these categories, increasingly, the terms themselves do not capture the most significant differences among industry players. Many insurance companies, for example, have launched their own investment funds and have become involved in the management and provision of pension products.

The retail sales force serves individual investors and smaller business accounts and usually comprises the largest single group of a firm’s employees. The activities of retail Investment Advisors (IAs) are extremely diverse, reflecting the spectrum of investor types and needs.

Some firms focus on private, high net worth clients, some firms offer a wide range of portfolio solutions, while other firms specialize as discount brokers.

To sell securities to the public, an IA must be registered with the provincial securities commission, be of legal age, have passed the CSC and the Conduct and Practices Handbook exam, and participate in a 90-day training program. IAs must also complete the Wealth Management Essentials Course within 30 months of their registration. Middle Office

The middle office provides functions that are critical to the efficient operation of the entire firm. The types of duties middle-office staff perform have to do with compliance, accounting, audits and legalities. They are responsible for ensuring that the firm’s products and services are designed and delivered in conformance with industry best practices and pertinent regulations. Back Office

The primary objective of the back office is to settle the firm’s security transactions in an efficient and effective manner; this activity is otherwise known as the trade settlement function. Security trades are not complete until they are “settled”. The trade settlement function fulfills the role of ensuring that all of the firm’s security transactions, both purchases and sales, are settled in the correct amounts, in the correct accounts (or portfolios/funds) and at the agreed-upon time.


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Investment Dealers and their Principal or Agency Functions As described earlier, investment dealers facilitate the trading or movement of the securities that transfer capital between suppliers and users. Investment dealers sometimes act as principals, and at other times act on their clients’ behalf as agents. When acting as a principal, the securities firm owns securities as part of its own inventory at some stage in its buying and selling transactions with investors. The difference between buying and selling prices is the dealer’s gross profit or loss. When acting as an agent, the broker acts for or on behalf of a buyer or a seller but does not itself own title to the securities at any time during the transactions. The broker’s profit is the agent’s commission charged for each transaction. UNDERWRITING/FINANCING SECURITIES

In the securities business, underwriting or financing has come to mean the purchase from a government body or a company of a new issue of securities on a given date at a specified price. The dealers act as principals, using their own capital to buy the issue in anticipation of being able to make a profit when later selling it to others in the primary or new issue market. The dealers also accept a risk since market prices may fall during the time the securities remain in their inventory. The issuer normally incurs no liability or responsibility in the sale of its own securities since payment is guaranteed by the underwriter regardless of its success in selling the securities to investors. OTHER PRINCIPAL TRANSACTIONS

Dealers also act as principals in secondary markets (i.e., after primary distribution has been completed) by maintaining an inventory of already issued, outstanding securities. Here the dealer buys securities in the open market, holds them in inventory for varying periods of time, and subsequently sells them. There is no central marketplace for most principal or dealer market activities. Instead, transactions are routinely conducted on the over-the-counter market by means of computer systems of inter-dealer brokers which link dealers and large institutions. Generally, most secondary trading of debt securities is conducted with the securities firm acting as principal, though occasional agency trades take place. For new money market issues, for instance, a dealer may sell the securities as an agent or, alternatively, take them into inventory as principal for later resale. By participating in the secondary market, and maintaining an inventory of outstanding securities, the dealer provides several useful services: •

Its knowledge of current conditions in secondary markets tempers the advice it gives about terms and features for new issues in the primary market.

•

The relative ease with which transactions can be made from their inventory, rather than waiting for simultaneous matching buy-sell orders from other investors, adds to the liquidity of the market.

•

Investment dealers may act as market makers who have the responsibility of taking positions in some listed stocks in order to enhance market liquidity and smooth out undue price distortions.



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•

Some firms buy listed stocks as principals in order to accumulate large blocks of shares to permit them to be more competitive in serving their larger institutional clients.

•

Firms also trade for their own account with the intent of making a profit.

The liquidity that investment dealers add to the secondary market also enhances the primary market, since it helps assure buyers of new securities that they will be able to sell their holdings at reasonable prices. BROKER OR AGENCY TRANSACTIONS

When acting as a broker, a securities firm is an agent in a secondary securities transaction. The broker’s clients who buy and sell securities are, in fact, the principals or owners of the securities, and the broker acts only as an agent, never actually owning them itself. Both the broker acting for the seller and the broker acting for the buyer charge their respective clients a commission for executing a trade. Commission rates are negotiated between clients and their brokers. By convention, however, the term ‘broker’ may be used interchangeably to describe an investment dealer acting as a principal or an agent.

Complete the following Online Learning Activity The Role of Financial Intermediaries The three roles of financial intermediaries in the securities industry are dealer, principal, and agent. In this exercise you’ll review how securities firms act in each of these roles and compare and contrast the roles. Complete the Three Roles of Intermediaries activity.

The Clearing System During a trading day, an exchange member will be both buyer and seller of many listed stocks. Instead of each member making a separate settlement with another member on each trade during the course of a trading day, a designated central clearing system handles the daily settlement process between members. In Canada, securities are cleared through CDS Clearing and Depository Services Inc. (CDS). Marketplaces (exchanges such as the TSX and TSX Venture) and alternative trading systems (ATSs) report trades to CDS’s clearing and settlement system, CDSX. Over-the-counter trades are also reported to CDS by participants in the system. Participants with access to the clearing and settlement system primarily include banks, investment dealers and trust companies. By using a central clearing system, the number of securities and the amount of cash that has to change hands among the various members each day is substantially reduced through a process called netting. The clearing system establishes and confirms a credit or debit cash or security position balance for each member firm, compiles their clearing settlement sheets and informs each member of the securities or funds it must deliver to balance its account.


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WHAT ROLES DO BANKS PLAY AS FINANCIAL INTERMEDIARIES? All banks operate under the Bank Act, which has been regularly updated, usually through revisions every five years. The Act sets out specifically what a bank may do and provides operating rules enabling it to function within the regulatory framework. In March 2010, Canada had 77 banks, made up of 22 domestic banks, 26 foreign bank subsidiaries and 29 foreign bank branches. The largest six domestic banks control more than 90% of the approximately $2.9 trillion in assets (Source: OSFI Annual Report, March 2010). The Canadian banking industry is one of the largest employers in the country, making it one of Canada’s biggest industries. However, as a result of international consolidation, the largest Canadian banks are becoming relatively smaller when judged against their international competitors. Banks are designated as Schedule I, Schedule II or Schedule III. Each designation has unique rules and regulations surrounding the banks’ activities. Most Canadian-owned banks are designated as Schedule I banks and the foreign-owned banks are either Schedule II or Schedule III banks. Currently, voting shares of large Schedule I banks must be widely held, subject to rules that restrict the control of any individual or group and non-NAFTA (North American Free Trade Agreement) shareholders to no more than 20 per cent. In contrast, a single shareholder, including a company, can control a medium-sized bank (shareholder equity of less than $5 billion) by owning up to 65% of the voting shares, provided that the remaining shares remain publicly traded. A small bank (shareholder equity of less than $1 billion) can be owned by one individual or organization.

Schedule I Chartered Banks Schedule I banks are the giants of Canada’s capital market. There are 23 Schedule I banks, with six (RBC Royal Bank, CIBC, BMO Bank of Montreal, Scotiabank, TD Bank Financial Group and National Bank of Canada) far out-distancing the asset size of other Canadian-owned banks and most other non-bank financial institutions. The major banks have achieved their present asset size largely by establishing a network of more than 9,000 retail branches throughout Canada, augmented in recent years with over 50,000 automated banking machines (ABMs), thus attracting and centralizing the savings of Canadians. They have also become major participants in the international banking scene. Most Schedule I banks are expanding their international operations through acquisitions of, or investments in, U.S. and other international financial institutions. While traditional banking such as retail, commercial and corporate banking services still exist, banks today provide a variety of services through investment dealer, insurance, mortgage, trust, mutual fund and international subsidiaries. In addition, banks have expanded their core services to respond to the increasing demand for wealth management services. Canadian banks offer consumer and commercial banking products and services, including mortgages and loans, bank accounts and investments. Banks also offer financial planning, cash management and wealth management services, some directly and some through subsidiaries.



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Wealth management products and services, including mutual funds and financial planning services, have been a growing part of banking business in recent years, as demographics in Canada provide record numbers of investors as potential clients. Banks have become more dominant players in this field. Services such as investment dealer activities, discount brokerage accounts, and the sale of insurance products are handled by subsidiaries within the banking group. While banks are permitted under current legislation to take part in diverse sectors of the financial services industry, there are controls on how they do so and on the sharing of customer information between subsidiaries. The controls that inhibit information sharing between various businesses and business units are commonly known as “Chinese walls.” Example: A bank may offer chequing accounts and mortgages through a local branch. If a customer wants a discount brokerage account, the customer would be directed to deal with the investment dealer subsidiary and would receive all further related correspondence from that subsidiary. The bank branch would not have access to information about the customer’s brokerage account or trades, and the investment dealer subsidiary would not have access to the customer’s bank account or loan balances. In this way, the operations of different businesses within the same banking group are kept quite separate.

A major activity of the banks is to loan funds to businesses and consumers at interest rates higher than the rates they must pay in interest on deposits and other borrowings. The spread between the two sets of interest rates covers the banks’ operating costs (rent, salaries, administration, appropriations for loan losses, etc.), as well as providing a margin for the banks’ profits.

Schedule II and Schedule III Banks Schedule II banks are incorporated and operate in Canada as federally regulated foreign bank subsidiaries. These banks may accept deposits, which may be eligible for deposit insurance provided by the Canada Deposit and Insurance Corporation (CDIC) and may engage in all types of business permitted to a Schedule I bank. Schedule II banks, in practice, derive their greatest share of revenue from retail banking and electronic financial services. Examples of Schedule II banks in Canada include the AMEX Bank of Canada, Citibank Canada, and BNP Paribas (Canada). Schedule III banks are federally regulated foreign bank branches of foreign institutions that have been authorized under the Bank Act to do banking business in Canada. Schedule III banks, in practice, tend to focus on corporate and institutional finance and investment banking. Examples of Schedule III banks in Canada include HSBC Bank USA, Comerica Bank and The Bank of New York Mellon. By allowing foreign banks to operate in Canada, the government has facilitated the expansion in the operations of Canadian-owned Schedule I banks abroad. The presence of foreign-owned banks in Canada also provides a conduit for investment of foreign capital in Canada as well as providing Canadian corporate borrowers with alternative sources of borrowed funds.


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WHAT ARE TRUST COMPANIES, CREDIT UNIONS AND LIFE INSURANCE COMPANIES?

Trust and Loan Companies Federally and provincially incorporated trust companies offer a broad range of financial services, which in many cases overlap services provided by the chartered banks. For example, trust companies accept savings, issue term deposits, make personal and mortgage loans, and sell RRSPs and other tax-deferred plans. However, trust companies are the only corporations in Canada authorized to engage in a trust business (i.e., to act as a trustee in charge of corporate or individual assets such as property, stocks and bonds). They also offer estate planning and asset management.

Credit Unions and Caisses Populaires Early in the 1900s, many individual savers and borrowers felt that chartered banks were too profit oriented. This led to the establishment of many co-operative, member-owned credit unions in English-speaking communities in Canada (predominantly in Ontario, Saskatchewan and British Columbia), and the parallel caisses populaires (people’s banks) in Quebec. Frequently, credit unions seek member-savers from common interest groups such as those in the same neighbourhood, those with similar ethnic backgrounds and those from the same business or social group. Credit unions and caisses populaires offer diverse services such as business and consumer deposit taking and lending, mortgages, mutual funds, insurance, trust services, investment dealer services, and debit and credit cards. The federal legislation governing credit unions is the Cooperative Credit Associations Act. The act generally limits activities of credit unions to providing financial services to their members, entities in which they have a substantial investment and certain types of co-operative institutions, and to providing administrative, educational and other services to cooperative credit societies. The act requires associations to adhere to investment rules based on a “prudent portfolio approach” and prohibits associations from acquiring substantial investments in entities other than a list of authorized financial and quasi-financial entities. It also sets out a number of limits designed to restrict the exposure of associations to real property and equity securities.

Insurance Companies The Canadian insurance industry, including agents, appraisers and adjusters, employs more than 200,000 people, divided more or less evenly between the life insurance industry and the property and casualty insurance industry. Between the two industries, more than $400 billion in assets, either directly or indirectly, is managed on behalf of policyholders.



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PRODUCTS AND SERVICES

The insurance industry has two main businesses: life insurance and property and casualty insurance. Life insurance and related products include insurance against loss of life, livelihood or health, such as health and disability insurance, term and whole life insurance, pension plans, registered retirement savings plans and annuities. The chief sources of a life insurance company’s funds are premiums on whole life, term and group insurance policies; premiums being paid for annuities, pensions, group medical and dental care programs; interest on policy loans and mortgages; and interest and dividends on securities and mortgages already owned. Life insurance products may be offered through either private or group insurance plans, often those sponsored by employers. Property and casualty insurance encompasses protection against loss of property, including home, auto and commercial business insurance. The largest aggregate premiums are generated by automobile insurance, followed by property insurance and liability insurance. Life insurance companies act as trustees for the funds entrusted to them by policyholders and, therefore, they must exercise extreme caution in selecting their investments. Safety of principal is most important. Contractual obligations will have to be met in the future and certainty of principal repayment is their first investment aim. Historically, life insurance companies have also tried, as far as market conditions permit, to invest as much as possible of their funds in high yielding, longer-term securities, since many of their contracts are long-term in nature, running for the lifetime of the insured. Life insurance companies, therefore, tend to be active in both mortgage and long-term bond markets. Underwriting operations are the most important aspect of the insurance business in Canada. Underwriting is the business of evaluating the risk an insurance company is willing to take from a client in exchange for insurance premiums, followed by the acceptance of the associated responsibility for fulfilling the terms of the insurance contract. The other significant aspect of the insurance business is acting as agent or broker for other underwriters. Such companies sell insurance policies underwritten by other firms. Reinsurance, the business of exchanging risk between insurance companies to facilitate better risk management, is a relatively small part of the Canadian insurance market, although it is an increasingly important business globally. INSURANCE REGULATION

The key federal legislation governing insurance companies is the Insurance Companies Act. The bill establishing the Act was proclaimed June 1, 1992. The legislation permits life insurance companies to explicitly own trust and loan companies, and thus enter new financial businesses through subsidiaries. Similarly, widely held institutions such as mutual insurance companies would be permitted to own Schedule I banks. Insurance companies are also allowed to hold a range of other types of corporations. While companies will have enhanced powers to make consumer and corporate loans, the Act contains a number of restrictions on activities such as in-house trust services and deposit-taking. It also continues the practice of allowing only life companies to offer annuities and segregated funds.


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The Act also requires insurance companies to adhere to investment rules based on a “prudent portfolio approach” which replaces the “legal for life” rules. Companies are prohibited from acquiring substantial investments in entities other than a list of authorized financial and quasi financial entities. The Act also sets out a number of portfolio limits designed to limit exposure to real property and equity securities. A number of insurance companies are wholly owned by the Canadian Schedule I banks. Although these large domestic banks have established their own insurance subsidiaries, the Bank Act does not permit the selling of insurance through their branch networks, with the exception of insurance related to loans such as mortgage insurance and loan insurance.

WHAT ARE INVESTMENT FUNDS, SAVINGS BANKS, SALES FINANCE AND CONSUMER LOAN COMPANIES, AND PENSION PLANS? The organizations described earlier are not the only intermediaries or distributors of financial products. Others, described below, are often characterized by the products and services that they offer. They also play a significant role in the Canadian financial services industry and can be categorized in the following ways: •

Investment Funds: Investment funds are companies or trusts that sell shares (often called units) to the public and invest the proceeds in a diverse securities portfolio. Closed-End Funds typically issue shares only at start-up or at other infrequent periods, while Open-End Funds (or mutual funds) continually issue shares to investors and redeem these shares on demand. Of the two types of funds, mutual funds are much larger, accounting for close to 95% of aggregate funds invested.

•

Savings Banks: The Alberta Treasury Branches (ATB) were formed in 1938 when chartered banks pulled out their branches from many smaller towns. The ATB became a provincial crown corporation in 1997 and became ATB Financial in 2002 providing a full range of financial services to Albertans.

•

Sales Finance and Consumer Loan Companies: Such companies make direct cash loans to consumers who usually repay principal and interest in instalments. They also purchase, at a discount, instalment sales contracts from retailers and dealers when such items as new cars, appliances or home improvements are bought on instalment plans.

•

Pension Plans: There has been a remarkable growth in the institutionalization of savings through pension plans during the past 55 years. Canada’s changing demographic landscape has focused public attention on the future viability of the Canada Pension Plan (CPP) and Québec Pension Plans (QPP).



Complete the following Online Learning Activity Who Are the Other Intermediaries in Canada? In addition to securities firms there are a number of other intermediaries that operate in the Canadian securities industry. Schedule I banks are the giants of the Canadian capital market and play a major role in the industry. In addition to banks, there are a number of other intermediaries that operate in the securities market. In this activity you will review the roles banks and other intermediaries play in the capital markets. Complete the Other Financial Intermediaries activity to learn more about their role in the securities industry.


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Summarize the state of the Canadian securities industry today. •

2.

3.

Canadian capital markets are among the most sophisticated and efficient in the world. These qualities are measured in terms of the variety and size of new issues brought to the markets and the depth and liquidity of secondary market trading.

Distinguish among the three categories of securities firms, explain how they are organized, and compare and contrast dealer, principal and agency transactions. •

Firms in the Canadian securities industry are categorized as integrated, institutional and retail. Integrated firms offer products and services that cover all aspects of the industry. Institutional firms primarily handle the trading activity of large clients such as pension funds and mutual funds. At the retail level, there are full-service firms that offer a wide variety of products and services, and discount brokers that provide reduced trading rates but do not provide advice.

•

One main role of an investment dealer is to bring new issues of securities to the primary markets and facilitate trading in the secondary markets. The dealer can act as a principal or as an agent in either market.

•

When acting as a principal, the dealer owns securities as part of its inventory when conducting transactions with clients and investors. Profit is made on the spread between the original cost of the securities and what they eventually sell for.

•

When acting as an agent, the dealer acts on behalf of a buyer or seller but does not itself own title to the securities at any time during the transaction. Profit is earned on the commission charged for each transaction.

Describe the role of the chartered banks in the capital markets. •

The Canadian chartered banks are the largest financial intermediaries in the country. They are designated as Schedule I, Schedule II or Schedule III banks. Each designation has different rules and regulations regarding ownership levels and the types of services that can be offered.

•

Most Canadian-owned banks are designated as Schedule I banks. They are the dominant competitors in the industry both in terms of the wide-ranging services offered and their overall asset base.

•

Schedule II banks are incorporated and operate in Canada as federally regulated foreign bank subsidiaries. These banks can engage in all the types of business that are permitted to Schedule I banks.



•

4.

Schedule III banks are federally regulated foreign bank branches of foreign institutions. Most operate as full-service branches able to accept deposits, though some are merely lending branches.

Describe the roles of trust companies, credit unions and insurance companies in the capital markets. •

5.

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These financial intermediaries offer a broad range of financial services that in many cases overlap with the services provided by chartered banks, including deposit-taking and lending, debit and credit cards, mortgages, and mutual funds.

Describe the roles of investment funds, savings banks, loan companies and pension plans in the capital markets. •

Investment funds sell their shares to the public, most often in the form of closed- or openend funds, and invest the proceeds in a diverse portfolio of securities.

•

Loan companies make direct cash loans to consumers who typically use them to repay principal and interest on instalment loans. These intermediaries also purchase instalment sales contracts from retailers on such items as new automobiles, appliances, or home improvements that are purchased on instalment.

•

Pension plans represent a type of institutionalized savings. These plans are offered to the employees of many companies, institutions and other organizations. One or the other of the government-related plans (the Canada Pension Plan and the parallel Québec Pension Plan) is compulsory for virtually all employed persons.






Chapter

3

The Canadian Regulatory Environment


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3 The Canadian Regulatory Environment

CHAPTER OUTLINE Who are the Regulators? • Federal Regulators • The Provincial Regulators • The Self-Regulatory Organizations • Investor Protection Funds • Role of Arbitration • Ombudsman for Banking Services and Investments What are the Principles of Securities Legislation? • Full, True and Plain Disclosure • Registration • The National Registration Database (NRD) • Know Your Client Rule • Client Relationship Model (CRM) What are the Ethics of Trading? • Examples of Unethical Practices • Prohibited Sales Practices What are Public Company Disclosures and Investor Rights? • Continuous Disclosure • Statutory Rights for Investors • Proxies and Proxy Solicitation

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What are Takeover Bids and Insider Trading? • Takeover Bids • Insider Trading Summary

LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Identify and describe the agencies and legal entities through which the Canadian securities industry is regulated. 2. Evaluate the role the self-regulatory organizations (SROs) play in the regulatory process. 3. Discuss the principles that underlie securities legislation. 4. Identify unethical practices and conduct in securities trading. 5. Describe the rules for public company disclosure and the statutory rights of investors. 6. Explain how takeover bids and insider trading are regulated.

GOALS OF REGULATION So far we have learned that financial markets and financial intermediaries developed over time to meet the ever-evolving needs of investors. While true, what we also need to consider are the ways in which industry regulation have evolved to protect investors and the industry itself. Although investor protection is the primary goal of securities regulation, it is not the only goal. The various Canadian regulatory bodies play a key role in fostering market integrity. What do we mean by market integrity? We have learned that productive investing takes place when savings are funnelled through the capital markets to the various products, for example, stocks and bonds, so that they are channelled into investments and projects that will yield the greatest benefit. For this to happen efficiently, investors must feel confident that they will be treated fairly and equally when participating in the capital markets. Ultimately, what this means is that individuals and institutions can invest with confidence in open and fair capital markets.


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How does the industry achieve this lofty goal? There are a variety of ways. The industry has developed high professional standards and educational programs to ensure the competence of industry employees. Investor protection funds are in place to protect individual investors in the unlikely event that a firm goes bankrupt. The regulatory bodies have the authority to prosecute individuals and firms that are suspected of wrongdoing. Also, they can impose penalties in the form of reprimands, fines, suspensions, and expulsion where fault has been proven. The focus of this chapter is an overview of the regulatory environment in Canada. We look at the role of the various regulatory bodies, the principles of regulation, and the rights of investors.

KEY TERMS Arbitration

National Registration Database (NRD)

Autorité des marchés financiers (AMF)

New Account Application Form

Beneficial owner

Nominee

Canada Deposit Insurance Corporation (CDIC)

Office of the Superintendent of Financial Institutions (OSFI)

Canadian Investor Protection Fund (CIPF) Canadian Securities Administrators (CSA)

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Director’s circular

Ombudsman for Banking Services and Investments (OBSI)

Insiders

Proxy

Investment Advisors (IAs)

Reporting issuer

Investment Representatives (IRs)

Right of action for damages

Mutual Fund Dealer Association Investor Protection Corporation (MFDA IPC)

Right of rescission

Material change

Self-Regulatory Organizations (SROs)

National Do Not Call List (DNCL)

Takeover bid

National policies

Universal Market Integrity Rules (UMIR)


Right of withdrawal

THREE • THE CANADIAN REGULATORY ENVIRONMENT

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WHO ARE THE REGULATORS? In this chapter, we examine the regulatory role played by federal regulators, the provincial securities regulators, the self-regulatory organizations (the SROs), and the various investor protection funds.

Federal Regulators THE OFFICE OF THE SUPERINTENDENT OF FINANCIAL INSTITUTIONS

The Office of the Superintendent of Financial Institutions (OSFI) is a regulatory body for all federally regulated financial institutions. OSFI is responsible for regulating and supervising: •

153 deposit-taking institutions including banks, trust and loan companies, and cooperative credit associations

•

284 insurance companies, including life insurance companies, fraternal benefit societies and property & casualty insurance companies

•

29 foreign bank representative offices that are chartered, licensed or registered by the federal government

•

1,200 federally regulated pension plans.

OSFI does not regulate the Canadian securities industry. CANADA DEPOSIT INSURANCE CORPORATION (CDIC)

The Canada Deposit Insurance Corporation (CDIC) is a federal Crown Corporation that provides deposit insurance and contributes to the stability of Canada’s financial system. CDIC insures eligible deposits up to $100,000 per depositor in each member institution (banks, trust companies and loan companies), and reimburses depositors for the amount of any insured deposits if a member institution fails. To be eligible for insurance, deposits must be held with a member institution in Canadian currency and payable in Canada. Term deposits must be repayable no later than five years from the date of deposit. The $100,000 maximum includes all insurable types of deposits you have with the same CDIC member. Deposits at different branches of the same member institution are not insured separately. Accounts and products insured by CDIC include: •

Savings and chequing accounts

•

Guaranteed investment certificates (GICs) and other term deposits that mature in five years or less

•

Money orders, certified cheques, traveller’s cheques and bank drafts

•

Accounts that hold realty taxes on mortgaged properties


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These accounts and products must be held at a CDIC member and in Canadian dollars to be eligible for deposit insurance. CDIC does not insure: •

Mutual funds and stocks

•

GICs and other term deposits that mature in more than five years

•

Bonds and Treasury bills

•

Debentures issued by governments, corporations, or chartered banks

•

Deposits held in foreign currency

It is possible to have more than $100,000 in deposits eligible for CDIC coverage, provided the deposits are held in more than one of CDIC’s six deposit insurance categories. These categories include deposits held: • • • • • •

in one name jointly in more than one name in a trust account in a registered retirement savings plan (RRSP) in a registered retirement income fund (RRIF) in a mortgage tax account Example: If a depositor has $80,000 cash on deposit in her own name and in the same institution $120,000 on deposit in a registered retirement savings plan, CDIC would insure her deposits in the amount of $180,000 ($80,000 fully covered for the cash deposit in her own name and a maximum of $100,000 covered for her registered retirement savings plan).

Since 1967, CDIC has provided protection to depositors in 43 member institution failures. As of April 30, 2011, the CDIC insured more than $622 billion in deposits.

The Provincial Regulators In Canada, the regulation of the securities business is a provincial responsibility. Each province and the three territories is responsible for creating the legislation and regulation under which the industry must operate. In several provinces, much of the day-to-day regulation is delegated to Securities Commissions. In other provinces, securities administrators, who are appointed by the province, take on the regulatory function. In Québec, the regulatory body is neither a securities commission nor a securities administrator and its power is not limited to the securities industry only. The Autorité des marchés financiers (AMF) is responsible for administering the regulatory framework for Québec’s financial sector, notably in the areas of insurance, deposit insurance institutions, the distribution of financial products, financial services, and securities.


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The 13 securities regulators of Canada’s provinces and territories joined together to form the Canadian Securities Administrators (CSA), a forum to co-ordinate and harmonize regulation of the Canadian capital markets. The mission of the CSA is to give Canada a securities regulatory system that protects investors from unfair, improper or fraudulent practices and that fosters fair, efficient and vibrant capital markets. PROVINCIAL INSURANCE CORPORATIONS

In each province, one or more organizations exist to protect the deposits of credit union members. This organization may be called a deposit insurance or deposit guarantee corporation or stabilization fund, corporation, board or central credit union. Terms and maximum coverage may vary by province, so it is important to check with your province to determine the specific coverage available. Table 3.1 gives an overview of terms and coverage in three Canadian provinces. TABLE 3.1

Province Ontario

British Columbia

Quebec

DEPOSIT INSURANCE CORPORATION OF SOME PROVINCES

Deposit insurance corporation

Maximum Amount Insured

Financial institutions covered

Deposit Insurance Corporation of Ontario

$100,000

All credit unions and caisses populaires in the province

The combined principal, interest, and dividends relating to that member’s total deposits.

Credit Union Deposit Insurance Corporation (CUDIC)

No limit to the amount insured

All credit unions in the province

Money on deposit

Autorité des Marchés Financiers

$100,000

Accounts and products insured

RRSP or RRIF contracts and unique trust or joint accounts are separately insured

Money invested in non-equity shares Accrued interest and declared and unpaid dividends

All Caisses Populaires in the province

Savings and chequing accounts; Guaranteed investment certificates (GICs) and other term deposits that mature in five years from the date of deposit; Drafts, certified cheques and travellers’ cheques


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The Self-Regulatory Organizations Self-Regulatory Organizations (SROs) are private industry organizations that have been granted the privilege of regulating their own members by the provincial regulatory bodies. SROs are responsible for enforcement of their members’ conformity with securities legislation and have the power to prescribe their own rules of conduct and financial requirements for their members. SROs are delegated regulatory functions by the provincial regulatory bodies, and SRO by-laws and rules are designed to uphold the principles of securities legislation. The provincial securities commissions monitor the conduct of the SROs. They also review the rules of the SROs in the province to ensure that the SRO rules do not conflict with securities legislation and are in the public’s interest. SRO regulations apply in addition to provincial regulations. If an SRO rule differs from a provincial rule, the most stringent rule of the two applies. Canadian SROs include the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association (MFDA).

Complete the following Online Learning Activity The Canadian Securities Industry Overview The securities industry is regulated by a number of provincial and selfregulatory bodies and a number of financial intermediaries play important roles within the industry. This activity reviews the main stakeholders of the Canadian securities industry. Read the Canadian Securities Industry Overview.

THE INVESTMENT INDUSTRY REGULATORY ORGANIZATION OF CANADA

The Investment Industry Regulatory Organization of Canada (IIROC) was created through the consolidation of the Investment Dealers Association of Canada (IDA) and Market Regulation Services Inc. (RS). The new organization was approved by the CSA and officially launched on June 1, 2008 with a mandate to oversee all investment dealers and trading activity on debt and equity marketplaces in Canada. IIROC carries out its regulatory responsibilities through setting and enforcing rules regarding the proficiency, business and financial conduct of dealer member firms and their registered employees and through setting and enforcing market integrity rules regarding trading activity on Canadian equity marketplaces. IIROC’s mandate is “to set high quality regulatory and investment industry standards, protect investors and strengthen market integrity while maintaining efficient and competitive capital markets.” IIROC plays the following roles: •

Financial Compliance: Includes monitoring dealer members to ensure they have enough capital to carry out their operations.



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•

Business Conduct Compliance: Includes monitoring dealer members to ensure policies and procedures are in place to properly supervise the handling of client accounts.

•

Registration: Responsibility for overseeing professional standards and educational programs designed to maintain the competence of industry employees.

•

Enforcement: Includes responsibility for enforcing the rules and regulations that cover sales, business, and financial practices and trading activities of individuals and firms that are under IIROC’s jurisdiction.

IIROC also conducts market surveillance by regulating securities trading and market-related activities of participants on Canadian equity marketplaces. Market surveillance includes: •

Real time monitoring of trading activity on stock exchanges, the Natural Gas Exchange Inc., and Alternative Trading Systems across Canada.

•

Ensuring dealer members comply with the timely disclosure of information by publiclytraded companies in Canada.

•

Carrying out trading analysis and compliance with the Universal Market Integrity Rules (UMIR). THE INVESTMENT INDUSTRY ASSOCIATION OF CANADA

The former IDA’s mission was twofold: to act as the self-regulatory organization of the industry to protect investors and to act as a professional association for its members. On April 1, 2006, the professional association was separated from the SRO function and a new association was created, the Investment Industry Association of Canada (IIAC). The IIAC is a member-based professional association that represents the interests of market participants. The IIAC provides support and services that contribute to the success of their members. It also represents the investment industry’s views and interests to federal and provincial governments and their agencies, and to other SROs.

THE MUTUAL FUND DEALERS ASSOCIATION

The Mutual Fund Dealers Association (MFDA) is the mutual fund industry’s self-regulatory organization responsible for regulating the distribution and sales of mutual funds by its members in Canada. The MFDA does not regulate the mutual funds themselves, as this responsibility has remained with provincial securities commissions. The MFDA is recognized as an SRO by Alberta, British Columbia, Nova Scotia, Ontario, Saskatchewan, New Brunswick and Manitoba. The MFDA has the ability to admit members, to audit, to enforce rules and apply penalties.


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Complete the following Online Learning Activity The Canadian Regulatory Environment: the Client-Advisor Relationship OSFI, CDIC, CSA, and SROs are regulators and agencies that regulate the securities industry in Canada. In this activity, you’ll review your understanding of these agencies along with examples of their jurisdictions. You’ll also use your knowledge to assess a situation in a case involving a client and his advisor. Review your understanding of the Canadian Regulatory Environment. Work through the Client-Advisorr activity.

Investor Protection Funds The securities industry offers the investing public protection against loss due to the financial failure of any firm in the self-regulatory system. To foster continuing confidence in the firmcustomer relationship, the industry created the Canadian Investor Protection Fund (CIPF) in 1969 and the Mutual Fund Dealer Association Investor Protection Corporation (MFDA IPC) in 2005. CANADIAN INVESTOR PROTECTION FUND

The primary role of the CIPF is investor protection and its secondary role is overseeing the self-regulatory system. The secondary role provides a mechanism to help CIPF contain the risk associated with its primary role. The Fund protects eligible customers in the event of the insolvency of an IIROC dealer member. The CIPF does not cover customers’ losses that result from changing market values, and accounts held at mutual fund companies, banks and other firms that are not members of IIROC. The CIPF is sponsored solely by IIROC and funded by quarterly assessments on dealer members. As of December 2011 the CIPF had $650 million of resources to pay customers’ claims. Since its inception, the CIPF has paid claims totalling $36 million to eligible customers of 18 insolvent members. GENERAL ACCOUNT AND SEPARATE ACCOUNTS

All accounts of a customer are covered either as part of the customer’s general account or as a separate account. Accounts of a customer such as cash, margin, short sale, options, futures and foreign currency are combined and treated as one general account entitled to the maximum coverage. Joint accounts are presumed to be equally divided in value among each owner of the account. Separate accounts are accounts disclosed in the records that are treated as if they belonged to a separate customer, and they are each entitled to the maximum coverage. Each separate account held in the same capacity is combined to constitute a single separate account. For example, two



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registered retirement accounts held for the benefit of the customer’s retirement are combined into one separate account. Two trust accounts held for the benefit of different beneficiaries would not be combined into a single separate account. Examples of separate accounts include: •

The combination of all registered retirement plans such as RRSPs and registered retirement income funds (RRIFs), life income funds (LIFs), locked-in retirement accounts or plans (LIRAs or LIRSPs) and locked-in retirement income funds (LRIFs).

•

Registered education savings plans (RESPs).

•

Partnerships.

•

Trusts.

COVERAGE

The CIPF covers customers’ losses of securities and cash balances that result from the insolvency (the inability to pay debts as they come due; also referred to as bankruptcy) of an IIROC dealer member, within the limits described below. Coverage provided for a customer’s general account is limited to $1,000,000 for losses related to securities and cash balances. Separate accounts of customers are each entitled to the maximum coverage of $1,000,000 unless they are combined with other separate accounts. The maximum amount of financial loss that CIPF may pay to a customer is the shortfall between any available securities and cash that the customer is entitled at the date of insolvency and the distribution of any assets of the insolvent dealer member, less any amounts owed by the client to the member.

Example: Judy has $2 million invested in securities and cash with ABC Investment Inc. when ABC declares bankruptcy. She did not owe any amount to ABC. At the time of bankruptcy, the market value of all accounts held by ABC was $100 million, but the amount available for distribution to clients after the bankruptcy was $80 million. Here’s how CIPF determines their involvement: • ABC has a shortfall of $20 million to cover client accounts. • ABC can cover only 80% of Judy’s account, or $1.6 million ($80 million divided by $100 million is 80% and 80% of $2 million is $1.6 million). • The CIPF will step in to cover this shortfall up to the $1 million maximum per account. • Judy will receive $1.6 million from ABC and $400,000 from the CIPF; no loss to her.

Customers have 180 days to file a claim with the CIPF. The 180-day period commences on the date of bankruptcy, if applicable, or the date of insolvency as determined and communicated by the CIPF. In the event of the insolvency of a dealer member, CIPF would normally expect to petition the court under the Bankruptcy and Insolvency Act (BIA) to appoint a trustee to liquidate the firm and protect its customers. The trustee and CIPF will usually arrange to have customer accounts transferred in whole or in part to another CIPF dealer member. Customers whose accounts


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are transferred are notified promptly to deal with the new firm or subsequently transfer their accounts to firms of their own choosing. This procedure minimizes disruption in customers’ trading activities and access to their assets. REGULATORY OVERSIGHT

As well as protecting investors through the actual fund, CIPF provides regulatory oversight by working with the financial examiners and senior regulatory officials. Their role includes: •

anticipating and solving financial problems of dealer members, and helping to bring about an orderly wind-down of business if required.

•

conducting an annual evaluation of the SRO’s examination activities to ensure compliance with CIPF Minimum Standards.

•

conducting financial examinations of dealer members to ensure compliance with the CIPF Minimum Standards.

•

establishing and reviewing national standards for capital adequacy and liquidity, financial reporting, accounting records, segregation of clients’ fully and partly paid securities and insurance.

•

co-ordinating surveillance and enforcement efforts of the examination staff.

•

maintaining a close liaison with the panel of public firms approved to audit and report annually on dealer members.

MUTUAL FUND DEALERS ASSOCIATION INVESTOR PROTECTION CORPORATION

The MFDA Investor Protection Corporation (MFDA IPC) provides protection for eligible customers of insolvent MFDA member firms. The IPC does not cover customers’ losses that result from changing market values, unsuitable investments, or the default of an issuer of a mutual fund. The coverage provided is limited to $1,000,000 per customer account for losses related to securities, cash balances, segregated funds, and certain other property held in the account of a MFDA member firm. Following the structure of the CIPF, customer accounts are covered either as part of a general account or as a separate account. Each account is eligible for up to $1,000,000 in coverage. Separate accounts include registered retirement accounts, such as Registered Retirement Savings Plans (RRSPs) or Registered Retirement Income Funds (RRIFs). These accounts are combined into one separate account for coverage purposes. General and separate accounts held with one MFDA member firm are not combined with accounts customers might hold at another member firm. The MFDA is not recognized as a self-regulatory organization in the province of Québec. Consequently, the MFDA IPC coverage is not currently available to customers with accounts held in Québec MFDA member firms.



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Role of Arbitration There are times when clients feel that they have been treated unfairly by a firm that is a member of an SRO. If, after discussing the problem with the firm, they still feel mistreated, clients have the option of suing the firm or requesting arbitration. Arbitration is a method of dispute resolution in which an independent arbitrator is chosen to: •

Listen to the facts and arguments of the parties to a dispute;

•

Decide how the dispute should be resolved; and

•

Decide what remedy, if any, should be imposed.

SROs can only discipline member registrants and cannot order restitution to be made to clients. The SROs therefore offer dissatisfied investors the option of pursuing damages through arbitration rather than in court. Arbitration may also be cheaper and faster than a court action, particularly where smaller amounts of money are concerned. A client must receive an arbitration brochure when opening an account. If a written complaint has been received, a current brochure must be sent to the client. If a client requests arbitration from an SRO, the dealer member must accept both the process and the arbitrator’s decision. To be eligible for arbitration, the dispute must meet the following criteria: •

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

•

The claim cannot exceed $100,000.

•

The events in dispute must have originated after January 1, 1992 in British Columbia, after January 1, 1996 in Québec, after June 30, 1998 in Ontario, after July 1, 1999 in Alberta, Saskatchewan and Manitoba, and after June 30, 1999 in Newfoundland, Prince Edward Island, New Brunswick and Nova Scotia.

Claims that do not fit within the dollar amount mentioned above may still be arbitrated if both parties agree to the process. The decision of the arbitrator is binding, and at the beginning of the arbitration process both parties must sign an agreement to give up the right to pursue the matter further in the courts.

Ombudsman for Banking Services and Investments Another avenue for investors who feel that they have been treated unfairly is the Ombudsman for Banking Services and Investments (OBSI). OBSI is an independent organization that investigates customer complaints against financial services providers, including banks and other deposit-taking organizations, investment dealers, mutual fund dealers and mutual fund companies. It provides a prompt and impartial resolution of complaints that customers have been unable to resolve with their financial services provider. The OBSI is independent of the financial services industry. The process is not binding for either the investor or the financial services provider. However, member companies who do not agree to a recommendation by the Ombudsman will be publicly reported. To date no member has failed to follow the Ombudsman’s recommendation.


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WHAT ARE THE PRINCIPLES OF SECURITIES LEGISLATION? The securities industry has extensive legislation and regulation to protect the investor and to ensure high ethical standards. This protection flows from self-regulatory organizations (SROs) as well as the provincial securities regulators and administrators. Regulation is covered in much greater detail in CSI’s The Conduct and Practices Handbook (CPH) course. Some of the basic concepts are covered here. Provincial securities acts are designed to regulate the underwriting, distribution and sale of securities, and to protect buyers and sellers of securities. The term act is used here to refer to the securities act or the securities-related legislation of a province. The term administrator is used to describe the securities regulatory authority of a province, whether it is a commission, registrar or other government official. No federal regulatory body for the securities industry exists in Canada, in contrast to the United States where the national Securities and Exchange Commission (SEC) has considerable regulatory authority. With increasing involvement in the investment business by federally regulated financial institutions such as banks, trusts and insurance companies, the number of National Policies issued by the CSA has increased. These National Policies attempt to create a regulatory environment that is harmonized throughout each and every provincial jurisdiction. Formal conferences of provincial administrators are held regularly and informal consultation and co-operation is continuous.

Full, True and Plain Disclosure The general principle underlying Canadian securities legislation is full, true and plain disclosure of all pertinent facts by those offering the securities for sale to the public. Until disclosure is made to the satisfaction of the administrator concerned, it is illegal to offer such securities for public sale. As discussed earlier, such disclosure is normally made in a prospectus issued by the company and accepted for filing by the administrator concerned. The laws are designed to prevent, as far as possible, fraud and deceit and to protect the investor from his or her own naiveté due to a lack of information or undue selling pressure from investment service providers. Nevertheless, no legislation supplants the rule that one must investigate before one invests or recommends an investment. Generally, the acts use three basic methods to protect investors: registration of securities dealers and advisors, disclosure of facts necessary to make reasoned investment decisions and enforcement of the laws and policies. The industry also relies on the SROs for their members’ compliance to legislation.

Registration Generally, every firm and all investment advisors (IAs) employed by such firms must be registered. As well as granting registrations, administrators have the power to suspend or cancel registration or otherwise discipline registrants. Investment advisors are licensed to give advice to clients.



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All employees of IIROC dealer members who deal with the investing public must register with IIROC as well as with the applicable administrator. Such employees must meet IIROC’s requirements for approval which include, as a minimum, completion of the Canadian Securities Course (CSC) and an examination based on the Conduct and Practices Handbook (CPH) course. New investment advisors must also complete a 90-day training program before they are permitted to deal with the public. After licensing, the registrant is subject to a six-month period of supervision by his or her supervisor. New registrants must also complete CSI’s Wealth Management Essentials Course (WME) within 30 months of becoming licensed as an IA. Participation in the industry’s Continuing Education program is also a condition of maintaining a licence. Applicants not giving any advice to clients may choose to be registered as investment representatives (IRs). The proficiency requirements for IRs are similar to those for IAs, with the exception of the length of the training period (30 days as opposed to 90 days) and the 30-month requirement. In order to become a Sales Manager, the candidate must successfully complete the Branch Managers Course (BMC). Within 18 months they must also complete the Effective Management Seminar (EMS). Both courses are offered by CSI. Firms may have full registration, allowing employees a fair amount of latitude in their dealings with the public. Some firms, such as mutual fund dealers, are restricted as to their permitted activities. IAs should be aware of any restrictions that apply to their firms. REGISTRATION CATEGORIES

Dealer members have several job positions where individuals must be registered. National Instrument (NI) 31-103, Registration Requirements, and IIROC Rule 2900, Proficiency and Education, lists the registration categories within a dealer member, all of which are distinguished by their functions:

Dealing Representative

Includes mutual fund representatives, investment representatives (or IRs), and registered representatives (also referred to as investment advisors or IAs). IAs are approved to give investment advice.

Trader

Approved to enter orders into the trading systems of specific exchanges.

Supervisor

Approved to supervise the business activities of other approved persons.

Executive

Approved to participate in the executive management of a dealer member.

Director

Approved to sit on the Board of Directors of a dealer member or occupy a similar position in a dealer member not organized as a corporation.

Ultimate Designated Person

The Chief Executive Officer of a dealer member or person in a similar position, approved to have overall responsibility for the dealer member’s compliance with laws and regulations, including IIROC Rules, governing its securities related activities.


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Chief Financial Officer (CFO)

Approved to be responsible for ensuring that the dealer member complies with the financial adequacy requirements of IIROC Rules.

Chief Compliance Officer (CCO)

Approved to be responsible for ensuring that the dealer member has systems and controls reasonably designed to ensure its compliance with laws and regulations, including IIROC Rules, governing its business conduct.

The National Registration Database (NRD) The National Registration Database (NRD) is a web-based system used by investment dealers and employees to file registration forms electronically when applying for approval by any one or more of the stock exchanges, the CSA or IIROC. The NRD is designed to enable a single electronic submission to satisfy all jurisdictions in Canada, rather than a registrant having to file separate registration forms in each jurisdiction. The NRD also allows regulators to verify registration status in other jurisdictions. Both the IA and the dealer member are required to notify the applicable SROs immediately in writing of any material changes in the original answers to the questions on the NRD application (e.g., change of address). Also, each dealer member is required to immediately report to the administrators and SROs to which it belongs, the termination of an IA. If the IA is dismissed for cause, a statement of the reasons for the dismissal must be reported.

Know Your Client Rule The SROs require that dealer members and their investment advisors: •

Learn the essential facts relative to every client and to every order or account accepted – the “know your client” rule.

•

Ensure that the acceptance of any order for any account is within the bounds of good business practice.

•

Ensure that recommendations made for any account are appropriate for the client and in keeping with his or her investment objectives, personal circumstances and tolerance to bearing risk – the suitability principle.

The first step in complying with this regulation is completion of a New Account Application Form (NAAF) prior to the acceptance of any order. A partner, director, officer or branch manager of the advisor’s firm must approve the application prior to or promptly after the completion of the first transaction.

Client Relationship Model (CRM) In 2012, IIROC introduced new requirements for dealer members as part of a project called the Client Relationship Model or CRM. CRM is part of a broader fundamental obligation of dealer members and their representatives to deal fairly, honestly and in good faith with clients.



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IIROC’s CRM reforms provide greater disclosure requirements for advisors which will enhance the standards they must meet when assessing the suitability of investments for their clients. The objective is increased transparency for investors surrounding the fees they pay, the services they receive, potential conflicts of interest and the performance of their accounts. RELATIONSHIP DISCLOSURE

To better inform clients of the nature of their account, a dealer member must provide all clients with a relationship disclosure document that outlines the account relationship and services to be provided to the client. Some of the information that the relationship disclosure must cover includes: • • • • • • •

the types of products and services offered by the firm, 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, when account suitability will be reviewed, all fees and charges associated with operating, transacting and holding investments in the account, complaint handling procedures, and the reporting the client will receive, including when account statements and trade confirmations will be sent and a description of the firm’s obligations to provide performance information.

CONFLICTS OF INTEREST MANAGEMENT / DISCLOSURE

Firms are required to develop and maintain policies and procedures to identify, disclose and address existing and potential material conflicts involving clients. All material conflict situations between an advisor and his or her clients and between the firm and its clients must be addressed by either: •

Avoiding the Conflict Any existing or potential material conflict of interest between the Approved Person and the client that cannot be addressed in a fair, equitable and transparent manner, and consistent with the best interests of the client or clients, must be avoided;

•

Disclosing the Conflict A material conflict of interest situation that has not been avoided must be disclosed to the client in all cases where a reasonable client would expect to be informed;

•

Otherwise Controlling the Conflict of Interest Situation In general, the only scenario under which a material conflict (that has not been avoided) would not be disclosed to the client would be where the Dealer Member has taken other steps to control the conflict of interest and has effectively ensured, with reasonable confidence, that the risk of loss to the client has been eliminated.


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SUITABILITY ASSESSMENT

The CRM Guidelines require that the suitability of an investment decision be conducted whenever any of the following trigger events occur: •

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; or

•

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

CRM was approved by the CSA on March 22, 2012 and will be implemented in stages, effective from the approval date.

WHAT ARE THE ETHICS OF TRADING? Ethical trading is of paramount importance to both the investing public and the users of the capital markets, the listing corporations. If trading on an exchange were considered unethical it would be impossible for corporations to raise the money they require for expansion and growth because the investing public would simply not participate. The exchanges and the SROs have developed extensive rules and regulations with the securities regulators to govern trading. Infractions may lead to fines, suspension, expulsion and even criminal charges. Unethical conduct may be defined as any omission, conduct, manner of doing business or negotiation, which in the opinion of the disciplinary body is not in the public interest nor in the interest of the exchange.

Examples of Unethical Practices The following are examples of practices which are considered unethical: •

Any conduct which has the effect of deceiving the public, the buyer or the vendor as to the nature of any transaction price or value of such security;

•

Creating or attempting to create a false or misleading appearance of active public trading in a security, e.g., fictitious orders for the same security placed with a variety of securities firms or a series of orders for one security in an attempt to create a false impression of market interest;

•

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

•

Deliberately causing the last sale for the day in a security to be higher than warranted (window dressing);



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•

Making a fictitious trade or giving or accepting an order which involves no change in the beneficial ownership of a security for the purposes of misleading the public;

•

Confirming a transaction where no trade has been executed (bucketing);

•

Improper solicitation of orders either by telephone or otherwise;

•

High pressure or other selling techniques considered undesirable;

•

Violation of any statute applicable to the sale of securities;

•

Leading a client to believe that there is no risk through opening or trading in an account or purchasing a specific security;

•

Making a practice of effecting a trade for the advisor’s own account prior to effecting a trade for a client (front running); or

•

Conduct that would bring the securities business, the exchanges, or IIROC into disrepute.

A dealer member is responsible for the acts or omissions of all its employees. Conduct by an advisor considered unethical may be dealt with, in matters of discipline, as though it were also the conduct of the dealer member itself.

Prohibited Sales Practices Securities legislation prohibiting certain types of selling activities exists for very good reasons. Unethical, dishonest, high-pressure operators will find that such regulations are designed to curb their style of selling. It is extremely important that all advisors study the rules applicable in their province and conform carefully to all the requirements. All changes in the law should be carefully noted, and the advisor should immediately conform to such changes. NATIONAL DO NOT CALL LIST

Advisors often use the telephone as a tool to solicit new clients. By doing so, they are considered as telemarketers by the Canadian Radio-television and Telecommunications Commission (CRTC). The CRTC has established Rules that telemarketers and organizations that hire telemarketers must follow. They include requiring the telemarketer to subscribe to the National Do Not Call List (DNCL). The DNCL Rules prohibit telemarketers and clients of telemarketers from calling telephone numbers that have been registered on the DNCL for more than 31 days. All telemarketers and clients of telemarketers must follow these Rules unless they are making calls that are specifically exempted. Telemarketing is broadly defined and includes sales or prospecting calls. Telemarketing firms must remove or “scrub” their calling lists of persons included in the DNCL. Detailed information about the DNCL can be found on the CRTC’s website: https://www.lnnte-dncl.gc.ca/ind/faqs-eng.


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Complete the following Online Learning Activity Employee Responsibilities In the investment industry there are three players: Investment Dealers, Investors and Employees. In this activity you’ll have the opportunity to review what you’ve learned about licensing requirements, Know Your Client and fiduciary duty. Finally, work through the case we’ve provided to check your understanding of the responsibilities of an advisor. Complete the Employee Responsibilities activity.

WHAT ARE PUBLIC COMPANY DISCLOSURES AND INVESTOR RIGHTS? Securities legislation in each of the provinces requires the continuous disclosure of certain prescribed information concerning the business and affairs of public companies. This disclosure usually consists of periodic financial statements (including management discussion and analysis), insider trading reports, information circulars required in proxy solicitation, an annual information form (AIF), press releases and material change reports. The principle of disclosure is seen also in the requirements of the acts, regulations and policy statements of most provinces covering a distribution of securities. Generally, every person or corporation that sells or offers to sell to the public securities which have not previously been distributed to the public, or which come from a control position, is required to file with, and obtain the approval of, the administrator in the province. They must deliver to the purchaser a prospectus containing full, true and plain disclosure of all material facts related to the issue.

Continuous Disclosure Once a reporting issuer has distributed securities, the issuer must comply with the timely and continuous public disclosure requirements of the acts. The primary disclosure requirements include issuing a press release and filing a material change report with the administrators if a material change occurs. A material change is a change in the business, operations or capital of an issuer that would reasonably be expected to have a significant effect on the market price or value of its securities. Issuers also must file with the administrators annual and interim financial statements meeting prescribed standards of disclosure. Companies are required to ensure that no selective disclosure of confidential material information occurs to third parties, such as during meetings with financial analysts or restricted conference calls with institutional investors. By taping all such discussions and reviewing the tapes immediately after all meetings or conference calls, a company can determine whether any previously undisclosed confidential material information was inadvertently disclosed. If it was, an immediate press release by one of its responsible officers should be released, and the appropriate regulators should be notified of the inadvertent disclosure. © CSI GLOBAL EDUCATION INC. (2013)


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While some securities legislation does not specifically require that the financial statements be sent directly to shareholders, provincial corporations legislation and stock exchange by-laws do make this a requirement. Most companies usually provide financial statements in the required form to all shareholders and send additional copies to the appropriate administrators. The financial disclosure provisions also require that the following information be sent to shareholders and administrators: •

Comparative audited annual financial statements within 120 days of the financial year-end for companies listed on the TSX Venture Exchange and 90 days for senior issuers on the TSX;

•

Comparative unaudited quarterly interim financial statements within 60 days of the end of each of the first three quarters of the financial year for companies listed on the TSX Venture Exchange and 45 days for issuers on the TSX.

Statutory Rights for Investors Canadian legislation provides three statutory rights for the purchaser of securities issued in Canada under prospectus requirements. RIGHT OF WITHDRAWAL

The relevant securities legislation usually provides purchasers during a distribution by prospectus with a right of withdrawal from an agreement to purchase securities within two business days after receipt or deemed receipt of a prospectus and any amendment, by giving notice to the vendor or its agent. If a distribution that requires a prospectus is done without a prospectus, the purchaser in most provinces can revoke the transaction, subject to applicable time limits. RIGHT OF RESCISSION

Most provinces give purchasers during a distribution by prospectus a right of rescission to rescind or cancel a contract for the purchase of securities, if the prospectus or amended prospectus offering the security contains a misrepresentation (e.g., an untrue statement of a material fact or an omission of a material fact). The right of rescission must be brought within 180 days of the date of the transaction. In most provinces, a purchaser alleging misrepresentation must choose between the remedy of rescission and damages. In Québec, rescission or revision of the price may be sought without affecting a purchaser’s claim for damages. RIGHT OF ACTION FOR DAMAGES

The acts of most provinces provide that the issuer, the directors of an issuer, the seller of a security, the underwriter who signs a certificate for a prospectus, and any other person who signs a prospectus, may be liable for damages if the prospectus contains a misrepresentation. The same right of action for damages applies to an expert (such as an auditor, lawyer, geologist or appraiser) whose report or opinion, or a summary thereof, containing a misrepresentation appears with his or her consent in a prospectus. Experts are not liable if the misrepresentation did not appear in their report or opinion. For example, liability will not arise against the underwriter or the directors if they act with due diligence by conducting an investigation sufficient to provide reasonable grounds for a belief that there has been no misrepresentation. If the person or


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company can prove that the purchaser of the securities had knowledge of the misrepresentation, the claim may be considered invalid. The acts also provide certain limitations with respect to maximum liability that may be imposed and time limits during which an action may be brought. A misrepresentation in a prospectus may also be a criminal offence for both the issuer and any of its directors or officers who authorized, permitted or acquiesced in the making of the misrepresentation.

Proxies and Proxy Solicitation Every shareholder who is registered on a company’s books as owning shares is entitled to vote at the company’s annual general meeting. Shareholders receive proxy resolution and voting materials and an information circular to inform them of issues for consideration at the annual meeting. The proxy form or information circular must contain, among other items, information on directors to be elected, management compensation, and any other matters of interest to management. However, it is not always possible for a shareholder to attend the annual meeting. In this case, shareholders have the option of completing a proxy form prior to the meeting. A proxy is a power of attorney given by a shareholder that gives a designated person the authority to vote the shareholder’s stock. A proxy must be in writing and signed by the shareholder granting the proxy. If a shareholder does not vote or leaves the items on the proxy form unmarked, the ballot is automatically cast with management’s viewpoint. It is therefore important for shareholders to read the resolutions and vote their proxy ballots. Proxy forms are available for viewing on SEDAR’s (the System for Electronic Document Analysis and Retrieval) website at www.sedar.com. Most provinces require the management of a reporting issuer to solicit proxies from holders of its voting securities whenever it calls a shareholders’ meeting. These regulations were prompted by the realization that effective control of many companies is achieved through the use of proxies and that management could abuse its position in this area by soliciting proxies without proper disclosure. Shares are most often registered in street form; that is, in the name of a bank, investment dealer or the Canadian Depository for Securities, rather than the true beneficial owner of the shares. In such cases, the institution in whose name the securities are registered would be known as the nominee. To ensure that all shareholders receive or could receive corporate information, the administrators introduced a policy requiring the nominees to mail out to all beneficial holders of corporate securities materials relating to meetings as well as certain shareholder information and voting instruction forms. This policy was designed to ensure that non-registered holders have the same access to corporate information and the same voting privileges as registered holders.

WHAT ARE TAKEOVER BIDS AND INSIDER TRADING? The securities legislation of most provinces contains provisions regulating takeover bids. Takeover bid legislation is basically designed to safeguard the position of shareholders of a company that is the target of a takeover by ensuring that each shareholder has a reasonable opportunity and adequate information to consider the bid.



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Takeover Bids A takeover bid is an offer to the shareholders of a company to purchase the shares of the company that, with the offeror’s already owned securities, will in total exceed 20% of the outstanding voting securities of the company. In a takeover situation, the company (or individual) making the offer, if successful, will obtain enough shares to control the targeted company. The definition includes an offer to purchase, an acceptance of an offer to sell, and a combination of the two. A takeover bid that is not exempted under the relevant act must comply with a number of rules including the following: •

The takeover bid must be sent to all holders in the province of the class of securities sought, including securities that are convertible into securities of that class prior to the expiry of the bid.

•

The offeror shall deliver a takeover bid circular setting out certain prescribed information. This includes details about the bid, the offeror’s holdings in the target company and its relation to management of the target company.

•

A directors’ circular must be sent to the security holders of the target company within 15 days of the date of the bid. The board of directors of the target company is required to provide certain information and to include either a recommendation to accept or reject the takeover bid and the reason for their recommendation. If that is not done, then the board is required to issue a statement that they are unable to make or are not making a recommendation. If no recommendation is made, they must specify the reasons for not making a recommendation.

•

Any securities taken up by the offeror under the bid must be paid for within three business days.

A takeover bid is exempt from the above requirements in any of the following cases: •

It is made through the facilities of the exchange in accordance with the by-laws, regulations and policies of such exchange.

•

It involves acquisitions which do not aggregate more than 5% of the securities of a class within a 12-month period and the price paid for any of the securities does not exceed the market price at the date of acquisition.

•

It is an offer by way of private agreement with five or fewer security holders at a price not exceeding 115% of the market price of the securities.

•

It is an offer to purchase shares in a private company.

•

In Ontario only, it is an offer where the number of holders of securities subject to the bid does not exceed 50 and the securities held constitute in aggregate less than two per cent of the outstanding securities of that class.

Under the acts, if a takeover bid circular is found to contain a misrepresentation and a security holder of the target company is deemed to have relied on this information to make an investment decision, that holder may elect to exercise a right to rescind the transaction. The investor also has a right of action for damages against the offeror, every director of the offeror, every expert


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(but only with respect to reports, opinions or statements made by such expert) and each other person who signed a certificate in the circular. Similarly if a directors’ circular contains a misrepresentation and a security holder of the target company is deemed to have relied on this information, that holder has a right of action for damages against every director or officer who has signed the circular. It is also an offence for a person or company to make a statement in a takeover bid circular or directors’ circular that contains a misrepresentation. EARLY WARNING DISCLOSURE

Most of the acts state that every person or company accumulating 10% or more of the outstanding voting securities of any class of a reporting issuer, or securities convertible into such securities, is required to issue a press release immediately. The purchaser must file the press release with the administrator and file a report within two business days with the administrator. The press release and report are to contain certain details of the acquisition including a statement of the purpose of the acquisition and any future intentions to increase ownership or control. After a formal bid is made for voting securities of a reporting issuer and before the expiry of the bid, every person or company, other than the offeror under the bid, acquiring five per cent or more of the securities of the class subject to the bid is required to issue a press release reporting this information. This press release must be issued no later than the opening of trading on the next business day, and a copy must be filed with the administrator.

Insider Trading Most provinces and the federal act require insiders of a reporting issuer to file reports of their trading in its securities. This is based on the principle that shareholders and other interested persons should be regularly informed of the market activity of insiders. In addition, insiders who make use of undisclosed information must give an accounting of their profits and may be liable for damages. The general principles of the law relating to insiders are described below. However, when a practical problem arises, great care must be taken to determine which of the various corporations acts, federal or provincial, apply to the situation. Their provisions differ slightly. WHO ARE INSIDERS

For the purposes of disclosure provisions of the acts, insiders are generally defined to include any of the following: •

A director or senior officer of the company, or a subsidiary;

•

A person or company (excluding underwriters in the course of public distribution) beneficially owning, directly or indirectly, or controlling or directing more than 10% of the voting shares of the company;

•

A director or senior officer of a company which is itself an insider of the company due to ownership, control or direction over more than 10% of the voting shares of the company involved; or

•

A reporting issuer where it has purchased, redeemed or otherwise acquired any of its securities, for so long as it holds any of its securities.



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In some circumstances, insiders of Corporation A that has itself become an insider of Corporation B, may be deemed to be insiders of Corporation B. When dealing with trades relating to securities of a company that has been involved in such transactions, care should be taken to ascertain whether the persons involved are deemed under the relevant legislation to be insiders. INSIDER REPORTING

Reports must state the extent of the insider’s direct or indirect beneficial ownership of, or control or direction over, securities of the company. Thereafter, the insider must report to the administrators details of any change from the previous report within ten days of the change, or any trade. Securities firms should be aware that most acts require an insider who transfers (except for giving collateral for a debt) securities of a reporting issuer into the name of an agent, nominee or custodian to file a report with the administrator. All reports filed with the administrator are open for public inspection, and in some cases summaries are published in the administrator’s regular publication. Failing to file an insider report or giving false or misleading information are offences under the acts and are usually punishable by a fine.


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2.

3.

Identify and describe the agencies and legal entities through which the Canadian securities industry is regulated. •

Each province is responsible for creating the legislation and regulation under which the securities industry must operate. This regulatory authority is usually delegated by the province to its own provincial securities commission or administrator.

•

The Office of the Superintendent of Financial Institutions (OSFI) provides regulatory oversight for all federally regulated financial institutions, including banks and insurance, trust, loan and investment companies licensed or regulated by the federal government.

•

The Canada Deposit Insurance Corporation (CDIC) is a federal Crown Corporation that protects eligible deposits from the financial failure of a member institution. Eligible deposits are insured for up to $100,000 per depositor in each member institution.

Evaluate the role self-regulatory organizations (SROs) play in the regulatory process. •

SROs are responsible for enforcing member conformity with securities legislation and they have the power to prescribe their own rules of conduct and financial requirements for their members.

•

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

•

SRO regulation is divided between securities markets and the mutual funds distribution side. IIROC deals with all investment dealers and trading activity regulation on debt and equity marketplaces in Canada while the MFDA deals with the distribution side of the mutual fund industry.

•

CIPF protects clients of IIROC dealer members against losses caused by the insolvency of an IIROC dealer member and the MFDA IPC protects clients of MFDA member firms against losses caused by the insolvency of an MFDA member firm.

Discuss the principles that underlie securities legislation. •

The general principle underlying securities legislation is that of full, true, and plain disclosure of all pertinent facts by those offering securities for sale to the public.

•

Securities legislation is designed to protect investors through the registration of securities dealers and advisors, the disclosure of facts necessary to make reasoned investment decisions, and the enforcement of laws and policies.



4.

Identify unethical practices and conduct in securities trading. •

5.

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Unethical conduct is defined as any omission, conduct, and manner of doing business or negotiation that in the opinion of the disciplinary body is not in the public interest or in the interest of the exchange.

Describe the rules for public company disclosure and the statutory rights of investors. •

After distributing securities to the public, a reporting issuer must comply with the timely and continuous public disclosure of information. Disclosure can include issuing a press release or filing a material change report when significant changes to the company’s operations occur.

•

Continuous disclosure also requires reporting issuers to regularly file annual and interim financial statements with provincial administrators.

•

There are three statutory rights available to the purchaser of securities issued in Canada under prospectus requirements. – The right of withdrawal gives the purchaser the right to withdraw from an agreement to purchase securities within two business days after the deemed receipt of the company’s prospectus. – The right of rescission gives the purchaser the right to cancel the purchase of securities if the prospectus contains a misrepresentation. The purchaser has 180 days after the purchase to take advantage of this right. – If it is deemed that a prospectus contains a misrepresentation, the issuer, the directors of the issuer, the seller of the security, the underwriter, and any other person who signs off on the prospectus may be liable for damages under the right of action for damages.

6.

Explain how takeover bids and insider trading are regulated. •

A takeover is considered a change in the controlling interest of a company. It is an offer to purchase the shares of the company that will in total exceed 20% of the outstanding voting securities of the company. Takeover bids are subject to a number of disclosure requirements.

•

The reporting of trading activity by insiders of a reporting issuer is based on the principle that shareholders and other interested persons should be regularly informed of the market activity of insiders.


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SECTION

II

The Economy


Chapter

4

Economic Principles


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4 Economic Principles

CHAPTER OUTLINE What is Economics? • Microeconomics and Macroeconomics • The Decision Makers • Demand and Supply How is Economic Growth Measured? • Measuring Gross Domestic Product • Productivity and Determinants of Economic Growth What are the Phases of the Business Cycle? • Phases of the Business Cycle • Using Economic Indicators • Identifying Recessions What are the Key Labour Market Indicators? • Labour Market Indicators • Types of Unemployment What Role do Interest Rates Play? • Determinants of Interest Rates • How Interest Rates Affect the Economy • Expectations and Interest Rates

4 •2


What is the Nature of Money and Inflation? • The Nature of Money • Inflation • Disinflation • Deflation How does International Economics Impact the Economy? • The Balance of Payments • The Exchange Rate Summary

LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Define economics, identify the decision makers in an economy, and describe the process for achieving market equilibrium. 2. Define gross domestic product (GDP), explain how GDP is measured, and list the factors that lead to growth in GDP. 3. Describe the phases of the business cycle, distinguish among the economic indicators used to analyze business conditions, and identify the determinants of long-term economic growth. 4. Compare and contrast the two key indicators of the labour market in Canada and the three main types of unemployment. 5. Describe the determinants of interest rates and discuss how interest rates affect the performance of the economy. 6. Define inflation, calculate the inflation rate using the Consumer Price Index (CPI), and analyze the causes and impacts of inflation, disinflation and deflation on an economy. 7. Define the accounts included in a country’s balance of payments, describe the determinants of the exchange rate, and explain the impact the balance of payments and the exchange rate have on the economy.


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ANALYZING ECONOMIC PERFORMANCE Economic news and events are announced daily. There are monetary policy reports from the Bank of Canada, quarterly gross domestic product estimates, regular changes in the Canadian exchange rate relative to the U.S. dollar, and data on monthly unemployment and housing starts to consider. For an investor or advisor, being able to recognize the impact these events could have on markets and individual investments helps make wise investment decisions. Economics is fundamentally about understanding the choices individuals make and how the sum of those choices affects our market economy. Whether it is the purchase of groceries, a home, or stocks and bonds, the interaction between consumer choices and the economy takes place in an organized market and at a price determined by demand and supply for goods and services by consumers, investors and governments. An example of an organized market is the Toronto Stock Exchange. Investors come together to buy and sell securities anonymously. Millions of transactions are carried out each day, and this anonymous interaction creates a market and an equilibrium price for a variety of securities. The buyer and seller of a security clearly have different views about the security (generally, the buyer believes it will go up in value and the seller believes it will go down), and it is likely that some type of economic analysis went into the decision to buy or sell. In this first chapter on economics, we start with some of the building blocks, such as economic growth, interest rates, the labour markets, the causes of inflation and the determinants of the exchange rate. These first principles are important because they are the basis of your understanding of how economics and the economy tie into the process of making an investment decision.

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KEY TERMS Balance of payments

Interest rates

Business cycle

Labour force

Capital and financial account

Lagging indicators

Coincident indicators

Leading indicators

Composite leading indicator

Macroeconomics

Consumer Price Index (CPI)

Market

Cost-push inflation

Microeconomics

Current account

Monetary aggregates

Cyclical unemployment

Natural unemployment rate

Deflation

Nominal GDP

Demand

Nominal interest rate

Demand-pull inflation

Output gap

Discouraged workers

Participation rate

Disinflation

Phillips curve

Economic indicators

Potential GDP

Equilibrium price

Real GDP

Exchange rate

Real interest rate

Final good

Sacrifice ratio

Fixed exchange rate

Soft landing

Floating exchange rate

Structural unemployment

Frictional unemployment

Supply

Gross Domestic Product

Unemployment rate


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4 •6


WHAT IS ECONOMICS? Economics is fundamentally about understanding the choices individuals make and how the sum of those choices determines what happens in our market economy. A market economy describes all of the activities related to producing and consuming goods and services, and how the decisions made by individuals, firms and governments determine the proper allocation of resources. Most of us would like to have more of what we have, or at least be able to buy or consume as much as we can. In reality, this is not possible because our spending habits are constrained by the amount of income we earn and by the fact that there is a limit to what an economy can produce during a given period. Because scarcity prevents us from having as much as we would like of certain goods, the performance of the economy hinges on the collective decisions made by millions of individuals. Ultimately, the interaction between these market participants determines what we pay for a good or service, or a stock or mutual fund, for example.

Microeconomics and Macroeconomics Economics is divided into two main topic areas: microeconomics and macroeconomics. Microeconomics analyzes the market behaviour of individual consumers and firms, how prices are determined, and how prices determine the production, distribution, and use of goods and services. For example, consumers decide how much of various goods to purchase, workers decide what jobs to take, and firms decide how many workers to hire and how much output to produce. Microeconomics looks to answer such questions as: •

How do minimum wage laws affect the supply of labour and company profit margins?

•

How would a tax on softwood lumber imports affect the growth prospects in the forestry industry?

•

If a government placed a tax on the purchase of mutual funds, will consumers stop buying them?

Macroeconomics focuses on the performance of the economy as a whole. It looks at the broader picture and to the challenges facing society as a result of the limited amounts of natural resources, human effort and skills, and technology. Whereas microeconomics looks at how the individual is impacted by changes in prices or income levels, macroeconomics focuses on such important issues as unemployment, inflation, recessions, government spending and taxation, poverty and inequality, budget deficits and national debts. Macroeconomics looks to answer such questions as: •

Why did total output shrink last quarter?

•

Why have the number of jobs fallen in the last year?

•

Will a decrease in interest rates stimulate economic growth?

•

How can a nation improve its standard of living?


FOUR • ECONOMIC PRINCIPLES

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The Decision Makers There are three main groups that interact in the economy: consumers, firms and governments. •

Consumers set out to maximize their satisfaction or well-being within the limitations of their available resources – income from employment, investments or other sources.

•

Firms set out to maximize profits by selling their goods or services to consumers, governments or other firms.

•

Governments spend money on education, health care, employment training and the military.They oversee regulatory agencies, and they take part in public works projects, including highways, hydro-electric plants and airports.

THE MARKET

The activity between consumers, firms and governments takes place in the various markets that have developed to make trade possible. A market is any arrangement that allows buyers and sellers to conduct business with one another. For example, the fixed income market is a network of investment professionals, distribution channels, suppliers and wholesalers who develop and trade products to meet various investor needs. These decision makers do not meet physically, but are connected and make their deals by a variety of electronic means. Ultimately, this organized marketplace allows participants access to a product that investors want to buy or sell.

Demand and Supply The price of a product is probably one of the most important factors that determines how much of that product individuals will buy or sell in the marketplace. Everything has a price and financial products and services are not exempt—stocks, bonds, commodities, currency—all have visible prices that allow individuals to make investment decisions. The price paid for any product is largely determined by the demand for and supply of that product in the marketplace. Two general economic principles help to explain the interaction between demand and supply: •

The quantity demanded of a good or service is the total amount consumers are willing to buy at a particular price during a given time period. According to the Law of Demand, the higher the price the lower the quantity demanded, while the lower the price the higher the demand, other factors held constant.

•

The quantity supplied of a good or service is the total amount that producers are willing to supply at a particular price during a given time period. According to the Law of Supply, the higher the price of a good, the greater the quantity supplied.

MARKET EQUILIBRIUM

The interaction that takes place between buyers and sellers in the market ultimately determines an equilibrium price for that product – basically, this is the price that matches what someone is willing to pay for the product with the price at which someone is willing to supply it.



For example, we can find the market equilibrium of a fictitious laptop market using the information from Table 4.1. TABLE 4.1

MARKET FOR LAPTOPS

Price

Quantity Demanded (units)

$1,000

500

0

$1,500

350

100

$2,000

200

200

$2,500

150

300

$3,000

10

450

Quantity Supplied (units)

Figure 4.1 shows the market for laptops. FIGURE 4.1

SHOWS THE MARKET FOR LAPTOPS.

Supply $3,000

Price

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Equilibrium Point

$2,000

$1,000 Demand 0

200

500

Quantity

Table 4.1 lists the quantities demanded and the quantities supplied at each price level. The one price that ensures a balance between the quantity demanded and the quantity supplied is $2,000. This intersection yields an equilibrium price of $2,000 and an equilibrium supply of 200 units.


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Demand and supply forces are instrumental in regulating the price of financial instruments. Consider these scenarios: The housing market in Asia is growing rapidly resulting in an increased demand for Canadian forestry products. The demand for Canadian dollars will rise because manufacturers in Asia will need to purchase products from Canada with Canadian dollars. The increased demand would result in an increase in the price of the Canadian dollar—this assumes the supply of money does not change. In another example, if a corporation reports poor financial performance, investors who own stock in the company may decide to sell their common shares. The increased supply of the company’s common shares in the marketplace would result in a decrease in the price of the shares.

Complete the following Online Learning Activity Microeconomics and Macroeconomics In the first activity you’ll have an opportunity to review the fundamentals of economics including key definitions, key decision makers in the economy and the concepts of supply, demand and equilibrium. Complete the Economic Fundamentals activity.

HOW IS ECONOMIC GROWTH MEASURED? There are different ways of valuing a nation’s total production of goods and services – i.e., its output. Economic growth is an economy’s ability to produce greater levels of output over time and is expressed as the percentage change in a nation’s gross domestic product (GDP) over a given period. By measuring growth, we can better gauge the performance and overall health of the entire economy.

Measuring Gross Domestic Product Gross domestic product (GDP) is the market value of all final goods and services produced within a country in a given time period, usually a year or a quarter. The quarterly reports are used to keep track of the short-term activity within the market, while the annual reports are used to examine trends and changes in production and the standard of living. Goods and services go through many stages of production before they end up in the hands of their final users. The calculation of GDP looks at the total amount of final goods produced over the period. A final good is a finished product, one that is purchased by the ultimate end user.


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Example: A Dell computer is a final good, but the Intel Pentium chip inside it is not since the Pentium chip was used to manufacture the computer. If the market value of all the Pentium chips were added together with the market value of all the Dell computers, GDP would be overstated. Only the market value of the Dell computer, a final good, is included in GDP. THE EXPENDITURE APPROACH AND THE INCOME APPROACH

There are two ways of measuring GDP: the expenditure approach or the income approach. TABLE 4.2

EXPENDITURE APPROACH VERSUS INCOME APPROACH

Approach

Description

How It Works

Expenditure Approach

The expenditure approach looks at total spending on final goods and services produced in the economy.

The expenditure approach measures GDP as the sum of four components: 1. Personal consumption (C) 2. Investment (I) 3. Government spending on goods and services (G) 4. Net exports (exports less imports) of goods and services (X – M) The expenditure approach measures GDP as: GDP = C + I + G + (X – M)

Income Approach

The income approach looks at the total income earned by producing those goods and services.

The income approach measures GDP by totalling the incomes that firms pay for the following: • Wages for labour • Rent for land • Interest for capital goods • Profits for entrepreneurs Spending on goods and services by one party is a source of income for another party. The income approach looks at the income generated by the goods and services produced in the economy during a given period.

These two measures of GDP show that all production results in income earned by workers, firms or investors, and all production is eventually consumed (or stored as inventory). Thus, GDP is obtained by adding up either all income earned in the economy, or all spending in the economy. In theory, GDP measured by the income approach and by the expenditure approach should be the same. REAL AND NOMINAL GDP

Producing more goods and services represents an improvement in a nation’s standard of living. However, if the increase in GDP was simply the result of higher prices, then the cost of buying those goods and services has increased, which reflects an increase in our cost of living but not an improvement in living standards. © CSI GLOBAL EDUCATION INC. (2013)


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Nominal GDP is the dollar value of all goods and services produced in a given year at prices that prevailed in that same year, and is typically the amount reported in the financial press. Changes in nominal GDP from year to year reflect both changes in the prices of goods and services and changes in the amount of output produced in a year.

Nominal GDP in Canada was $1.625 trillion in 2010 and increased to $1.721 trillion in 2011 – an increase of about 5.91%. Since GDP was higher in 2011 than it was in 2010, one or both of the following things happened during the year: 1. The economy expanded and produced more goods and services in 2011 than in 2010. 2. Prices increased and consumers had to pay more for goods and services in 2011 compared with 2010.

Real GDP, or constant dollar GDP, is the dollar value of all goods and services produced in a given year valued at prices that prevailed in some base year. Holding prices constant to this base year establishes a better measure of the change in GDP that is the result of changes in the amount of output produced during the year. A doubling of GDP during the year tells us nothing about what is happening to the rate of real production unless we also know how prices or inflation also changed over the year. Therefore, differences between real and nominal GDP are entirely the result of changes in prices. Real GDP tells us what would have happened to spending on goods and services if quantities had changed but prices had not changed.

Real GDP in Canada was $1.325 trillion in 2010 and $1.357 trillion in 2011. Nominal GDP increased by 5.91% between 2010 and 2011, while the increase in real GDP was somewhat lower at 2.42%. The difference between the nominal and real GDP of 3.49% is due to price changes. Real GDP is therefore the amount of output adjusted for the effects of inflation (or deflation) because it eliminates the impact of changes in the prices of goods and services on the amount of output produced during the year.

Productivity and Determinants of Economic Growth Since the industrial revolution, the GDP of industrialized economies has tended to grow over time. Growth in GDP results from a variety of factors; among the more important are: •

Increases in population over time. Even if the output of every worker remained constant, GDP would rise due to the growing work force.

•

Increases in the capital stock. As more workers are provided with additional equipment and as their skills have been improved with better training and education, individual productivity rises.


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•

Improvements in technology. Technological innovation helps firms and workers to recombine existing resources of land, capital and labour in new and increasingly productive ways. Generally, this has involved the substitution of capital (i.e., improved machinery) for labour in the production of goods and services. A recent example is the continuing replacement of bank tellers by ATM machines.

Gains in individual prosperity are ultimately related to increases in productivity. If productivity growth exceeds increases in the unit costs of production, firms are able to lower the prices of the goods and services they sell. Sustained growth compounds remarkably over time. A policy measure that increases annual growth from 2% to 3% doubles a nation’s standard of living over a 30- to 40-year period. The analysis of long-term trends in GDP growth rates is important, as it allows for the identification of countries with higher expected growth rates. If the analysis is correct, investment in these countries can lead to superior investment returns. THE DETERMINANTS OF ECONOMIC GROWTH

Increases in output per worker, or productivity, must originate from either an increase in capital per worker or improvements in the technology that combine labour and capital to produce output. The liquidity to support investment – i.e., additions to the capital stock – is generated from savings. Current research on the determinants of economic growth (which are reflected in higher investment values) suggests the following conclusions: •

Capital accumulation alone cannot sustain growth. Eventually, increased capital leads to smaller and smaller gains in output. So a higher savings rate is not responsible for a sustained higher growth rate over long periods of time. Nonetheless, a higher savings rate can ultimately support a higher level of output per individual.

•

Sustained growth requires technological progress which is associated with a complex pattern of basic research, applied research and product development situated in a supportive entrepreneurial context.

Complete the following Online Learning Activity Do you Know What Factors Impact Economic Growth? Gross domestic product (GDP), the business cycle, and the labour market all play key roles in determining the economic health of an economy. In this activity you will review how economic growth is measured and the key factors that influence economic growth, including the business cycle and the labour market. Complete the Measuring Growth activity.


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WHAT ARE THE PHASES OF THE BUSINESS CYCLE? Economic fluctuations present a recurring problem for policy makers as downturns in economic growth are directly related to rising unemployment. Such fluctuations in output and employment are called the business cycle, and directly affect the value of investments over time. GROWTH RATE IN CANADA’S REAL GDP

Real GDP in Canada has grown on average by about 3.4% since the 1960s. Figure 4.2 shows that this growth has not been uniform throughout the period. In fact, growth was the most rapid in the 1960s while there have been periods over the past three decades where the economy recorded periods of negative growth. FIGURE 4.2

GROWTH RATE IN REAL GDP (%)

8 7 6

Growth %

5 4 3 2 1 0 -1 -2 -3

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

Year Source: Bloomberg

Phases of the Business Cycle Growth in the economy is measured by the increase in real GDP. Even though the term cycle suggests that the business cycle is regular and predictable, this is not really the case. In reality, fluctuations in real output are both irregular and unpredictable, and this makes each business cycle unique. Nonetheless, the following sequence of events is relatively typical over the course of a business cycle.


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EXPANSION

In times of normal growth, the economy is steadily expanding. An expansion is characterized by the following activities: •

Inflation is stable.

•

Businesses have adjusted inventories to meet higher demand and are investing in new capacity to meet increased demand and to avoid shortages.

•

Corporate profits are rising.

•

New business start-ups outnumber bankruptcies, and stock market activity is strong.

•

Job creation is steady and the unemployment rate is steady or falling.

Overall, real GDP is rising during an expansion. PEAK

The top of the cycle is called a peak. A peak is characterized by the following activities: •

Demand begins to outstrip the capacity of the economy to supply it.

•

Labour and product shortages cause wage increases and inflation to rise.

•

Interest rates rise and bond prices fall. This begins to dampen business investment and reduce sales of houses and big-ticket consumer goods.

•

Business sales decline, resulting in accumulation of unwanted inventory and reduced profits.

•

Stock prices fall and stock market activity declines.

CONTRACTION

When an economy passes its peak, it enters a downturn, or contraction. If the downturn lasts longer than two consecutive quarters, then the economy has typically entered a recession. A contraction is characterized by the following activities: •

The level of economic activity actually begins to decline – i.e., real GDP decreases.

•

Firms faced with unwanted inventories and declining profits reduce production, postpone investment, curtail hiring and may lay off employees.

•

Business failures outnumber start-ups.

•

Falling employment erodes household income and confidence.

•

Consumers react by spending less and saving more, which further cuts into sales, fuelling the recession.

If other countries are also experiencing a recession – especially the United States – the magnitude and duration of the recession in Canada is significantly increased by the reduction in the sale of goods to those outside Canada; in short, by the reduction in our exports. In turn, the rate of default and the probability of default by corporate borrowers increase, and are reflected in a higher default premium on corporate borrowings.



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TROUGH

As the recession continues, falling demand and excess capacity curtail the ability of firms to raise prices and of workers to demand higher salaries. The growth cycle reaches its lowest point and is characterized by the following activities: •

Interest rates fall, triggering a bond rally.

•

Inflation falls.

•

Consumers who postponed purchases during the recession are spurred by lower interest rates and begin to spend.

•

Stock prices rally.

RECOVERY

During the recovery, GDP returns to its previous peak. The recovery typically begins with renewed buying of interest rate–sensitive items like houses and cars. A recovery is characterized by the following activities: •

Firms that reduced inventories during the recession must increase production to meet the new demand.

•

They are typically still too cautious to hire back significant numbers of workers, but the period of widespread layoffs is over.

•

Firms are not yet ready to make significant new investment.

•

Unemployment remains high; wage pressures are restrained and inflation may decline further.

When the economy rises above its previous peak, at point A in Figure 4.3, another expansion has begun.



FIGURE 4.3

THE BUSINESS CYCLE

Peak

Rising Trend in GDP

Peak

Co

si

E xp

an

Ex

y ve r co

n

Re

i ns

pa

tio

er y R

Trough

Re

co

ve r

y

i

ov

ct

on

ec

si

ac

ra

an

tr

nt

E xp

n

on

on

Co

A

tio

C

A on

ac

A

Peak

n tr

on

GDP

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Trough

Trough

Time

Using Economic Indicators Economic indicators are statistics or data series that are used to analyze business conditions and current economic activity. They can help to show whether the economy is expanding or contracting. For example, if certain key indicators suggest that the economy is going to do better in the future than had previously been expected, investors may decide to change their investment strategy. Economic indicators are classified as leading, coincident or lagging. LEADING INDICATORS

Leading indicators tend to peak and trough before the overall economy, i.e., they are designed to anticipate emerging trends in economic activity. They are the most useful and widely used of the economic indicators since they anticipate change by indicating what businesses and consumers have actually begun to produce and spend. Leading indicators include the following: •

Housing starts.

•

Manufacturers’ new orders, which indicate expectations of higher levels of consumer purchases of such items as automobiles and appliances.



•

Commodity prices, which reflect rising or falling demand for raw materials.

•

Average hours worked per week, which rise or fall depending on the level of output and therefore anticipate changes in employment.

•

Stock prices, which suggest changing levels of profits.

•

The money supply, which indicates available liquidity and thus has an impact on interest rates.

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The Macdonald-Laurier Institute, a Canadian think-tank, began publishing a monthly composite leading index to track the performance of the Canadian economy. This index was created to fill the void created by the cancellation in May 2012 of Statistics Canada’s composite leading index. The MLI leading index is published the last week of every month. The MLI index tracks the performance of these nine components: 1. The money supply (M1) 2. The stock market 3. Interest rate differential between corporations and government short term borrowings. 4. Commodity prices 5. Claims for Employment Insurance 6. The housing index 7. New orders for durable manufactured goods 8. The average workweek in manufacturing 9. The US leading indicator

COINCIDENT INDICATORS

Coincident indicators are those which change at approximately the same time and in the same direction as the whole economy, thereby providing information about the current state of the economy. Coincident indicators include the following: •

Personal income

•

GDP

•

Industrial production

•

Retail sales Example: Personal income is a good example because if it is rising, economic growth will typically follow.


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LAGGING INDICATORS

Lagging indicators are those which change after the economy as a whole changes. These indicators are important because they can confirm that a business cycle pattern is occurring. Lagging indicators include the following: •

Unemployment

•

Private sector plant and equipment spending

•

Business loans and interest on such borrowing

•

Labour costs

•

The inflation rate Example: Unemployment is one of the more popular lagging indicators because a rising unemployment rate is an indication that the economy is doing poorly or that companies are anticipating a downturn in the economy.

Identifying Recessions A popular definition of a recession is at least two consecutive quarters of declining growth in real GDP. However, Statistics Canada and the U.S. National Bureau of Economic Research describe a recession differently. Statistics Canada judges a recession by the depth, duration and diffusion of the decline in business activity. Here is some of the criteria they look at: •

The decline must be of substantial depth, since marginal declines in output may be merely statistical error.

•

The duration must be more than a couple of months, since bad weather alone can cause a temporary decline in output.

•

The decline must be a feature of the whole economy. While a strike in a major industry can cause GDP to decline, that does not constitute a recession.

•

The behaviour of employment and per capita income may also be taken into account.

In recent years, the term soft landing has been used to describe a business cycle phase when economic growth slows sharply but does not turn negative, while inflation falls or remains low. Soft landings are considered the “Holy Grail” of policy makers, who want sustained growth without the cost of recurring recessions.


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EXHIBIT 4.1

POST-WAR PERIODS OF ECONOMIC SLOWDOWN AND RECESSION IN CANADA

The recession that began in April 1990 posed particular dating problems. After four quarters of unambiguous decline and one quarter of unambiguous growth, the economy neither grew nor shrank meaningfully for six quarters, although employment continued to fall. We have dated the end of that recession to the second quarter of 1992, when employment reached its trough. The recession that began in April 2001 was viewed by many as a mini-recession as the economy never actually produced two successive quarters of declining growth. The latest recession in Canada began in July 2008.

Dates

Duration

Highest Unemployment Rate (%)

* Apr. ’60 – Jan. ’61

10 months

7.7

1.7

Feb. ’70 – Sept. ’70

8 months

6.7

0.5

* June ’74 – Mar. ’75

10 months

7.2

0.6

* Nov. ’79 – June ’80

8 months

7.8

1.9

* July ’81 – Dec. ’82

18 months

12.7

6.5

Apr. ’90 – Mar. ’92

23 months

11.5

3.6

** Apr. ’01 – Sept. ’01

5 months

7.9

4.3

12 months

8.6

3.3

July ’08 – July ’09

Peak-to-Trough Decline in GDP (%)

* Recession as determined by Statistics Canada. ** Technically a growth slowdown or downturn and not a recession. Some economists feel that the February–September, 1970 period should be regarded as a recession, breaking the expansion period from January, 1961 to June, 1974 into two segments. Source: Adapted from Statistics Canada, www.statscan.gc.ca


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Complete the following Online Learning Activity Where are we in the Canadian Business Cycle? Economic indicators provide clues about where the Canadian economy has been, where it is now, and where it might be going. It’s important to keep in touch with the latest economic news to help you develop a feel for the current and future economic climate here in Canada and abroad. In this activity, you’ll read a sample analysis of economic indicators and then share your opinions with your peers via @CSCchatt on Twitter.r The activity will allow you to monitor and keep track of the latest economic news, giving you the opportunity to share your analysis about the business cycle with your peers. Complete the Business Cycle activity.

WHAT ARE THE KEY LABOUR MARKET INDICATORS? For most Canadians, the performance of the economy affects them most personally in the labour market. When the economy is strong, so is the demand for labour. Employment rises, the unemployment rate falls, and workers win bigger wage raises and/or non-wage benefits. Conversely, when the economy weakens, so does the demand for labour, and wage demands are restrained. Statistics Canada divides the population into two groups: the working-age population (those individuals aged 15 years and older) and those too young to work. Statistics Canada also defines the labour force as the sum of the working-age population who are either employed or unemployed.

Labour Market Indicators There are two key indicators that describe the labour market: the participation rate and the unemployment rate. •

The participation rate represents the share of the working-age population that is in the labour force. For Canada, it was 66.6% in August 2012 (Source: Statistics Canada Labour Force Survey). The participation rate is an important indicator because it shows the willingness of people to enter the work force and take jobs.

•

The unemployment rate represents the share of the labour force that is unemployed and actively looking for work. The unemployment rate may rise either because the number of employed fell or the number of people entering the work force looking for work rose, or both. The number of people unemployed in Canada was 1.5 million and the unemployment rate was 7.3% in August 2012. Incidentally, the average unemployment rate in Canada over the past 40 years has been approximately 7.7%.


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The participation rate in Canada has followed a mostly upward trend over the last 50 years, rising from 54% in the early 1960s to its current level of 66.6% in 2012. In fact, the participation rate remained relatively stable in Canada over the last several years, averaging around 65%. CANADIAN UNEMPLOYMENT RATE

Figure 4.4 shows the patterns in the Canadian unemployment rate since the 1960s. In general, the upward trend with large fluctuations corresponds to the trend and stages of the business cycle. • Significant post-war peaks in unemployment were recorded during the last two major recessions in Canada. • The peak at 11.9% corresponds to the recession of 1980–1983, while the peak of 11.4% corresponds to the recession of 1991. • Typically, the impact of economic downturns varies across workers, with young and unskilled workers the most vulnerable. • The recession of 1990–91 was somewhat different as the unemployment rate among prime-age workers jumped higher than usual. FIGURE 4.4

UNEMPLOYMENT RATE IN CANADA (%) 1976 - 2011

Unemployment Rate (%)

12

10

8

6

4

2 1975

1980

1985

1990

1995

2000

2005

2010

Year

Source: Bloomberg

Some people are unemployed for a short time, while others are unemployed for longer periods. The average duration of unemployment varies over the business cycle and is typically shorter during an expansion and longer during a recession. At times, job prospects are so poor that some of the unemployed simply drop out of the labour force and become discouraged workers. Discouraged workers are those individuals that are available and willing to work but cannot


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find jobs and have not made specific efforts to find a job within the previous month, and so are not included as part of the labour force. The disappearance of these “discouraged unemployed workers” can produce an artificially low unemployment rate.

Types of Unemployment There are three general types of unemployment: cyclical, frictional and structural.

Type

Description

Cyclical unemployment

Tied directly to fluctuations in the business cycle. It rises when the economy weakens and firms lay off workers in response to lower sales. It drops when the economy strengthens again.

Frictional unemployment

Is the result of normal labour turnover, from people entering and leaving the work force and from the ongoing creation and destruction of jobs. Even in the best of economic times, people are looking for work because they have finished school, quit, been laid off or been fired from their most recent job. This is a normal part of a healthy economy.

Structural unemployment

Occurs when workers are unable to find work or fill available jobs because they lack the necessary skills, do not live where jobs are available, or decide not to work at the wage rate offered by the market. This type of unemployment is closely tied to changes in technology, international competition and government policy. Structural unemployment typically lasts longer than frictional unemployment because workers must retrain or possibly relocate to find a job.

The distinction between frictional and structural unemployment is sometimes difficult to determine. There are always job openings and potential workers to fill those jobs. With frictional unemployment, unemployed workers have the required skill levels to fill a job vacancy. With structural unemployment, however, unemployed workers looking for work do not possess the needed skills to find a job. The existence of frictional and structural factors in the economy prevents unemployment from falling to zero. This means that even in times of healthy economic growth, there is a level below which unemployment will not drop without causing other negative economic effects. This minimal level of unemployment is called the natural unemployment rate. At this level of unemployment, the economy is thought to be operating at close to its full potential or capacity such that all resources, including labour, are fully employed. Further employment growth is achieved either through increased wages to attract people into the labour force which fuels inflation, or by more fundamental changes to the labour market that removes impediments to job creation.



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The Bank of Canada pays close attention to the actual unemployment rate and the natural unemployment rate as the gap between the two has an important influence on wage inflation. •

When the actual unemployment rate is above the natural rate, an excess supply of workers in the market weakens labour bargaining power, which discourages wage gains and helps to keep inflation in check.

•

When the actual unemployment rate is below the natural rate, a shortage of workers contributes to an increase in wage gains and higher inflation.

Thus, the natural unemployment rate is often viewed as the level of unemployment that is consistent with stable inflation, which is why it is an important number with respect to monetary and fiscal policy decisions.

WHAT ROLE DO INTEREST RATES PLAY? Interest rates are an important link between current and future economic activity. For consumers, interest rates represent the gain from deferring consumption from today to tomorrow via saving. For businesses, interest rates represent one component of the cost of capital – i.e., the cost of borrowing money. Thus, the rate of growth of the capital stock, which determines future output, is related to the current level of interest rates. Interest rates are one of the most important financial variables affecting securities markets. Since they are essentially the price of credit, changes in interest rates reflect, and affect, the demand and supply for credit and debt, and this has direct implications for the bond and money markets. Changes in interest rates made by the Bank of Canada also signal changes in the direction of monetary policy, and this has broader implications for the entire economy.

Determinants of Interest Rates A broad range of factors influences interest rates: •

Demand and supply of capital: A large government deficit or a boom in business investment raises the demand for capital and forces up the price of credit (interest rates), unless there is an equivalent increase in the supply of capital. In turn, the higher interest rate may encourage people to save more. An increase in the savings of government, companies or households may reduce their demand for borrowing. This, in turn, may reduce interest rates.

•

Default risk: The greater the risk that borrowers may default on money they have borrowed, the higher the interest rate demanded by lenders. If the central government is at risk of defaulting on its debt, interest rates rise for everybody. This additional interest rate is referred to as a default premium.

•

Foreign interest rates and the exchange rate: Since Canada has an open economy and investors are free to move their money between Canada and other countries, foreign interest rates and financial conditions influence Canadian interest rates.


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Example: A rise in interest rates in the U.S. increases investors’ returns on money invested there. Investors holding Canadian dollars and who would like to invest in the U.S. will need to sell their Canadian dollars to purchase U.S. dollar-denominated securities. This increases the supply of Canadian dollars on the foreign exchange market and places downward pressure on the value of the Canadian dollar. If the Bank of Canada would like to slow or reduce the fall in the value of the Canadian dollar, they can intervene and raise short-term interest rates, even if underlying conditions in Canada are unchanged. This will encourage investors to continue holding Canadian investments rather than switch to U.S. dollar-denominated securities.

•

Central bank credibility: The central bank exercises its influence on the economy by raising and lowering short-term interest rates. One of its main responsibilities is to keep inflation low and stable. The more credible and long-established a commitment to low inflation has been, the lower interest rates will be to compensate for the risk of rising inflation.

•

Inflation: The higher the expected inflation rate, the higher the interest rate that must be charged by lenders to compensate for the erosion of the purchasing power of money over the duration of the loan.

How Interest Rates Affect the Economy Higher interest rates affect the economy in the following ways: •

They may raise the cost of capital for business investments. An investment should earn a greater return than the cost of the funds used to make the investment. Higher interest rates reduce the possibility of profitable investments. In turn, this reduces business investment.

•

By increasing the cost of borrowing, higher interest rates discourage consumers from spending, especially to buy houses and major durable goods like cars and furniture on credit. This encourages consumers to save more.

•

By increasing the portion of household income needed to service debt, such as mortgage payments, they reduce the income available to be spent on other items. This effect may be offset somewhat by the higher interest income earned by savers.

Thus, higher interest rates have a negative effect on growth prospects. The effect of lower interest rates is the opposite in each case and can provide a positive environment for economic growth.

Expectations and Interest Rates Investment decisions are forward-looking. Any decision to purchase a security is based on an expectation about the future return from the security. Increased optimism in the market can generate a rise in stock prices. Consumer pessimism can stall economic growth, and decrease share prices. Moreover, government economic policies may work only through their impact on people’s expectations. For example, the Bank of Canada makes considerable effort to maintain the credibility of its commitment to low inflation. The role of inflation expectations is particularly important in determining the level of nominal interest rates. The nominal interest rate is one where the effects of inflation have not been removed – for example, the rate charged by a bank on a loan, or the quoted rate on an investment



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such as a Guaranteed Investment Certificate or Treasury bill. Other things equal, the higher the rate of inflation, the higher nominal interest rates will be. In contrast, the real interest rate is the nominal interest rate minus the expected inflation rate. Example: Nominal and historical real rates in Canada have slowly trended downwards over the last 30 years. Nominal interest rates are considerably lower than they were in the early 1980s. Real rates have fluctuated between 5% and 7% until recently when they dropped below 1%.

WHAT IS THE NATURE OF MONEY AND INFLATION? Money is the essential ingredient that makes the economy function. Inflation occurs when prices are rising. This is problematic because as prices rise money begins to lose its value—that is, more and more money is needed to buy the same amount of goods and services, and this has a negative effect on living standards. Inflation is an important economic indicator for securities markets because it is the rate at which the real value of an investment is eroded.

The Nature of Money Money can be any object that is accepted as payment for goods and services, and that can be used to settle debts. •

Its function as a medium of exchange is essential. Without money, goods and services would need to be exchanged with other goods and services in some form of barter system.

•

Money also acts as a unit of account so that we know exactly the price of a good or service.

•

Finally, money represents a store of value since it does not have an expiration date if a consumer decides to save it for a later use. The more stable the value of money, the better it can act as a store of value.

The amount of money in circulation can be measured in a variety of ways. Some of these different measures, known as monetary aggregates, are one way of monitoring economic activity. The Bank of Canada looks primarily at changes in the growth rate of the various monetary aggregates it tracks when conducting monetary policy because these aggregates provide information about changes that are occurring in the economy. By monitoring these aggregates, the Bank strives to keep the rate of money growth consistent with low inflation and long-term growth.

Inflation Inflation in an economy-wide sense is a generalized, sustained trend of rising prices: •

A one-time jump in prices caused by an increase in the price of oil or the introduction of a new sales tax is not true inflation, unless it feeds into wages and other costs and initiates a wage-price spiral.


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•

Likewise, a rise in the price of one product is not in itself inflation, but may just be a relative price change reflecting the increased scarcity of that product.

Inflation is ultimately about money growth. It is a reflection of “too much money chasing too few products.” MEASURING INFLATION

The Consumer Price Index (CPI) is one of the most widely used indicators of inflation and is considered a measure of the cost of living in Canada. Statistics Canada tracks the retail price of a shopping basket comprised of 600 different goods and services, each weighted to reflect typical consumer spending. In this way, the CPI represents a measure of the average of the prices paid for this basket of goods and services.

Statistics Canada has a difficult task creating a basket of goods and services that is representative of the typical Canadian household. They try to make the relative importance of the items included in the CPI basket the same as that of an average Canadian household. However, it is almost impossible to construct a “basket of goods” that would be representative of all consumers. For example, the spending patterns of a family with young children would not be the same as the spending patterns of a retired couple.

When calculating CPI, prices are measured against a base year, which at the moment is 2002 in Canada, and this base year is given a value of 100. The total CPI was 121.8 at the end of August 2012, which indicates that the basket of goods costs 21.8% more than it did in 2002. The inflation rate is calculated by comparing the current period CPI with a previous period: Inflation Rate

CPI Current Period CPI Previous Period q100 CPI Previous Period

The CPI was 121.8 in August 2012 and 120.3 in August 2011. The inflation rate over the 12-month period was 1.25%: Inflation Rate

121.8 120.3 q100 120.3 0.012469 q100

1.25%


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THE INFLATION RATE IN CANADA

Inflation has not been much of a problem over the last decade. In recent history, Canada’s inflation rate reached a high of 12.2% in 1981 and fell as low as -0.9% in July 2009. The inflation rate declined dramatically in both the early 1980s and 1990s based on monetary policy actions taken by the Bank of Canada. Figure 4.5 shows the inflation rate in Canada over the last 45 years. FIGURE 4.5

THE INFLATION RATE IN CANADA 1965 – 2011

15

12

Inflation Rate %

9

6

3

0 1965

1970

1975

1980

1985

-3

1990

1995

2000

2005

2010

Year

Source: Bloomberg

THE COSTS OF INFLATION

Inflation imposes many costs on the economy: •

It erodes the standard of living of those on a fixed income and those who lack wage bargaining power. It rewards those able to increase their income either through increased wages or changes to their investment strategy, in response to inflation.

•

Inflation reduces the real value of investments such as fixed-rate loans, since the loans are paid back in dollars that buy less. This can be good for the borrower if his or her income rises with inflation. But, more likely, inflation results in lenders demanding a higher interest rate on the money they lend.


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•

Inflation distorts the signals prices send to participants in market economies, where prices are critical for balancing supply with demand. Rising prices draw resources into areas of scarcity, and falling prices move funds away from glutted areas. When inflation is high, it is difficult to determine if a price increase is simply inflationary, or a genuine relative price change.

•

Accelerating inflation usually brings about rising interest rates and a recession. Thus, highinflation economies usually experience more severe booms and busts than low-inflation economies.

THE CAUSES OF INFLATION

The relationships among the growth rate of money, inflation and the rate of unemployment are a subject of considerable controversy. An important determinant of inflation is the balance between supply and demand conditions in the economy. Economists use an indicator called the output gap to measure inflation pressures in the economy by looking at the difference between real GDP, what the economy actually produces, and potential GDP, what the economy is capable of producing when its existing inputs of labour, capital, and technology are fully employed at their normal levels of use. Think of potential output as the maximum level of real GDP that the economy can maintain without inflation increasing. •

A negative output gap occurs when actual output is below potential output. In this case, economists would say there is spare capacity in the economy – the economy can produce more output because its resources are not being used to their full capacity. Unemployed workers and unused plant and equipment resources can be called into service without impacting wages or prices. Thus, inflation will fall or remain steady.

•

A positive output gap occurs when actual output is above potential output. In this case, economists would say the economy is operating above capacity – the economy is trying to produce more than it can with existing resources. Scarce labour fuels wage increases, and other strains on productive resources place upward pressure on inflation. In general, a positive output gap occurs as the economy moves through an expansion towards the peak. Output continues to expand, consumer income is rising, and this leads to strong consumer demand for goods and services. However, this creates a situation whereby if companies can continue to operate well above normal capacity, they can raise prices in response to this strong demand. In this way, higher and continued consumer demand pushes inflation higher. This state of affairs is called demand-pull inflation.

•

Inflation can also rise or fall due to shocks from the supply side of the economy – when the cost of producing output changes. At a given price level, when faced with higher costs of production from higher wages or increases in the price of raw materials, firms respond by raising prices and producing a smaller amount of their product. In this way, the higher costs push inflation higher. This is an example of cost-push inflation.


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Disinflation Just as there are costs associated with rising inflation, a falling rate of inflation can also have a negative impact on the economy. Disinflation is a decline in the rate at which prices rise – i.e., a decrease in the rate of inflation. Prices are still rising, but at a slower rate. The potential cost of disinflation is captured by the Phillips curve, which says that when unemployment is low, inflation tends to be high, and when unemployment is high, inflation tends to be low. According to this theory: •

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.

To gauge the cost of disinflation, the sacrifice ratio is used to describe the extent to which GDP must be reduced with increased unemployment to achieve a 1% decrease in the inflation rate. DISINFLATION IN CANADA

Recent studies by the Bank of Canada suggest that the sacrifice ratio is as high as 5; that is, 5% of output must be sacrificed to bring down inflation 1%. So there may be a considerable cost in lost output in pursuing the goal of lower inflation. This cost could involve a significant period of relatively high unemployment. EXHIBIT 4.2

DISINFLATION IN CANADA

The costs of disinflation were evident in Canada in the early 1990s. In 1988, the inflation rate in Canada was 4% and the unemployment rate was 7.8%. Six years later in 1994, the inflation rate had dropped dramatically to 0.2% while the unemployment rate had risen to 10.4%. As the table shows, real GDP also dropped considerably during this period before it began to recover in 1992. More recently, the Canadian economy in 2008 experienced a drop in the inflation rate that was accompanied by an increase in the unemployment rate and a drop in the growth rate of real GDP. However, it is interesting to note that the duration of these events was less severe than those that occurred in the early 1990s. Year

Bank Rate (%)

1988

9.69

1989

Unemployment (%)

Inflation (%)

Real GDP (%)

7.8

4.0

5.0

12.29

7.5

5.0

2.6

1990

13.05

8.1

4.8

0.2

1991

9.03

10.3

5.6

-2.1

1992

6.78

11.2

1.5

0.9

1993

5.09

11.4

1.8

2.3

1994

5.77

10.4

0.2

4.8

Source: Bloomberg and Bank of Canada website.


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Deflation Deflation is a sustained fall in prices where the annual change in the CPI is negative year after year. In fact, deflation is just the opposite of inflation. Falling prices are generally preferred over rising prices. Goods and services become cheaper, and our income seems to go a little farther than it used to. Although true in the short term, there are negative consequences of deflation. One view holds that the impact of sustained falling prices eventually leads to a decline in corporate profits. As prices continue to fall, businesses must sell their products at lower and lower prices. Businesses cut back on productions costs and wage rates, and if conditions worsen, lay off workers. For the economy as a whole, unemployment rises, economic growth slows and consumers shift their focus from spending to saving. Ultimately, declining company profits will negatively impact stock prices. As the economy slows and enters a recession, the central bank can use lower short-term interest rates to stimulate consumer and business spending. Example: In 2007, the Bank Rate in Canada was 4.75% (the Bank Rate is the rate of interest that the Bank of Canada charges on very short term loans to financial institutions and is used as a signal of monetary policy actions). During the 2008-2009 recession the Bank Rate fell to as low as 0.50% and remained there for more than a year to help stabilize the economy. For Canada, the recession was not as deep as expected and low interest rates played a key role in stimulating the Canadian economy.

Complete the following Online Learning Activity Interest Rates and Inflation Interest rates are an important link between current and future economic activity and are one of the most important financial variables affecting securities markets. Changes in interest rates reflect and affect supply and demand for credit and debt. In this exercise you will learn more about how interest rates and inflation affect the economy. Complete the Interest Rates and Inflation activity.

HOW DOES INTERNATIONAL ECONOMICS IMPACT THE ECONOMY? International economics deals with the interactions Canada has with the rest of the world – trade, investments and capital flows, and the exchange rate. Since the end of the Second World War, the dependence of industrial economies on trade has risen significantly. This is especially so for Canada - exports of goods and services are approximately 30% of GDP, compared to 20% in the 1960s. As a result, the economic performance of our trading partners is an important determinant of Canadian economic growth. © CSI GLOBAL EDUCATION INC. (2013)


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The Balance of Payments The balance of payments is a detailed statement of a country’s economic transactions with the rest of the world for a given period of time – typically over a quarter or a year. The two components of the balance of payments are the current account and the capital and financial account. •

The current account records the exchanges of goods and services between Canadians and foreigners, the earnings from investment income, and net transfers such as for foreign aid.

•

The capital and financial account records financial flows between Canadians and foreigners related to investments by foreigners in Canada and investments by Canadians abroad.

Balance of payments transactions can be thought of as incurring either a demand or supply of foreign currency and a corresponding supply or demand of Canadian currency. Current account outflows, such as to buy foreign goods or pay interest on debt held by foreigners, create a demand for foreign currency to make those payments. Canadian dollars are offered in exchange for this foreign currency unless there is a corresponding demand for Canadian dollars. Think of the current account as what we spend on things and the capital and financial account as what we use to finance this spending. •

During a given year, if Canada buys more goods and services from abroad than it sells, it will run a current account deficit for the year. It will need to sell more assets to finance the spending, which means running a capital and financial account surplus, or go into debt.

•

As an analogy, when an individual spends more than he/she earns, the difference is made up by either borrowing money or selling something of value and using the proceeds to pay off the debt. In this way, a country experiencing a current account surplus is saving more than it is spending and can lend out this surplus amount to foreigners.

THE CURRENT ACCOUNT

The most important component of the current account is merchandise trade – the goods and services we produce and sell abroad and those we import from other countries. A number of factors influence the performance of Canada’s trade. The most important is the relative pace of demand in foreign and Canadian economies. Strong growth in U.S. demand for automobiles, raw materials and other products made in Canada boosts exports. Likewise, strong demand in Canada for foreign products boosts imports. The competitive position of Canadian firms in foreign markets and foreign firms in Canada also influences trade. A falling Canadian dollar, for example, lowers the price of Canadian exports in foreign markets and raises the price of imports in Canada. This boosts exports and depresses imports. Those benefits are lost, however, if the price of Canada’s goods rises in response to the lower dollar. A rising Canadian dollar has the opposite effect.


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THE CAPITAL AND FINANCIAL ACCOUNT

The key difference between current and capital and financial account transactions is that the latter result in an acquisition of an asset and the right to any income it earns. Thus, the purchase of a computer made in Canada is a current account transaction, whereas the purchase of the company that made the computer is a capital and financial account transaction.

The Exchange Rate Buying foreign goods or investing in a foreign country requires the use of another currency to complete the transactions. Conversely, when foreigners buy Canadian goods or invest in Canadian assets, they need Canadian dollars. The foreign exchange market includes all the places in which one nation’s currency is exchanged for another at a specific exchange rate – the price of one currency in terms of another. For example, a Canadian dollar exchange rate of US$0.90 means that it costs 90 U.S. cents to buy one Canadian dollar. THE EXCHANGE RATE AND THE CANADIAN DOLLAR

Although the United States dollar (US$) exchange rate is the most important rate for Canada because so much of our business is carried on with the U.S., an official exchange rate exists between the Canadian dollar and every other convertible currency in the world. The value of the Canadian dollar relative to other currencies influences the economy in a number of ways. The most important influence is through trade. A higher dollar makes Canadian exports more expensive in foreign markets and imports cheaper in Canada. When the Canadian dollar rises in value relative to a foreign currency, the dollar is said to have appreciated in value against that currency; conversely, when the Canadian dollar falls in value relative to a foreign currency, the dollar has depreciated in value against that currency. Example: Suppose a machine made in Canada sells for $1,000. With the Canadian dollar at US$0.90, it sells for US$900 in the U.S. If a similar product sells for $950 in the U.S., the Canadian manufacturer benefits at this exchange rate as the machine will sell for a lower price in the U.S. market. If the exchange rate appreciates in value to US$0.95, the machine would now sell for US$950, making its manufacturer less competitive in the U.S. market and decreasing sales and probably corporate profitability. Likewise, a U.S. company that sold a similar machine for US$900 in the U.S. would sell it for $1,000 in Canada with the exchange rate at US$0.90, but for only $947.37 with the exchange rate at US$0.95, taking sales away from the Canadian company.

Since many Canadian exporters price their products in U.S. dollars, they will often elect to keep its US$ price unchanged as the dollar appreciates in value, even though that results in less revenue in Canadian dollars. Such a decision would force the exporter either to accept lower profits, or find a way to reduce the costs of making the product. A lower exchange rate would have the opposite effects, making Canada’s exports cheaper and imports more expensive. An exporter that kept its US$ price unchanged would pocket higher profits, or allow costs to rise.


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EXHIBIT 4.3

HOW THE CANADIAN DOLLAR HAS TRADED AGAINST THE US DOLLAR

The figure shows the exchange rate between Canada and the U.S. between 1975 and 2009. The figure shows that the Canadian dollar depreciated steadily against the U.S. dollar for most of this period, other than for a brief rise in the currency in the late 1980s. This downward trend reversed beginning in early 2003, as the currency rose steadily against the U.S. In fact, the Canadian dollar traded above par (US$1.00) in 2007 for the first time since the mid-1970s. 1.2

US$

1.0

0.8

0.6 1975

1980

1985

1990

1995

2000

2005

2010

Year Source: Bloomberg

DETERMINANTS OF EXCHANGE RATES

Predicting the direction of exchange rates consumes the attention of many economists and analysts. The following factors are widely accepted as influencing the exchange rate, but the weight ascribed to each is by no means agreed upon. •

Commodity Prices: One of the strongest influences on the Canadian exchange rate is the price level of commodities. Canada is heavily dependent on trade, particularly the export of natural resources to other countries, including commodities such as forestry products, base metals, crude oil and wheat. Countries around the world that buy Canadian products need Canadian dollars to finance their purchases. As the demand for commodities increase and as commodity prices rise, the demand for Canadian dollars also rises. Analysts refer to this relationship as positive correlation—rising commodity prices places upward pressure on the value of the Canadian dollar. The opposite holds true when the price of commodities fall.

•

Inflation differentials: Over time, the currencies of countries with consistently lower inflation rates rise, reflecting their increased purchasing power relative to other currencies.


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•

Interest rate differentials: Central banks can influence the value of their exchange rate by raising and lowering short-term nominal interest rates. Higher domestic interest rates increase the return to lenders relative to other countries. This attracts capital and lifts the exchange rate. Lower interest rates have the opposite effect. However, the impact of higher interest rates is reduced if domestic inflation also is much higher or if other factors are driving the currency down.

•

Current account: A country with a current account deficit is spending more than it is earning and must borrow funds to make up the difference. In effect, this means the deficit country is constantly demanding more foreign currency than it receives through its exports, and supplying more domestic currency than the rest of the world demands for its products. This excess demand for foreign currency puts downward pressure on the domestic exchange rate. This occurs until domestic exports or assets are cheap enough to attract foreigners and imports, or foreign assets are too expensive to attract domestic interests.

•

Economic performance: A country with a strongly growing economy may be more attractive to foreign investors because it improves investment returns and attracts investment capital.

•

Public debts and deficits: Countries with large public-sector debts and deficits are less attractive to foreign investors for a variety of reasons. –

First, such debts give the government an incentive to allow inflation to grow – higher inflation means that the government can repay these debts with cheaper dollars.

–

Second, governments must often turn to foreigners to finance those deficits if domestic savings are insufficient – this involves selling government bonds or Treasury bills. This increases the supply of securities outstanding and lowers their price.

–

Third, such debts may eventually cast doubt on the government’s ability to repay them. This raises the threat of default and reduces foreigners’ willingness to own these securities. These last two factors also apply to private-sector debt.

Thus, countries with a financially sound public sector but heavily indebted private sector may also see their currencies suffer. For these reasons, decisions by debt-rating agencies, such as Moody’s, Standard & Poor’s and DBRS, often have an impact on the exchange rate. •

Political stability: Investors seldom like to invest in countries with unstable or disreputable governments, or those at risk of disintegrating politically. Thus, political turmoil in a country can cause a loss of confidence in its currency and a “flight to quality” to the currencies of more politically stable countries.

TYPES OF EXCHANGE RATES

A number of different exchange rate systems or regimes exist in the world. The most common are fixed and floating. Under a fixed exchange rate, a country’s central bank maintains the domestic currency at a fixed level against another currency or a composite of other currencies.


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Most advanced countries, including Canada and the U.S., have a floating exchange rate. In such a system, the central bank allows market forces to determine the value of the currency. The central bank may intervene if it thinks movements in the exchange rate are excessive or disorderly. The Bank of Canada has occasionally used interest rates to halt free-falls in the Canadian dollar because of the threat such a fall poses either to orderly markets or inflation. Example: If interest rates in Canada rise relative to rates in the U.S., Canadian dollar–denominated assets may become more attractive to investors. If this is the case, the demand for Canadian dollars increases and the exchange rate appreciates in value. Similarly, if interest rates in Canada fall relative to U.S. rates, investors transfer out of Canadian investments and into U.S. dollar–denominated investments. This has the effect of increasing the supply of Canadian dollars and leads to a depreciation in the currency.

Complete the following Online Learning Activity International Economics Canada’s economy depends significantly on trade. As a result, the economic performance of our trading partners is an important determinant of Canadian economic growth. This activity will reinforce your understanding of how trade, the balance of payments and exchange rates affect the Canadian economy. Complete the International Economics activity.


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2.

Define economics, identify the decision makers in an economy, and describe the process for achieving market equilibrium. •

Economics is fundamentally about understanding the choices individuals make and how the sum of those choices affects our market economy. Whether it is the purchase of groceries, a home or stocks and bonds, this interaction ultimately takes place within organized markets.

•

The three main decision makers in the economy are consumers, companies and governments. While consumers set out to maximize their well-being and firms aim to maximize profits, governments set out to maximize the public good.

•

The forces of demand and supply and the interaction between buying and selling decisions by consumers ultimately leads to market equilibrium, and this is the price at which we buy and sell goods and services.

Define gross domestic product (GDP), explain how GDP is measured, and list the factors that lead to growth in GDP. •

Economic growth is an economy’s ability to produce greater levels of output over time and is expressed as the percentage change in a nation’s GDP. GDP is the market value of all finished goods and services produced within a country in a given time period, usually a year or a quarter.

•

There are two ways to measure GDP. The expenditure approach measures GDP as the sum of personal consumption, investment, government spending, and net exports of goods and services. The income approach measures GDP as the total income earned producing those goods and services.

•

Growth in GDP is tied to increases in population over time, increases in the capital stock, and improvements in technology.



3.

4.

5.

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Describe the phases of the business cycle, distinguish among the economic indicators used to analyze business conditions, and identify the determinants of long-term economic growth. •

There are five phases to a typical business cycle: recovery, expansion, peak, recession and trough.

•

Various leading, lagging and coincident economic indicators are used to analyze business conditions and current economic activity. They are useful to show whether the economy is expanding or contracting. For example, the combination of higher new housing starts, new orders for durable goods, and an increase in furniture and appliance sales suggests an economy that is moving from recovery to expansion.

•

Improvements in long-term economic growth are attributed to improvements in productivity. Productivity growth has major implications for the overall wealth of an economy, as there is a direct relationship between the amount of output generated per worker and the standard of living of a typical family.

Compare and contrast the two key indicators of the labour market in Canada and the three main types of unemployment. •

The participation rate represents the share of the working-age population that is in the labour force. The unemployment rate represents the share of the labour force that is unemployed and actively looking for work.

•

Cyclical unemployment is the result of fluctuations in the business cycle. Frictional unemployment is the result of normal labour turnover, for example, from people entering and leaving the work force and from the ongoing creation and destruction of jobs. Structural unemployment occurs when workers are unable to find work or fill available jobs because they lack the necessary skills, do not live where jobs are available, or decide not to work at the wage rate offered by the market.

Describe the determinants of interest rates and discuss how interest rates affect the performance of the economy. •

A broad range of factors influences interest rates: demand for and supply of capital, default risk, central bank operations, foreign interest rates and inflation.

•

Higher interest rates raise the cost of capital for consumers and businesses. This discourages consumers from spending and borrowing money to purchase, for example, homes, cars, and other big-ticket items. Businesses forgo taking part in expansion projects or other forms of investment. Thus, higher rates lead to slower economic growth.

•

In contrast, lower interest rates have an expansionary effect on the economy.


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6.

Define inflation, calculate the inflation rate using the Consumer Price Index (CPI), and analyze the causes and effects of inflation, disinflation and deflation on an economy. •

Inflation is a generalized, sustained trend of rising prices measured on an economy-wide basis. A one-time jump in prices caused by an increase in the price of a good or service is not inflation unless it ultimately leads to higher wages and other costs felt throughout the economy.

•

The CPI is considered a measure of the cost of living in Canada. The CPI can be used to measure the inflation rate: Current CPI – Previous CPI q100 Inflation Previous CPI

7.

•

Inflation erodes the standard of living for those on a fixed income, it reduces the real value of investments because the loans are paid back in dollars that buy less, and it distorts the signal that prices send to participants in the market. Rising inflation typically brings about rising interest rates and slower economic growth.

•

Disinflation is a decline in the rate at which prices rise, meaning a decrease in the rate of inflation. The Phillips curve can be used to gauge the potential costs of disinflation.

•

Deflation is a sustained fall in prices where the annual change in the CPI is negative year after year. Although falling prices are generally good for the economy, a sustained fall in prices can have negative implications for corporate profits and the economy.

Define the accounts included in a country’s balance of payments, describe the determinants of the exchange rate, and explain the impact the balance of payments and the exchange rate have on the economy. •

The balance of payments is a detailed statement of a country’s economic transaction with the rest of the world.

•

The current account records the exchange of goods and services between Canadians and foreigners, the earnings from investment income, and net transfers.

•

The capital and financial account records financial flows between Canadians and foreigners, related investments by foreigners in Canada, and investments by Canadians abroad.

•

The exchange rate is the price of one currency in terms of another. The key determinants of the exchange rate include inflation differentials, interest rate differentials, the current account, economic performance, public debt and deficits, and political stability.








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Chapter

5

Economic Policy


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5 Economic Policy

CHAPTER OUTLINE What are the Different Economic Theories? • Rational Expectations Theory • Keynesian Theory • Monetarist Theory • Supply-Side Economics What is Fiscal Policy? • The Federal Budget • How Fiscal Policy Affects the Economy What is the Role of the Bank of Canada? • Role of the Bank of Canada • Functions of the Bank of Canada What is Monetary Policy? • Implementing Monetary Policy • Open Market Operations • Cash Management Operations What are the Challenges of Government Policy? • The Consequences of Failed Fiscal Policy Summary

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LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Compare and contrast the rational, Keynesian, monetarist and supply-side theories of the economy. 2. Analyze the mechanisms by which governments establish fiscal policy and evaluate the impacts of fiscal policy on the economy. 3. Explain the role and functions of the Bank of Canada. 4. Analyze how the Bank of Canada implements and conducts monetary policy. 5. Discuss the challenges governments face in their fiscal and monetary policies and the consequences of failed policy.

ROLE OF ECONOMIC THEORIES In February each year, the Federal Minister of Finance announces the government’s budgetary requirements, which is its annual fiscal policy score card of spending and taxation measures. Not far from Parliament Hill, the Bank of Canada watches over the economy and uses monetary policy and its influence over interest rates and the exchange rate to maintain balance. Although the government and the Bank operate mostly independently of one another, both have a goal of creating conditions for long-term, sustained economic growth. This chapter builds on information in the previous chapter about the principles of economics to explore the benefits and costs of fiscal and monetary policy, particularly from the standpoint of making investment decisions. For example, if you believe the economy is moving through expansion into the peak phase of the business cycle, what investments or strategies would you pursue given the policy action the Bank of Canada is likely considering? If the economy has been stalled in recession and unemployment continues to rise, what fiscal policy options is the federal government likely to consider? Understanding what route economic policy will follow is a factor in making investment decisions. It is important, therefore, to be familiar with the fiscal and monetary policy options available to the government and how these policy actions will affect financial markets.


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KEY TERMS Bank rate

Monetarist theory

Basis points

Monetary policy

Budget deficit

National debt

Budget surplus

Overnight rate

Canadian Payments Association (CPA)

Rational expectations theory

Drawdown

Redeposit

Fiscal agent

Sale and Repurchase Agreements (SRAs)

Fiscal policy

Special Purchase and Resale Agreements (SPRAs)

Keynesian economics

Supply-side economics

Large Value Transfer System (LVTS)

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FIVE • ECONOMIC POLICY

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WHAT ARE THE DIFFERENT ECONOMIC THEORIES? Prior to the 1930s, most economists believed that the market followed a self-correcting mechanism and would automatically adjust to temporary imbalances. Left to these built-in stabilizers, market adjustments would quickly move the economy from recession to a stable growth path. Over the years, a number of theories have been put forward to help us better understand the workings of the economy.

Rational Expectations Theory Rational expectations theory suggests that firms and workers are rational thinkers and can evaluate all the consequences of a government policy decision, thereby neutralizing the intended impact of the policy. Example: Suppose the government decides to cut taxes temporarily in order to boost consumer spending and improve economic conditions. If consumers behave rationally, they will realize that the tax cut will create a deficit that eventually has to be repaid with higher taxes. Instead of spending the tax cut, they save it to repay future taxes, and the government’s move has no impact.

Keynesian Theory Keynesian economics advocates the use of direct government intervention as a means of achieving economic growth and stability. British Economist John Maynard Keynes offered an alternative to the view that the economy worked best when left to its own devices. Example: Consider the case when the economy enters a recession. Keynesians advocate an increase in government spending or lower taxes to raise consumer income. With more money in their pockets, consumers increase their spending on goods and services. To meet the higher consumer demand for their products, businesses hire more workers to expand production and unemployment falls. Lower unemployment leads to a further increase in consumer income and spending. The increase in income and spending may continue for some time. However, once policymakers believe that spending is rising too quickly, policy will change to reflect lower government spending and higher taxes.

The analysis Keynes put forward became the rationale for the use of government spending and taxation to stabilize the business cycle. When spending was insufficient and a recession loomed, government would pursue a policy of increased spending and lower taxes. During an economic boom and when higher spending threatened inflation, government policy would change in favour of lower spending and higher taxes.


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Monetarist Theory Monetarist theory suggests that the economy is inherently stable and, left to its own selfadjusting mechanism, will automatically move to a stable path of growth. In contrast to the Keynesian view, the Monetarist movement, led by American economist Milton Friedman in the late 1950s, held that instability in the money supply is the major cause of fluctuations in real GDP and that rapid money supply growth is the major cause of inflation. In fact, it was Friedman who coined the phrase “inflation is always and everywhere a monetary phenomenon.” Example: Monetarists believe that instead of pursuing active monetary or fiscal policy, the central bank should simply expand the money supply at a rate equal to the economy’s long-run growth rate – somewhere in the neighbourhood of 2% to 3% per year, for example. According to this view, controlling inflation as the main policy goal creates a foundation for the economy to grow at its optimal rate.

Supply-Side Economics According to supply-side economics, to foster an environment of prosperity, the market should be left on its own and government intervention should be held to a minimum. Although there are similarities with the monetarist view, “supply-siders” suggest that government intervention should only occur through changes in tax rates. Example: Specifically, this view advocates that changes in tax rates exert important effects over supply and spending decisions in the economy. They maintain that reducing both government spending and taxes provides the stimulus for economic expansion. Reducing taxes and the size of the government would help to fuel economic expansion. According to supply-siders, a reduction in marginal tax rates stimulates investment in the economy and ultimately leads to a higher level of output.

Complete the following Online Learning Activity Economic Theories In this activity, you will review the various economic theories that have been put forward to help us better understand the workings of the economy. Complete the Economic Theories activity to review each of the economic theories that drive current policy.



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WHAT IS FISCAL POLICY? Governments, through their power to tax, spend, and borrow, exercise enormous influence on the economy. Since the end of the Second World War, most Western governments have taken it for granted that one of their mandates is to smooth out the fluctuations in the business cycle. Fiscal policy is the use of the government’s spending and taxation powers to pursue such economic goals as full employment and sustained long-term growth. They do this by spending more and taxing less when the economy is weak, and by spending less and taxing more when the economy is strong. Both the federal and provincial governments play a role in Canadian fiscal policy. Both have responsibility for certain areas of activity. The federal government is responsible for such things as employment insurance, defence, old age security, veterans’ affairs and native affairs. The provincial governments are responsible for health, education and welfare. However, the federal government shares some responsibility for those areas with the provinces. A large segment of its spending consists of transfer payments to the provincial governments to pay for health, education and welfare. At times, federal deficit reduction efforts result in cuts to these transfers, putting upward pressure on provincial deficits, since the provinces have little other revenue to compensate for the loss of transfers. Federal and provincial governments oversee important areas of spending that do not appear on their respective budgets. These include the Canada and Quebec Pension Plans, Workplace Safety and Insurance Board, the Export Development Corp., and a wide range of other crown corporations ranging from Canada Post to Quebec’s Société générale de financement. In theory, most of these agencies are meant to be self-supporting. In practice, many accumulate large deficits or unfunded liabilities, which are the responsibility of the government that runs the agency or corporation.

The Federal Budget Early each year, usually in February, the federal Minister of Finance presents to the House of Commons the federal budget for the upcoming fiscal year, which runs from April 1 to March 31. The budget contains projections for the coming year, and usually for at least one subsequent year, for spending, revenue, the amount of the projected surplus or deficit, and debt. An important part of the budget is the economic assumptions that underlie projections for tax revenue, debt service costs and other parts of the budget. The government’s budget balance is equal to its revenues less its total spending. •

If the revenue collected during the year exceeds spending for the year, the government has a budget surplus.

•

If total spending for the year is higher than the revenue collected, the government has a budget deficit for the year.

•

Accordingly, if the revenue collected for the year equals total spending, the government has a balanced budget. When the government runs a budget deficit, it must borrow to make up the difference by selling government bonds and Treasury bills into the market.


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•

The accumulation of total government borrowing over time is referred to as the government debt or the national debt. It is the sum of past deficits minus the sum of past surpluses.

The amount of the surplus or deficit is the most important number in the budget, because it tells markets the extent to which the government will be borrowing in the coming year and how it will compete with other borrowers for funds. If the government predicts a deficit, the amount projected in the budget may differ from what the government actually borrows in the debt market (called its financial requirements) for several reasons: •

Previously issued bonds that mature in the coming fiscal year must be refinanced. Since this is not new borrowing, it is usually not included in projected financial requirements.

•

The government has access to several special-purpose accounts for funds. These alternatives reduce its dependence on debt markets. The most important source of such funds is the civil service pension fund. This is the main reason financial requirements are usually less than the deficit.

How Fiscal Policy Affects the Economy Fiscal policy affects the economy in several ways: •

Spending: Governments can purchase goods or services themselves, such as a new highway, thereby boosting economic activity. Or they can simply transfer money to citizens to spend or save themselves, such as with social security cheques. Only the first type is recorded as government spending in GDP.

•

Taxes: The amount of tax collected may vary because the size of the tax base changed, i.e., the number of people or companies paying the tax expanded or contracted. Also, it can vary because the tax rate changed, so that each dollar of economic activity yields more or less tax. Raising tax rates reduces the disposable income of consumers, thereby dampening their spending. The main types of taxes are: –

Direct taxes, levied on the income of individuals and companies;

–

Sales taxes (including value-added taxes, like the goods and services tax, and excise taxes, such as on liquor);

–

Payroll taxes, levied as a share of wages;

–

Capital taxes, levied on the size of a company’s assets or capital;

–

Property taxes, levied on residential and commercial property.

All taxes tend to discourage the type of activity being taxed. Income taxes reduce the incentive to work and earn; payroll taxes reduce the incentive to hire; and sales taxes reduce the incentive to spend. Persistent deficits emerged during the 1980s and the annual deficit grew considerably. Unfortunately, a vicious circle emerged: the deficit led to increased borrowing; this led to a larger national debt and larger interest payments to service the debt; and these larger interest payments led to a larger deficit and a larger debt. In fact, it was not until 1997 that the federal government finally managed to run a surplus.


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EXHIBIT 5.1

FEDERAL GOVERNMENT DEBT AS A PERCENTAGE OF GDP

From its dollar peak of $563 billion in 1996–1997, the federal debt has declined by $100 billion to $463 billion as of March 31, 2009. This is good news from a global perspective, as Canada’s federal debt as a percentage of GDP fell significantly over the past decade. The debt-to-GDP ratio is regarded as a sound measure of a nation’s overall debt burden because it measures the debt relative to the ability of the government and the nation’s taxpayers to finance it. The figure shows the federal government debt as a percentage of GDP for Canada from 1975 to the end of the 2008-2009 fiscal year.

80 70

Debt-to-GDP (%)

60 50 40 30 20 10 1975

1980

1985

1990

1995

2000

2005

2010

Year Source: Annual Financial Report of the Government of Canada, Fiscal Year 2008-2009.

As a share of GDP, federal debt dropped to 32.8 % in 2008-2009, down from its peak of 68.4% in 1995–1996. The debt-to-GDP ratio has steadily declined over the last 15 years, and is now back to the levels of early 1980s.


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Complete the following Online Learning Activity Fiscal Policy Macroeconomic policies fall into two categories: monetary policy and fiscal policy. Monetary policy uses interest rates, exchange rates and the money supply to influence consumer demand and control inflation. Fiscal policy tries to regulate growth through government taxation and spending. In this activity on fiscal policy, you will review the policy-making process and who makes the decisions, and learn more about how fiscal policy affects the economy. Review Fiscal Policy with this activity.

WHAT IS THE ROLE OF THE BANK OF CANADA? The Bank of Canada (the Bank) was founded in 1934 and began operations in 1935 as a privately owned corporation. By 1938, ownership passed to the Government of Canada. Responsibility for the affairs of the Bank of Canada rests with a Board of Directors composed of the Governor, the Senior Deputy Governor and twelve Directors from outside the Bank.

Role of the Bank of Canada The duties and role of the Bank are stated in a general way in the preamble of the Bank of Canada Act: •

“To regulate credit and currency in the best interests of the economic life of the nation...

•

To control and protect the external value of the national monetary unit...

•

To mitigate by its influence fluctuations in the general level of production, trade, prices and employment, as far as may be possible within the scope of monetary action and generally...

•

To promote the economic and financial welfare of the Dominion.”

The Act does not specify the manner in which the Bank should pursue these objectives but it (and other legislation) grants powers to the Bank which are designed to enable it to fulfill its role. While the Bank administers policy independently without day-to-day Government intervention, the thrust of policy is the ultimate responsibility of the elected Government.



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Functions of the Bank of Canada The major functions of the Bank of Canada are: •

To act for the Government in the issuance and removal of bank notes;

•

To act as the Government’s fiscal agent (i.e., being the Government’s financial advisor on debt management, foreign exchange and monetary policy and acting as its agent in financial transactions); and

•

To conduct monetary policy (i.e., managing the supply of the nation’s money). This is the Bank’s most important function.

As fiscal agent to the Government, the Bank has a variety of functions. The Bank administers the Government’s deposit accounts and funds. This includes: •

Deposit accounts with the Bank of Canada and the chartered banks in which Government cash is held; and

•

The Exchange Fund Account, which holds the Government’s foreign exchange reserves.

Almost all of the Government’s Canadian dollar receipts and expenditures flow through the account it maintains at the Bank of Canada. The Bank manages Canada’s official international currency reserves. It operates for the Government in foreign exchange markets in keeping with its mandate “to control and protect the external value of the national monetary unit.” The Bank of Canada Act empowers the Bank to: •

Buy and sell gold, silver and foreign exchange;

•

Maintain deposits with other central banks and commercial banks inside and outside Canada; and

•

Act as agent and depository for central banks and certain international institutions.

As is the case in connection with monetary policy and debt management, the Bank provides the Government with information and advice and acts as its agent in dealings in gold and foreign exchange. The Bank acts as a depository for gold held by the Exchange Fund Account. It also buys and sells gold. This activity has diminished importance reflecting the marginal role of gold in securing the value of the Canadian dollar. Financial advisor to the Government: The Bank advises the Government on the timing of new federal securities issues. It advises on the price, yield and other special features needed to make them marketable. The Bank also advises the Government about where such securities should be sold (i.e., domestically, in the U.S. or offshore). In order to keep abreast of market developments, the Bank conducts regular discussions with investment dealers, bankers and other investors to obtain views and suggestions.


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Debt management: The Bank of Canada acts as the federal Government’s fiscal agent in its activities in debt management. The planning and arrangements necessary for a new debt issue are major undertakings. Not only must each issue be distributed and sold, arrangements for payments, transfers of funds, etc., must be made. Then there is regular record keeping, payments of interest, transfers of ownership and finally providing funds to repay the issue at maturity. The Minister of Finance is responsible for debt management programs but relies on the Bank for advice and implementation of policy. While there is a wide range of maturities in Government debt, there are two principal categories of debt: marketable (treasury bills and marketable bonds) and non-marketable (Canada Savings Bonds and Canada RRSP Bonds). These securities are discussed in the material on fixed-income products.

Complete the following Online Learning Activity Bank of Canada The Bank of Canada plays a key role in the Canadian economy since its mandate includes: • Regulation of credit and currency; • Control and protection of the external value of the Canadian dollar; • Maintenance of stability in the market; and • Promotion of the economic and financial welfare of Canada. Learn more about the Bank’s role and its function in the Canadian economy in the Bank of Canada activity.

WHAT IS MONETARY POLICY? Monetary policy sets out to improve the performance of the economy by regulating the growth in money supply and credit. The goal of monetary policy is to ensure that money can play its vital role in helping the economy run smoothly. Canadian monetary policy strives to protect the value of the Canadian dollar by keeping inflation low and stable. As Canada’s central bank, the Bank of Canada achieves this through its influence over short-term interest rates. The goal of monetary policy is to preserve the value of money by promoting sustained economic growth with price stability. In other words, growth in levels of employment, consumption and our standard of living generally should be supported by increasing liquidity in the system at a rate that is not inflationary. Over time, inflationary increases erode the value of our currency and ultimately our economic health.



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Since 1991, the Bank has committed to specific inflation-control targets that establish a target range within which it aims to contain annual inflation as measured by the year-over-year rate of increase in the CPI. Currently, the target range extends from 1% to 3%. Here is how the Bank keeps inflation within this range: •

If inflation approaches the top of the target range, this usually indicates that the demand for goods and services is rising too strongly and must be controlled through an increase in shortterm interest rates.

•

If inflation falls towards the bottom of the target range, this usually indicates that economic growth is slowing or weakening and support is needed through a decrease in interest rates.

Over the long run, the rate of inflation is linked to the rate of growth of money and credit. Through its influence over short-term interest rates, the Bank affects the demand for, and supply of, money and credit. The influence of monetary policy on total spending is exerted indirectly and with some time lag – roughly one to two years. Monetary policy must therefore be forward looking. Thus, the Bank conducts monetary policy by consistently aiming their efforts at the midpoint of the target range. That is, by aiming for an inflation rate of 2% over the next 12-month period, the Bank believes it can achieve its inflation-control targets.

Implementing Monetary Policy The Bank of Canada carries out monetary policy primarily through changes to what it calls the Target for the Overnight Rate. The overnight rate is the interest rate set in the overnight market – a marketplace where major Canadian financial institutions lend each other money on an overnight basis. When the Bank changes the target for the overnight rate, other short-term interest rates also usually change. Currently, the overnight rate operates within a 50 basis points (or one-half of a percentage point) wide operating band. Each day, the Bank targets the mid-point of the operating band as its key monetary policy objective. For example, if the operating band is 5% to 5.5%, then the target for the overnight rate is 5.25%. The target is an important policy tool as it may signal a policy shift towards an easing or tightening of monetary conditions in order to meet the Bank’s inflation-control targets. The Bank Rate is the minimum rate at which the Bank of Canada will lend money on a short-term basis to the chartered banks and other members of the Canadian Payments Association (CPA) in its role as lender of last resort. It is closely related to the Target for the Overnight Rate because the Bank Rate is the upper limit of the operating band. Continuing with our example from above, with an operating target range of between 5% and 5.5%, the Bank Rate is 5.5%.


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Figure 5.1 illustrates a hypothetical example of the target range for the overnight rate. FIGURE 5.1

EXAMPLE OF THE BANK OF CANADA’S OPERATING BAND

5.5%

5.25%

Bank Rate

50 basis points target range

5.0% Bank Rate less 50 basis points

Standing arrangements are in place under which the Bank is prepared to provide secured loans (at the Bank Rate) for one business day to the chartered banks and members of the CPA. Such access to central bank credit plays a useful role in providing individual banks and dealers with a safety valve. Such access provides an underlying assurance of liquidity in circumstances when funds are not readily available from other sources. The Bank is accordingly known as the banking system’s lender of last resort.

Open Market Operations The two main open market operations that the Bank uses to conduct monetary policy are Special Purchase and Resale Agreements and Sale and Repurchase Agreements. Special Purchase and Resale Agreements (commonly referred to as SPRAs or “Specials”) are used by the Bank of Canada to relieve undesired upward pressure on overnight financing rates. If overnight money is trading above the target of the operating band, the Bank may believe that the higher rate will dampen economic activity. To combat this, the Bank intervenes and offers to lend at the upper limit of the operating band. For example, if the upper limit of the operating band is 4.25% while overnight money trades at 4.50%, it does not make sense for financial institutions to borrow at the higher overnight rate. SPRAs work as follows: •

The Bank offers to purchase government securities from a primary dealer (such as a chartered bank) with an agreement to sell them back the next day at a predetermined price.

•

When the Bank purchases securities from an institution, they pay the institution cash for the securities. Essentially, the cash payment acts as a very short-term loan.

•

The next day, when the securities are resold to the institution, the Bank receives money in exchange for the securities they are returning.

This operation is used to reinforce the upper limit or top end of the overnight target and is closely watched by market participants.


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Sale and Repurchase Agreements (SRAs) are used to offset undesired downward pressure on overnight financing costs. If overnight money is trading below the target of the operating band, the Bank may believe that inflationary pressures in the economy will rise. To combat this, the Bank intervenes and offers to borrow at the lower limit of the operating band. For this example, if the lower limit of the operating band is 3.75% while overnight money trades at 3.50%, financial institutions would much prefer the Bank of Canada rate. SRAs work as follows: •

The Bank offers to sell government securities to chartered banks with an agreement to repurchase them the next day at a predetermined price.

•

In exchange for the sale, the Bank receives money. Essentially, the Bank is borrowing money from the Chartered Bank when it sells securities under this program.

•

The next day, the Bank repurchases those securities in exchange for the cash. In effect, the money they borrowed is paid back.

This operation is used to reinforce lower the limit or floor of the operating band and is the focus of considerable market attention. On a number of occasions, the offering itself is sufficient to eliminate the downward pressure on the overnight rate. Partly as a result of this, the amounts of SRAs dealt tend to be quite small relative to SPRAs. Figure 5.2 shows that SPRAs are conducted at the top end of the band, which is also the Bank Rate, while SRAs are conducted at the bottom end of the band. FIGURE 5.2

THE OPERATING BAND

SPRA – the Bank lends overnight at the upper limit of the operating band Bank Rate

Operating Band = 50 basis points wide

Bank Rate less 0.50% SRA – the Bank sells securities at the lower end of the operating band

Instead of letting it vary from day to day depending on conditions in the market, the Bank aims to keep the overnight rate within its 50-basis-point range. Financial institutions know that the Bank will always lend money at the upper end of the band, and borrow money at the lower limit of the band. Thus it makes no sense to trade in the overnight market at rates outside this band. It repeatedly conducts similar operations to keep most of the overnight trading within the range.


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If the Bank is changing the range, it enters the market and conducts specials or SRAs at the new ceiling or floor. Alternatively, the Bank allows the overnight rate to move to its new range, then confirms the new target with open market operations. Changes in the overnight band (and therefore, the Bank Rate) are now accompanied by a press release explaining the Bank’s actions. The Bank’s intention is to make such changes as transparent (or clear) as possible to avoid confusion in financial markets.

Cash Management Operations The trend of the Bank Rate is important to both users and suppliers of credit. A rising trend, for example, signals a desire on the part of the Bank to reduce the demand for credit by raising its cost. Administered rates such as prime rates (i.e., chartered bank rates to their prime or most creditworthy borrowers) usually follow the trend of the Bank Rate. EXHIBIT 5.2

THE LARGE VALUE TRANSFER SYSTEM

Each day, billions of dollars flow through the financial system to settle transactions between the major financial institutions. These transactions include cheques, wire transfers, direct deposits, preauthorized debits and bill payments. To facilitate the transfer of these payments, the Bank established the Large Value Transfer System (LVTS) in 1991. This system allows participating financial institutions to conduct large transactions with each other through an electronic wire system. Among other things, this system permits these financial institutions to track their LVTS receipts and payments electronically throughout the day and to know the net outcome of these flows by the end of the day (same day settlement). How the LVTS works This system provides an important setting for conducting monetary policy. Throughout the day, financial institutions in the LVTS send payments back and forth to each other as part of their normal operations. At the end of each day, all of the transactions that occurred during the day are added up, and some financial institutions may end up needing to borrow funds while some may have funds left over. Example: Bank A had $50 million in payments to other financial institutions and $40 million in receipts during the day. At the end of the day, it finds itself in a deficit position of $10 million for that day. Since participants in the LVTS are required to clear their balances with one another each day, Bank A will need to borrow $10 million in funds to cover that position. Bank A will then need to borrow the funds from another participant in the LVTS at the current overnight rate. Overall, the LVTS helps to ensure that trading in the overnight market stays within the Bank’s 50basis-point operating target. LVTS participants know that the Bank will always lend money at the upper limit of the band, and will borrow money at the lower limit of the band. Therefore, it does not make sense for financial institutions in the LVTS to borrow or lend outside of the target band.


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DRAWDOWNS AND REDEPOSITS

The federal government maintains accounts with the Bank of Canada and the chartered banks. As the banker for the federal government, the Bank of Canada can transfer funds from the government’s account at the Bank to its account at the chartered banks or from the government’s account at the chartered banks to its account at the Bank of Canada. This strategy is used to influence short-term interest rates and is achieved using drawdowns or redeposits. •

A drawdown refers to the transfer of deposits to the Bank from the chartered banks, effectively draining the supply of available cash balances from the banking system. This decreases deposits and reserves available to the banks to utilize in their business. Removing money from the system causes a contraction in the availability of loans to consumers and businesses, and this places upward pressure on interest rates.

•

A redeposit is just the opposite, a transfer of funds from the Bank to the chartered banks. This increases deposits and reserves and the availability of funds in the banking system. Adding money to the system places downward pressure on interest and gives banks an incentive to increase loans to consumers and businesses.

Complete the following Online Learning Activity Monetary Policy The Bank of Canada’s key function is to set monetary policy, which means it manages the supply of money in the economy. The Bank needs to ensure that growth in levels of employment and consumption, and in Canadians’ standard of living, is generally supported by increasing liquidity in the system at a rate that is not inflationary. Complete the Monetary Policy exercise to review how the Bank of Canada implements monetary policy.

WHAT ARE THE CHALLENGES OF GOVERNMENT POLICY? Disagreements about the role and nature of government policy are often related to basic differences in analyzing how the economy reacts to changing circumstances. Two attitudes are widespread. The first emphasizes that the economy may be slow to react. As a consequence, interventionist policy may not be effective or even essential in guiding the economy in the right direction. The alternative view emphasizes that the economy makes its way quickly to its natural equilibrium, and that no need exists for policy other than to constrain policy. This difference, for example, is at the heart of the controversy surrounding the role of money growth. Monetary policy may be seen to be effective in the short run but not in the long run. What is unknown is how long is the short run.


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Two sections in Chapter 4 dealt with the evolution of the economy in this framework. The discussion of the short run emphasized the business cycle and the problems posed by downturns in the cycle. The second dealt with the determinants of long-run growth and emphasized the role of technological development in supporting continued gains in productivity. Government policy in the first context is directed towards counter-cyclical initiatives, and in the second context to the development of human capital and the enhancement of technological advances. In recent years, the federal government has dealt successfully with reducing the deficit to the extent that there is some fiscal room to manoeuvre. Ultimately, the policy challenge for the government is to evaluate the competing claims of those who stress the need for intervention and flexible stabilization policies versus those with a more restrictive view of the role of government in guiding the economy. Each choice has both growth and uncertainty implications for the overall Canadian economy, and for the financial investments issued by both governments and corporations.

The Consequences of Failed Fiscal Policy In the past, governments’ failure to address their budget deficits have had several consequences: •

Because governments did not eliminate the deficit when it first emerged seriously in the late 1970s and early 1980s, the cost of interest payments on the national debt began to rise rapidly and remained high through the early 1990s. They were the federal government’s single biggest expenditure throughout most of the 1990s, peaking at 27.1% of total spending in 1998–1999, compared to 10.3% in 1974–1975. In turn, the interest burden made it difficult for the government to reduce the deficit. It did so by drastically cutting total expenditures, especially transfer payments to the provinces. Successive budget surpluses in the 2000s helped to lower the federal government’s overall debt position, with the cost of interest payments falling to about 13% of total expenditures in the government’s 2008-2009 fiscal year.

•

Fiscal policy is often unsynchronized with monetary policy, increasing the cost to the economy. For example, in the late 1980s when the economy was growing strongly and inflationary pressure was building, federal and provincial governments in Canada continued to run large deficits. This tended to increase inflationary pressures and led the Bank of Canada to raise interest rates more than would otherwise have been necessary. In turn, the cost of servicing government debts grew and contributed to increased deficits.

•

In the end, a large national debt constrains the ability of governments to run countercyclical fiscal policy. When debts are large, any move to increase the deficit upsets investors, who sell bonds, driving up interest rates. This reaction reduces the beneficial impact on the economy of the increased deficit. When a recession occurs, the government may cut spending and raise taxes to control its growth and, as a consequence, worsen the recession.



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2.

Compare and contrast the rational, Keynesian, monetarist and supply-side theories of the economy. •

The rational expectations theory suggests that firms and workers are rational thinkers and can evaluate all the consequences of a government policy decision, thereby neutralizing its intended impact.

•

Keynesian economics advocates the use of direct government intervention to achieve economic growth and stability. Keynesians believe the use of active fiscal policy, using government spending and taxation, is necessary to stabilize the business cycle.

•

Monetarist theory suggests that the economy is inherently stable, with its own selfadjusting mechanism that automatically moves the economy to a stable path of growth. Monetarists argue against the use of active monetary or fiscal policy and believe the central bank should simply expand the money supply at a rate equal to the economy’s long-term growth rate.

•

Supply-side economics suggests that to foster an environment of prosperity, the market should be left alone and government intervention should be minimal, only occurring through changes in tax rates. This theory maintains that lower government spending and lower taxes provide the stimulus for economic expansion.

Analyze the mechanisms by which governments establish fiscal policy and evaluate the impacts of fiscal policy on the economy. •

Fiscal policy is the use of government spending and taxation to pursue full employment and sustained long-term growth. In general, governments pursue this goal by spending more and taxing less when the economy is weak, and by spending less and taxing more when the economy is strong.

•

In Canada, the federal budget is the key mechanism through which the government conducts fiscal policy. The budget contains projections for the coming year for spending, revenue, and the amount of the projected surplus or deficit.


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3.

4.

Explain the role and functions of the Bank of Canada. •

The role of the Bank of Canada is to monitor, regulate and control short-term interest rates and the external value of the Canadian dollar.

•

The major functions of the Bank of Canada include the issue and removal of bank notes, acting as fiscal agent and financial advisor for the Federal Government, and the implementation of monetary policy.

•

The goal of monetary policy is to improve the performance of the economy by regulating growth in the money supply and credit. The Bank of Canada achieves this through its influence over short-term interest rates.

Analyze how the Bank of Canada implements and conducts monetary policy. •

In Canada, monetary policy involves following specific inflation-control targets that establish a range within which to contain annual inflation. Currently, the target range is 1% to 3%.

•

The Bank uses the target for the overnight rate to implement changes in the direction of monetary policy. The overnight rate is the interest rate set in the overnight market. When the Bank changes the target for the overnight rate, other short-term interest rates also tend to change.

•

Special Purchase and Resale Agreements (SPRAs) and Sale and Repurchase Agreements (SRAs) are the two main open market operations used by the Bank to conduct monetary policy. – SPRAs are used to relieve undesired upward pressure on the overnight rate. If overnight money trades above the target of the operating band, the Bank intervenes and offers to lend at the upper limit of the band. This action effectively reinforces the upper limit of the overnight target. – SRAs are used to offset undesired downward pressure on the overnight rate. If overnight money is trading below the target of the operating band, the Bank intervenes and offers to borrow at the lower limit of the band. This action effectively reinforces the lower limit of the overnight target.

•

The Bank established the Large Value Transfer System (LVTS) in 1991 to facilitate its cash management operations. This system allows participating financial institutions to conduct large transactions with each other through an electronic wire system. This system provides an important setting to conduct monetary policy.

•

A drawdown is the transfer of deposits to the Bank from the chartered banks, effectively draining the supply of available cash balances from the banking system. This causes a contraction in the availability of loans to consumers and businesses, which places upward pressure on interest rates.

•

A redeposit is the transfer of funds from the Bank to the chartered banks, effectively increasing deposits and reserves and the availability of funds in the banking system, which places downward pressure on interest rates.


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5.

Discuss the challenges governments face in their fiscal and monetary policies and the consequences of failed policy. •

One challenge the government faces is that the economy may be slow to react to policy changes. As a consequence, interventionist policy may not be effective or even essential in guiding the economy in the right direction.

•

A second challenge is the view that the economy makes its way quickly to its natural equilibrium, and that no need exists for policy other than to constrain policy.

•

Interest payments on the national debt were the federal government’s single biggest expenditure throughout most of the 1990s. However, successive budget surpluses in the late 2000s helped to lower the federal government’s overall debt position.

•

Fiscal and monetary policies are often unsynchronized, increasing the cost to the economy. The late 1980s saw rising provincial and federal deficits at a time when the economy was growing strongly and inflationary pressure was building.

•

The Bank of Canada responded by raising interest rates, which resulted in higher debt servicing costs for governments.






SECTION

III

Investment Products


Chapter

6

Fixed-Income Securities: Features and Types


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6 Fixed-Income Securities: Features and Types

CHAPTER OUTLINE What is the Fixed-Income Marketplace? • The Rationale for Issuing Fixed-Income Securities What are the Basic Features and Terminology of Fixed-Income Securities? • Basic Terminology • Describing Bond Features • Liquid Bonds, Negotiable Bonds and Marketable Bonds • Strip Bonds • Callable Bonds • Extendible and Retractable Bonds • Convertible Bonds and Debentures • Sinking Funds and Purchase Funds • Protective Provisions of Corporate Bonds What are Government of Canada Securities? • Marketable Bonds • Treasury Bills • Canada Savings Bonds • Canada Premium Bonds • Real Return Bonds

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What are Provincial and Municipal Government Securities? • Guaranteed Bonds • Provincial Securities • Municipal Securities What are Corporate Bonds? • Mortgage Bonds • Collateral Trust Bonds • Equipment Trust Certificates • Subordinated Debentures • Floating-Rate Securities • Corporate Notes • Domestic, Foreign and Eurobonds • Preferred Securities • High-Yield Bonds What are some Other Fixed-Income Securities in the Marketplace? • Bankers’ Acceptances • Commercial Paper • Term Deposits • Guaranteed Investment Certificates • Fixed-Income Mutual Funds and ETFs How to Read Bond Quotes and Ratings? Summary


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LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Describe the fixed-income market and discuss the rationale for issuing debt instruments. 2. Define the terms used in transactions involving bonds, describe bond features, explain the use of a sinking fund and a purchase fund, and describe the protective provisions found in a bond indenture. 3. Compare and contrast the types of Government of Canada securities. 4. Compare and contrast the different types of provincial government securities and municipal debentures. 5. Identify the different types of corporate bonds and describe their features. 6. Describe the features of other fixed-income securities, including bankers’ acceptances, commercial paper, term deposits and guaranteed investment certificates. 7. Interpret bond quotes and summarize and evaluate bond ratings.

INVESTING IN DEBT Governments, corporations and many other entities borrow funds to finance and expand their operations. In addition to bank lending and private loans, these entities also have the option of issuing fixed-income securities in the financial markets. From the investor’s perspective, purchasing a fixed-income security essentially represents the decision to lend money to the issuer. Investors become creditors of the issuing organization and do not gain ownership rights as they would with an equity investment. Many investors overlook the fixed-income market. Trading activity on the TSX and other international stock markets grabs most of the investing public’s attention. Trading in bonds, Treasury bills and other fixed-income securities tends to be less enticing because these are not the very public price spikes that are seen in, for example, the shares of small capitalization companies. Most investors would be surprised to learn the extent of the fixed-income market. To put it in perspective, the dollar amount traded on Canada’s bond markets consistently averages about ten times that of total equity trading in any given year. In spite of that value and because they are less visible than the equity markets, bond and fixed-income markets generally remain off the radar screens of most investors. Further, investors generally lack an understanding of the features, characteristics and terminology of the fixedincome market. In this first chapter on fixed-income securities, we look at the terminology, describe the reasons governments and corporations issue fixed-income securities, and describe the features and characteristics of the securities available in the fixed-income markets.

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KEY TERMS After-acquired clause

Guaranteed Investment Certificates (GICs)

Bond

Instalment debenture

Callable bond

Maturity date

Canada Premium Bonds (CPBs)

Moody’s Canada Inc.

Canada Savings Bonds (CSBs)

Mortgage

Canada yield call

Par value

Collateral trust bond

Payback period

Conversion price

Principal

Convertible bonds

Purchase fund

Coupon rate

Real return bonds

Debenture

Redeemable bond

DBRS

Retractable Bond

Election period

Serial bond

Equipment trust certificate

Sinking funds

Eurobonds

Standard & Poor’s Bond Rating Service

Extendible bonds

Strip Bond

Extension date

Subordinated debentures

Face value

Term to maturity

First mortgage bond

Treasury bills

Fixed-income securities

Trust deed

Floating-rate securities

Yield

Forced conversion

Zero coupon bond

Foreign bonds


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WHAT IS THE FIXED-INCOME MARKETPLACE? Fixed-income securities represent debt of the issuing entity. The terms of a fixed-income security include a promise by the issuer to repay the maturity value or principal on the maturity date, and to pay interest either at stated intervals over the life of the security or at maturity. In most case, if the security is held to maturity, the rate of return is fairly certain. Fixed-income securities trading in the market today come in a multitude of varieties, including bonds, debentures, money market instruments, mortgages, and even preferred shares, reflecting widely different borrowing needs as well as investor demands. Borrowers modify the terms of a basic fixed-income security to suit both their needs and costs, and to provide acceptable terms to various lenders. Many Canadians are concerned about high government debt levels. We know that corporate debt can lead to bankruptcy and personal debt can keep individuals from getting ahead financially. It is useful to explore the rationale for borrowing money. There are two main reasons: •

To finance operations or growth

•

To take advantage of operating leverage

If a government spends more on programs and other payments than it receives in tax revenue, it must make up the difference by borrowing money. Most governments borrow by issuing fixedincome securities. Government borrowing is an example of issuing fixed-income securities to finance operations.

The Rationale for Issuing Fixed-Income Securities Unlike governments, companies have more options when they find themselves spending more on expenses than they receive in revenue; issuing fixed-income securities is only one option. They can also use cash on hand, raise cash by selling assets, borrow from the bank, or issue equity securities. The choice of financing method will depend on the costs associated with each. Companies generally prefer to raise money from the lowest-cost source possible. In many cases, companies do not issue fixed-income securities to finance year-to-year cash shortfalls. These will usually be financed with cash on hand or bank borrowing. A company that consistently finds itself using more cash than it takes in will not be in business for too long. Most companies issue fixed-income securities to finance growth. This usually means using the proceeds of a fixed-income issue to add to or expand the companies’ current operations, or to buy other companies. When companies announce a new bond issue, they usually say why they are issuing the bond. If it is not being issued to buy another company or other specific assets, they will usually state that the proceeds will be used for “general corporate purposes.” This typically means that the company will invest the proceeds in current operations. Companies also borrow to take advantage of operating leverage. If companies believe they can earn a greater return on cash invested in their business than it would cost to borrow money, they can increase the return on shareholders’ equity by borrowing money. This is what is meant by financial leverage. The analysis that determines whether to use leverage is made on an after-tax basis. This increases the leverage potential of bonds because, unlike dividends on equity securities, the interest payments on bonds are a tax-deductible expense for the corporation. © CSI GLOBAL EDUCATION INC. (2013)

SIX • FIXED-INCOME SECURITIES: FEATURES AND TYPES

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Example: Suppose a company wants to open a new plant to increase production capacity. It could borrow $1 million for the plant at 10% interest, at a cost of $50,000 a year after tax. If the expanded capacity is expected to increase after-tax profits by more than $50,000 a year, the company will probably proceed with the project. If the after-tax profits are projected to be less than $50,000 a year, the company will either abandon the project or find a cheaper source of funds.

WHAT ARE THE BASIC FEATURES AND TERMINOLOGY OF FIXED-INCOME SECURITIES? A bond is a long-term, fixed-obligation debt security that is secured by physical assets. The details of a bond issue are outlined in a trust deed and written into a bond contract. Bonds are considered fixed-income securities because they impose fixed financial obligations on issuers – the payment of regular interest payments and the return of principal on the date of maturity. If the bond goes into default, which means the issuer can no longer meet these fixed obligations, the trust deed provisions allow the bondholders to seize specified physical assets and sell them to recover their investment. These physical assets could be a building, a railway car, or any other physical property owned by the issuing company. A debenture is a type of bond that promises the payment of regular interest and the repayment of principal at maturity but may be secured by something other than a physical asset. For this reason, debentures are also referred to as unsecured bonds. In contrast to regular bonds, debentures are typically secured by a general claim on residual assets or by the issuer’s credit rating. In this chapter, we follow the industry practice of referring to both types as bonds, unless the difference is important. For example, government bonds are never secured by physical assets, and so technically are really debentures, but in practice they are always referred to as bonds.

Basic Terminology Exhibit 6.1 summarizes the important characteristics of a bond. EXHIBIT 6.1 SUMMARY OF THE MAIN CHARACTERISTICS OF A BOND A $1,000, 6%, semi-annual coupon bond due May 1, 2025 will pay $30 to the bondholder on May 1 and on November 1 of each year until maturity. The semi-annual payment of $30 represents the fixed obligation the issuer is required to make for the life of the bond. The yield on the bond on May 1, 2012 is 5.2% and trades at a price of 107.491 for a total cost of $1,074.91. Where: $1,000

The face or par value of the bond – the principal amount the bond issuer contracts to pay at maturity to the bond holder. Upon maturity, the issuer will pay back to the investor the principal amount of $1,000.

6%

The coupon rate – the rate at which the bond issuer pays regular interest. Most bonds pay fixed coupon rates.


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EXHIBIT 6.1

SUMMARY OF THE MAIN CHARACTERISTICS OF A BOND – Cont’d

May 1, 2025

The maturity date – the date at which the bond matures and the principal amount of the loan is paid back to the investor holding the bond. On May 1, 2012, the term to maturity in the example above is 13 years.

107.491

The price of the bond – bond prices are quoted using an index with a base value of 100. In the example above, the bond is quoted at a price of 107.491, which means each $100 of face value will cost $107.491 to purchase. Based on the quoted price of 107.491, the price of a $1,000 face value bond is currently 107.491% of its face value, or $1,074.91 (107.491/100 x $1,000). Another way of thinking about the price: a $1,000 face value bond has 10 units of $100 face value, and therefore costs 10 x $107.491.

5.2%

The yield – the bond yield is an approximate measure of the annual return on the bond if it is held to maturity.

Describing Bond Features Interest on Bonds: While most bonds pay a fixed coupon rate, bonds with variable coupon rates are typically referred to as floating-rate securities. The coupon indicates the income that the bond investor will receive from holding the bond, and is also referred to as interest income, bond income or coupon income. Interest payment provisions may also take other forms: •

Coupon rates can change over time, according to a specific schedule (e.g., step-up bonds, most savings bonds).

•

There may be no periodic coupon interest – interest can be compounded over time, and paid at maturity (e.g., zero-coupon bonds, strip coupons and residuals).

•

A rate of interest does not have to be applied – the loan can be compensated in the form of a return based on future factors, such as the change in the level of an equity index. These securities are known as index-linked notes.

In North America the majority of bonds pay interest twice a year at six-month intervals. Other bonds may pay interest monthly or annually (for the purposes of this course, one should assume that bonds pay interest semi-annually unless stated otherwise). In all cases, the amount of interest at each payment date is equal to the coupon rate divided by the number of payments per year. Denominations: Bonds can be purchased only in specific denominations. The most commonly used denominations are $1,000 or $10,000. Larger denominations may be issued to suit the preference of investing institutions such as banks and life insurance companies. Normally, an issue designed for a broad retail market is issued in small denominations. An issue for institutional investors may be made available in denominations of millions of dollars.


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Bond pricing: A bond trading at a quoted price of 100 is said to be trading at face value, or par. A bond trading below par, say at a price of 98, is said to be trading at a discount (the 98, based on the index of 100, indicates the bond is trading at 98% of par). A bond trading above par, say at a price of 104, is said to be trading at a premium. The yield of a bond should not be confused with the coupon rate; they are two different things. While the coupon rate, along with the face value and maturity date, do not change, the price and yield of a bond fluctuates from day to day. Given the yield and the coupon rate, the following relationships hold: •

If the yield is greater than the coupon rate, the bond is trading at a discount.

•

If the yield is equal to the coupon rate, the bond is trading at par.

•

If the yield is less than the coupon rate, the bond is trading at a premium.

Categorizing bonds: Bonds can be grouped into three categories according to their term to maturity. Short-term bonds have less than five years remaining in their term. Bonds with terms of five to ten years are called medium-term bonds, and long-term bonds have a term to maturity greater than ten years. Table 6.1 shows these categories. TABLE 6.1

CATEGORIZATION OF BONDS BY TERM TO MATURITY

Money Market

Short-Term Bonds

Medium-Term Bonds

Long-Term Bonds

Up to one year term to maturity

From one up to 5 years remaining to maturity

From 5 to 10 years remaining to maturity

Greater than 10 years remaining to maturity

Application: If a bond was issued eight years ago with an original term of 15 years, it is no longer referred to as a 15-year bond. Because eight years have passed and only seven remain in the life of the bond, it is referred to as a seven-year bond. This means a bond that is classified as a long-term bond when first issued will, over time, become a medium-term bond, a short-term bond and eventually a Money Market security (provided the bond is not called before its maturity date).

Money market securities are a special type of short-term fixed-income security, generally with terms of one year or less. Certain high-grade short-term bonds may trade as money market securities when their term is reduced to a year or less, but for the most part, money market securities include Treasury bills, bankers’ acceptances and commercial paper.

Liquid Bonds, Negotiable Bonds and Marketable Bonds Liquid bonds are bonds that trade in significant volumes and for which it is possible to make medium and large trades quickly without making a significant sacrifice on the price. Negotiable bonds are bonds that can be transferred because they are in deliverable form (in “good delivery” means the certificates are not torn, a power of attorney has been signed, and so on). That a bond be negotiable is not much of an issue anymore, as most bonds are book-based now and certificates are not issued.


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Marketable bonds are bonds for which there is a ready market. For example, a private placement or other new issue may be marketable (clients will buy it) because its price and features are attractive. It would not necessarily be liquid, however, since most private placements do not have an active secondary market.

Strip Bonds A strip bond or zero coupon bond is created when a dealer acquires a block of high-quality bonds and separates the individual future-dated interest coupons from the rest of the bond (known as the underlying bond residue). The dealer then sells each coupon as well as the residue separately at significant discounts to their face value. Holders of strip bonds receive no interest payments. Instead, the strips are purchased at a discount at a price that provides a certain compounded rate of return when they mature at par. Similar to Treasury bills, the income is considered interest rather than a capital gain and tax must be paid annually on the income, even though the interest income on the bond is not received until the instrument matures. For this reason, it is often recommended that strip bonds be held in a tax-deferred plan such as an RRSP. Example: An investment dealer might buy $10 million face value of a five-year, semi-annual pay Government of Canada bond with a coupon of 5.50%, intending to strip the bond for sale to clients. With this bond, the dealer can create 10 different strip coupons, each with a face value of $275,000 ($10 million × 0.055 × 1/2) and each with a different maturity date, as each coupon will have its own maturity date. The face value of each strip coupon is equal to the dollar value of each interest payment on the regular bond. The bond’s principal repayment can be sold as a residual with a face value of $10 million. The strip coupons are then sold at a discount to the $275,000 face value. For this example, let’s assume that it sells today for $204,626 (bond price calculations are covered in Chapter 7). An investor buying this strip bond today and holding it until maturity receives $275,000 in five years time. The strip bond does not generate any other regular income flow during this five-year period for the investor.

Callable Bonds Bond issuers often reserve the right, but not the obligation, to pay off the bond before maturity, either to take advantage of lower interest rates, or simply to reduce their debt when they have the excess cash to do so. This privilege is known as a call or redemption feature. A bond bearing this clause is known as a callable bond or a redeemable bond. As a rule, the issuer agrees to give 10 to 30 days’ notice that the bond is being called or redeemed. In Canada, most corporate and provincial bond issues are callable. Government of Canada bonds and municipal debentures are usually non-callable. STANDARD CALL FEATURES

A standard call feature allows the issuer to call bonds for redemption at a specified price on specific dates or during specific intervals over the life of the bond. The call price is usually set higher than the par value of the bond. This provides a premium payment for the holder, as it is somewhat unfair to take away from the investor an investment from which he or she expected to


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receive a stated income for a certain number of years. The closer the bond is to its maturity date before it is redeemed, the less the hardship for the investor. In recognition of this principle, the redemption price is often set on a graduated scale and the premium payment becomes lower as the bond approaches the maturity date. Provincial bonds are usually callable at 100 plus accrued interest. Accrued interest refers to the interest that has accumulated since the last interest payment date. Accrued interest belongs to the holder of the bond. Example: DEF Corporation’s call feature (for other than sinking fund purposes) is shown in Table 6.2. In this example, if you owned a $1,000 debenture of this issue and your debenture was called:

• • •

after May 1, 2012, and before or on April 30, 2013, you would receive $1,036.80 plus accrued interest; after May 1, 2013 and before or on April 30, 2014, you would receive $1,024.60 plus accrued interest; and so on, with the premium gradually reduced according to Table 6.2. TABLE 6.2

EXAMPLE OF A CORPORATE DEBT CALL FEATURE

DEF Corporation 7.375% debentures due May 1, 2016. Not redeemable before May 1, 2012. Thereafter, redeemable on 30 days’ notice up to the 12 months ending May 1 of each year, as follows: 2012

103.68

2013

102.46

2014

101.23

2015

100.00

Thereafter redeemable at par to maturity.

For callable bonds, the period before the first possible call date (during which the bonds cannot be called) is known as the call protection period. CANADA YIELD CALLS

Most corporate bonds are issued with a call feature known as a Canada yield call. These allow the issuer to call the bond at a price based on the greater of (a) par or (b) the price based on the yield of an equivalent-term Government of Canada bond plus a yield spread. A yield spread is simply an additional amount of yield. Generally, this spread is less than what the spread was when the bond was issued, and remains constant throughout the term of the issue.


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EXHIBIT 6.2

CANADA YIELD CALL

A 10-year corporate bond is issued at par with a coupon and yield of 7%, which represents a yield spread of 200 basis points above the current 5% yield on 10-year Canada bonds. (A basis point equals one one-hundredth of a percentage point, so 200 basis points equals 200/100 or 2%.) The corporate bond contains a Canada yield call of +50, meaning that the bond can be called at a price based on a yield of 50 basis points over Canada bonds, with a minimum call price of par. The following year, with 9-year Canada bonds yielding 4.75%, the company decides to call the bonds. Given the Canada yield call of +50, the company must call their bonds at a price based on a yield of 5.25% (which is 4.75% + 0.50%), regardless of where their bonds have been trading in the market before the call. At 5.25%, the price of this 9-year, 7% coupon bond would be $112.42 per $100 par value. Application: This calculation is explained in Chapter 7, Calculating the Fair Price of a Bond. After reviewing Chapter 7, turn back to the Canada Yield Call example above and try your hand at calculating the call price of $112.42.

Table 6.3 summarizes the corporate bond’s major characteristics at the time of issue and at the time the bond is redeemed by the issuer. TABLE 6.3

EXAMPLE OF A CANADA YIELD CALL

When Issued

When called 1 year later

10 years

9 years

$100

$100

Coupon Rate

7%

7%

Yield

7%

5.25%

Price

$100

$112.42

Term to Maturity Face Value

Note that while the term to maturity has changed, the actual date of maturity as well as the face value and coupon remain unchanged. Since the corporation is required to use a yield of 5.25% to calculate the redemption price, the redemption price is significantly higher than its face value. Note also from earlier discussions in the chapter the relationship between the yield, the coupon rate and the price of the bond. When the yield and coupon rate are the same, the price of the bond is par or 100. When the yield falls below the coupon rate, the price of the bond rises higher than par.

Extendible and Retractable Bonds Some corporate bonds are issued with extendible or retractable features. Extendible bonds and debentures are usually issued with a short maturity term (usually five years), but with an option for the investor to exchange the debt for an identical amount of longer-term debt (usually ten years) at the same or a slightly higher rate of interest by the



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extension date. In effect, the maturity date of the bond can be extended so that the bond changes from a short-term bond to a long-term bond. Example: GHI International Inc. 7% Extendible Junior Bonds, Series B2.1, due July 26, 2015, are extendible to July 26, 2035 from July 26, 2015 at a rate of 7.125%.

Retractable bonds are the opposite of extendible bonds. These bonds are issued with a long maturity term (usually at least ten years), but give investors the right to turn in the bond for redemption at par several years sooner (usually five years) by the retraction date. Example: JKL Inc. 4% bonds due June 30, 2025, are retractable at par on June 30, 2015.

With both extendible and retractable bonds, the decision to exercise the maturity option must be made during a time period called the election period. In the case of an extendible bond, the election period may last from a few days to six months or more, before the short maturity date. During the election period, the holder must notify the appropriate trustee or agent of the debt issuer either to extend the term of the bond or to allow it to mature on the earlier date. If the holder takes no action, the bond automatically matures on the earlier date and interest payments cease. In the case of a retractable bond, if the holder does not notify the trustee or agent before the retraction date of his or her decision to shorten the term of the bond, the debt remains a longer term issue.

Convertible Bonds and Debentures Convertible bonds and debentures combine certain advantages of a bond with the option of exchanging the bond for common shares. In effect, a convertible security allows an investor to lock in a specific price (the conversion price) for the common shares of the company. The right to exchange a bond for common shares on specifically determined terms is called the conversion privilege. Convertibles have the characteristics of regular bonds, in that they have a fixed interest rate and there is a definite date upon which the principal must be repaid. They offer the possibility of capital appreciation through the right to convert the bonds into common shares at the holder’s option at stated prices over stated periods. WHY CONVERTIBLES ARE ISSUED

The addition of a conversion privilege makes a bond more saleable or attractive to investors. It tends to lower the cost of the money borrowed and may enable a company to raise equity capital indirectly on terms more favourable than those possible through the sale of common shares. The convertible bond permits the holding of a two-way security. In other words, it combines much of the safety and certainty of the income earned on a bond with the option to convert it into common shares and benefit from any increase in their value. The convertible has a special appeal for the investor who: •

Wants to share in the company’s growth while avoiding any substantial risk; and

•

Is willing to accept the lower yield of the convertible in order to have a call on the common shares.


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CHARACTERISTICS OF CONVERTIBLES

For most convertible bonds, the conversion price is gradually raised over time to encourage early conversion. A properly drawn trust deed provides that, if the common shares of the company are split, the conversion privilege will be adjusted accordingly. This is known as protection against dilution. Convertible bonds may normally be converted into stock at any time before the conversion privilege expires. However, some convertible debenture issues have a clause in their trust deeds that stipulates “no adjustment for interest or dividends.” This clause excuses the issuing company from having to pay any accrued interest on the convertible bond that has built up since the last designated interest payment date. Similarly, any common stock received by the bond holder from the conversion will normally entitle the holder only to dividends declared and paid after the conversion takes place. Convertibles are normally callable, usually at a small premium and after reasonable notice. FORCED CONVERSION

Forced conversion is an innovation built into certain convertible debt issues to give the issuing company more scope in calling in the debt for redemption. This redemption provision usually states that once the market price of the common stock involved in the conversion rises above a specified level and trades at or above this level for a specific number of consecutive trading days, the company can call the bonds for redemption at a stipulated price. The price is much lower than the level at which the convertible debt would otherwise be trading, because of the rise in the price of the common stock. This provision is an advantage to the issuing company rather than to the debt holder for several reasons: •

• •

a forced conversion can improve the company’s debt/equity ratio. A high debt/equity ratio may indicate that a company has borrowed excessively, increasing the financial risk of the company a forced conversion relieves the issuer of having to make mandatory interest payments on debt once investors convert their debt into equities a forced conversion can also help to make room for new debt financing if needed

However, it is not so disadvantageous to the debt holder that it detracts from an issue when it is first sold. Once the price of the convertible debt rises above par, subsequent prospective buyers should check the spread between the prevailing purchase price and the possible forced conversion level. Example: The 7% convertible bonds of RFC Inc. that are due February 28, 2020, have a forced conversion clause. Before February 28, 2015, the bonds are convertible into 44.033 common shares for each $1,000 of face value. This gives them a conversion price of $22.71 a common share ($1,000/44.033). The bonds are not redeemable before February 1, 2013. The company has the option to pay the principal amount on redemption or maturity, or to pay the investor in common shares. The number of common shares will be obtained by dividing $1,000 by 95% of the weighted average trading price for 20 consecutive trading days on the TSX, ending five days before maturity or the date fixed for redemption.



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This is considered to be a forced conversion clause, because the client must choose whether to convert the bond into common shares at $22.71 a share or accept the company’s redemption offer, which could force the investor to pay a considerably higher price per share. For example, if the weighted average price was $27, the company would divide $1,000 by $25.64 (95% of $27) to arrive at 39 shares. The investor would receive 39 shares, compared to 44.033 shares if they had chosen to convert before the forced conversion was imposed by the issuer. MARKET BEHAVIOUR OF CONVERTIBLES

The market price of convertible bonds is influenced by their investment value as a fixed-income security and by the price of the common shares into which they can be converted. When the stock price of the issuing company is below the conversion price, the convertible behaves like any other fixed-income security with the same credit rating, term to maturity, yield, etc. However, because these debentures can be converted into common shares, their price behaves differently than comparable fixed-income securities when the price of the underlying stock rises above the conversion price. The conversion price is the bond price divided by the number of shares the debenture can be converted in to. Let’s take an ABC 6% convertible bond that trades at $980 and can be converted into 40 ABC common shares that currently trade at $22 a share. Even if interest rates rise sharply and comparable bond prices fall, the ABC bond will have a conversion value of at least $880 because it can be converted into 40 common shares that trade at $22 (40 shares × $22 = $880). If the common shares now trade at $27, the price of the bond will rise accordingly to at least $1,080, even if comparable bonds still trade at $980. The reason is simple: the investor holds a security that can be sold today for $1,080 (40 shares × $27) if converted. The conversion price is the bond price divided by the number of shares the debenture can be converted in to. In this example, the conversion price of the ABC convertible is $24.50 ($980/40).

Sinking Funds and Purchase Funds Some issuers must repay portions of their bonds for redemption before maturity, either by calling them on a fixed schedule of dates (via a sinking fund obligation) or by buying them in the secondary market when the trading price is at or below a specified price (through a purchase fund). Some corporate bonds have a mandatory call feature for sinking fund purposes. 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. Sinking fund provisions are as binding on the issuer as any mortgage provision. Example: ABC 6.89% debentures, due June 17, 2015, have a mandatory sinking fund. The company must retire $1,000,000 of the principal amount on June 17 every year, from 2011 to 2015 inclusive. Any debentures purchased or redeemed by the company other than through the sinking fund can be paid to the trustee as part of the sinking fund obligation. The debentures are redeemable for sinking fund purposes at the principal amount plus accrued interest to the date specified.


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Some companies have a purchase fund instead of a sinking fund. Under such an arrangement, a fund is set up to retire a specified amount of the outstanding bonds or debentures through purchases in the market, if these purchases can be made at or below a stipulated price. Occasionally, a bond will have both a sinking fund and a purchase fund. Example: DEF Inc. 5.5% debentures, due April 15, 2031, have a purchase fund. Beginning on July 1, 2011, the company must make all reasonable efforts to purchase at or below par 1.125% of the aggregate principal amount during each quarter.

Since sinking fund provisions are binding, whereas purchase funds retire bonds only under the right market conditions, purchase funds normally retire less of an issue than a sinking fund.

Protective Provisions of Corporate Bonds In addition to principal repayment features, corporate bonds may also have general covenants that secure the bond and make it more likely that the investor will receive all that he or she is due. These clauses are called protective provisions or covenants, and are essentially safeguards in the bond contract to guard against any weakening in the security holder’s position. The object is to create a strong instrument that does not force the company into a financial straitjacket Some of the more common protective covenants found in Canadian corporate bonds are listed below: •

Security: In the case of a mortgage, or asset-backed or secured debt, this clause includes details of the assets that support the debt.

•

Negative Pledge: This clause provides that the borrower will not pledge any assets if the pledge results in less security for the debt holder.

•

Limitation on Sale and Leaseback Transactions: This clause protects the debt holder against the firm selling and leasing back assets that provide security for the debt.

•

Sale of Assets or Merger: This clause protects the debt holder in the event that all of the firm’s assets are sold or that the company is merged with another company, forcing either the retiring of the debt or its assumption by the new merged company.

•

Dividend Test: This provision establishes the rules for the payment of dividends by the firm and ensures equity will not be drained by excessive dividend payments.

•

Debt Test: This provision limits the amount of additional debt that a firm may issue by establishing a maximum debt-to-asset ratio.

•

Additional Bond Provisions: This clause states which financial tests and other circumstances allow the firm to issue additional debt.

•

Sinking or Purchase Fund and Call Provisions: This clause outlines the provisions of the sinking or purchase fund, and the specific dates and price at which the firm can call the debt.



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Complete the following Online Learning Activity Terminology Review Can you tell a bond from a debenture? In this activity you will review bond terminology. As an investment advisor you need to be familiar with key terms used in the industry since you will be involved with the trading of fixed-income securities and may be required to explain these securities and their features to clients. Complete the Terminology Review w to check your knowledge of key fixed-income security terms.

WHAT ARE GOVERNMENT OF CANADA SECURITIES? The Government of Canada issues marketable bonds in its own name. It also allows Crown Corporations to issue debt that has a direct call on the Government of Canada. Example: The Farm Credit Corporation, a Crown Agency, issues medium- and long-term notes that are “direct obligations of Farm Credit and as such will constitute direct obligations of Her Majesty in right of Canada. Payment of principal and interest on the Notes will be a charge on and payable out of the Consolidated Revenue Fund.”

These issues are called marketable bonds because, as well as having a specific maturity date and a specified interest rate, they are transferable, which means that they may be traded in the market. This is in contrast to instruments such as Canada Savings Bonds (CSBs) and Canada Premium Bonds (CPBs), which are not transferable and not marketable.

Marketable Bonds The federal government is the largest single issuer of marketable bonds in the Canadian bond market, having direct marketable debt of about $460 billion outstanding as of August 31, 2012, excluding Treasury bills (Source: Bank of Canada). All Government of Canada bonds are non-callable, that is, the government cannot call them for redemption before maturity. When comparing the bonds issued by Canadian issuers (corporations, federal, provincial and municipal governments), investors assign the highest quality rating to federal government bonds. However, foreign investors compare the quality of Canadian issues to the issues of other governments. The relative risk of investing in each country is reflected in the yields of their bonds and the yields fluctuate in response to political and economic events.


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Treasury Bills Treasury bills are short-term government obligations. They are offered in denominations from $1,000 up to $1 million and have traditionally appealed to large institutional investors such as banks, insurance companies, and trust and loan companies, and to some wealthy individual investors. When the government started offering them in denominations as low as $1,000, their appeal broadened to retail investors with smaller amounts of money to invest. Treasury bills are particularly popular when their yields exceed the yield on Canada Premium Bonds and other retail instruments, such as commercial paper. Treasury bills do not pay interest. Instead, they are sold at a discount (below par) and mature at 100. The difference between the issue price and par at maturity represents the return on the investment, instead of interest. Under the Income Tax Act, this return is taxable as income, not as a capital gain. Every two weeks, Treasury bills are sold at auction by the Minister of Finance through the Bank of Canada. These bills have original terms to maturity of approximately three months, six months and one year.

Canada Savings Bonds Canada Savings Bonds (CSBs) are a secure savings product issued and fully guaranteed by the Government of Canada. The bonds are issued with a three-year term and pay a fixed interest rate or coupon that is adjusted at the start of each new period. Canadians who invest in CSBs have the flexibility to redeem their bonds at any time throughout the year. When redeemed, the bondholder receives the face value plus interest earned for each full month that has elapsed since the issue date. Beginning in November 2012, CSBs can only be purchased through the Payroll Savings Program. This program allows employees to purchase CSBs at their place of work through automatic payroll deductions. More than 10,000 organizations across Canada participate in the Payroll Savings Program, including all levels of government, universities, school boards, hospitals, and corporations.

Canada Premium Bonds Similar in structure to CSBs, Canada Premium Bonds (CPBs) represent a secure investment fully guaranteed by the Government of Canada. Like CSBs, the bonds are issued with a three-year term with interest rates on the bonds set at the start of each period. The bonds are redeemable at any time throughout the year with the bondholder receiving the face value plus interest earned up to the last anniversary date of issue at the time or redemption. In contrast to CSBs, CPBs can be purchased directly through most financial institutions across Canada, including banks, credit unions and caisses populaires, trust companies and most investment dealers. CPBs typically pay a higher rate of return than CSBs. CSBs and CPBs are not transferrable and therefore have no secondary market. As a result, CSBs and CPBs do not rise and fall in price as market conditions change. Also, no interest is earned on CSBs or CPBs redeemed within the first three months following the issue date. The sales campaign for CSBs and CPBs runs from early October to December 1st each year.



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In the current low interest rate environment, CSBs and CPBs pay low rates of return (often less than inflation) and have fallen out of favour with investors. Together, these bonds currently represent only a small fraction of the federal government’s borrowings.

Real Return Bonds The Government of Canada also issues real return bonds (RRB). A RRB resembles a conventional bond because it pays interest throughout the life of the bond and repays the original principal amount on maturity. Unlike conventional bonds, however, the coupon payments and principal repayment are adjusted for inflation. RRBs have a fixed real coupon rate. At each interest payment date, the real coupon rate is applied to a principal balance that has been adjusted for the cumulative level of inflation since the date the bond was issued. The cumulative level of inflation is known as the bond’s inflation compensation. Example: The Government bonds carry a 4.25% coupon, were priced at 100 at issue date, and provide a real yield of about 4.25% to maturity on December 1, 2021. Both the semi-annual interest payments and the final redemption value of each bond are calculated by including an inflation compensation component.

If inflation (as measured by changes in the CPI) had been 1.5% over the first six-month period after issue, the value of a $1,000 RRB at the end of the six months would have been $1,015. The interest payment for the half-year would be based on this amount ($1,015) rather than the original bond value of $1,000. At maturity, the maturity amount would be calculated by multiplying the original face value of the bond by the total amount of inflation since the issue date. RRBs have risen in popularity since they were first issued, as understanding of their structure has become more widespread and the net benefit of government-guaranteed inflation protection is better recognized as a valuable component in constructing a portfolio of securities.

WHAT ARE PROVINCIAL AND MUNICIPAL GOVERNMENT SECURITIES? Provincial “bonds,” like Government of Canada “bonds,” are actually debentures. They are simply promises to pay and their value depends upon the province’s ability to pay interest and repay principal. No provincial assets are pledged as security. All provinces have statutes governing the use of funds obtained through the issue of bonds. Provincial bonds are second in quality only to Government of Canada direct and guaranteed bonds because most provinces have taxation powers second only to the federal government. Different provinces’ direct and guaranteed bonds trade at differing prices and yields, however. Bond quality is determined by two primary factors: credit quality and market conditions. The credit quality of a province – the degree of certainty that interest will be paid and the principal repaid when due – depends on such factors as the amount of existing debt in the province per capita, the level of federal transfer payments, the stability of the provincial government and the wealth of the province in terms of natural resources, industrial development and agricultural production.


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Guaranteed Bonds Many provinces also guarantee the bond issues of provincially appointed authorities and commissions. Example: The Ontario Electricity Financial Corporation’s 8.5% notes, due May 26, 2025, are “Irrevocably and Unconditionally Guaranteed by the Province of Ontario.” Provincial guarantees may also be extended to cover municipal loans and school board issues. In some instances, provinces extend a guarantee to industrial concerns, usually as an inducement to a corporation to locate (or remain) in that province. Most provinces (and some of their enterprises) also issue Treasury bills. Investment dealers and banks purchase them, both at tender and by negotiation, usually for resale.

In addition to issuing bonds in Canada, the provinces (and their enterprises) also borrow extensively in international markets. Unlike the federal government, whose policy is to borrow abroad largely to maintain exchange reserves, the provinces resort to foreign markets to take advantage of lower borrowing costs, based on the foreign exchange rate and financial market conditions. Issues sold abroad are underwritten by syndicates of dealers and banks similar to those that handle foreign financing for federal government Crown Corporations. In recent years, issues have been sold, for example, payable in Canadian dollars, U.S. dollars, euros, Swiss francs and Japanese yen.

Provincial Securities Some provinces offer their own savings bonds. As with CSBs, there are certain characteristics that distinguish these instruments from other provincial bonds and make them suitable as savings vehicles: •

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 (in Quebec, they can be redeemed at any time).

Some provinces issue different types of savings bonds. For instance, there are three types of Ontario Savings Bonds (OSBs): a step-up bond (interest paid increases over time), a variable-rate bond, and a fixed-rate bond.

Municipal Securities Today, the instrument that most municipalities use to raise capital from market sources is the instalment debenture or serial bond. Part of the bond matures in each year during the term of the bond. Example: A debenture of $1 million may be issued so that $100,000 becomes due each year over a 10-year period. The municipality is actually issuing 10 separate debentures, each with a different maturity. At the end of 10 years, the entire issue will have been paid off.



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Installment debentures are usually non-callable: the investor who purchases them knows beforehand how long he or she may expect to keep funds invested. Also, if the money is needed at future specific dates, it can be invested in an instalment debenture so that it will be available when it is needed. Broadly speaking, a municipality’s credit rating depends upon its taxation resources. All else being equal, the municipality with many different types of industries is a better investment risk than a municipality built around one major industry.

WHAT ARE CORPORATE BONDS? Corporations have more choices than governments to raise capital. They can sell ownership of the company by selling stocks to investors or by borrowing money from investors. Generally speaking, corporate bonds have a higher risk of default than government bonds. This risk depends upon a number of factors: the market conditions prevailing at the time of issue, the credit rating of the corporation issuing the bond, and the government to which the bond issuer is being compared to, among other things. There are many types of corporate bonds with different features and characteristics to choose from. The most common types of corporate bonds are discussed below.

Mortgage Bonds A mortgage is a legal document containing an agreement to pledge land, buildings or equipment as security for a loan and entitling the lender to take over ownership of these properties if the borrower fails to pay interest or repay the principal when it is due. The lender holds the mortgage until the loan is repaid, at which point the agreement is cancelled or destroyed. The lender cannot take ownership of the properties unless the borrower fails to satisfy the terms of the loan. There is no fundamental difference between a mortgage and a mortgage bond except in form. Both are issued to allow the lender to secure property if the borrower fails to repay the loan. The mortgage bond was created when the capital requirements of corporations became too large to be financed by the resources of any one individual lender. However, since it is impractical for a corporation to issue separate mortgages securing different portions of its properties to different lenders, a corporation can achieve the same result by issuing one mortgage on its properties to many lenders. First mortgage bonds are the senior securities of a company, because they constitute a first charge on the company’s assets, earnings and undertakings before unsecured current liabilities are paid. It is necessary to study each first mortgage issue to determine exactly what properties are covered by the mortgage. First mortgage bonds are generally regarded as the best security a company can issue, particularly if the mortgage applies to “all fixed assets of the company now and hereafter acquired.” This last phrase, known as the “after-acquired clause,” means that all assets can be used to secure the loan, even those acquired after the bonds were issued.


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Collateral Trust Bonds A collateral trust bond is one that is secured, not by a pledge of real property, as in a mortgage bond, but by a pledge of securities, or collateral. Collateral trust bonds are issued by companies such as holding companies, which do not own much in the way of fixed assets on which they can offer a mortgage, but do own securities of subsidiaries. This method of securing bonds with other securities is similar to the common practice of pledging securities with a bank to secure a personal loan.

Equipment Trust Certificates A variation on mortgage and collateral trust bonds is the equipment trust certificate. These certificates pledge equipment as security instead of real property. CP Locomotives, for example, issues these kinds of bonds, using its locomotives and train cars (i.e., rolling stock) as security. The investor owns the rolling stock under a lease agreement with the railway, until all of the stock has been paid off. These certificates are usually issued in serial form, with a set amount that matures each year.

Subordinated Debentures Subordinated debentures are junior to other securities issued by the company or other debts assumed by the company. The exact status of an issue of subordinated debentures is described in the prospectus.

Floating-Rate Securities Floating-rate securities (also known as variable-rate securities) automatically adjust to changing interest rates, and they can be issued with longer terms than more conventional issues. Floating-rate securities have proved popular because they offer protection to investors during periods of volatile interest rates. For example, when interest rates are rising, the interest paid on floating-rate debentures is adjusted upwards at regular intervals of six months, which improves the price and yield of the debentures. The disadvantage of these bonds is that when interest rates fall, the interest payable on them is adjusted downwards at six-month intervals. A minimum rate on the bonds can provide some protection to this process, although the minimum rate is normally relatively low.

Corporate Notes A corporate note is a short-term unsecured promise made by a borrower to pay interest and repay the funds borrowed at a specific date or dates. Corporate notes rank behind all other fixedinterest securities of the borrower.

Domestic, Foreign and Eurobonds Domestic bonds are issued in the currency and country of the issuer. If a Canadian corporation or government issued bonds in Canadian dollars in the Canadian market, these would be domestic bonds. This is the most common type of bond.


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Foreign bonds are issued outside of the issuer’s country and denominated in the currency of the foreign country where issued. This allows issuers access to sources of capital in many other countries. For example, Rogers Cable Inc., a Canadian company, has issued U.S. dollardenominated bonds in the U.S. market; these bonds are considered foreign bonds in the U.S. market. (Bonds denominated in yen and issued in Japan by non-Japanese issuers are known as Samurais, just as bonds denominated in U.S. dollars and placed in the U.S. market by non-U.S. issuers are called Yankee bonds.) Some bonds offer the investor a choice of interest payments in either of two currencies; others pay interest in one currency and the principal in another. These foreign-pay bonds offer investors increased opportunity for portfolio diversification while providing the issuer with cost-effective access to capital in other countries. Eurobonds are issued in a foreign market and are denominated in a currency other than that of the market where the bonds are issued. They are issued in the Eurobond market or the international bond market and can be issued in any number of different currencies. The Eurobond market is a large international market with issues in many currencies, including Canadian dollars, and attracts both international and domestic investors looking for alternative investments. For example, the Province of Ontario has issued Australian-dollar-denominated bonds in the Eurobond market, attracting investors around the globe, including Canadian investors seeking foreign currency exposure. If a Canadian corporation or government issued Eurobonds denominated in Canadian dollars, they would be called EuroCanadian bonds. If they were denominated in U.S. dollars, they would be Eurodollar bonds. Other examples are shown in Table 6.4. TABLE 6.4

TYPES OF BONDS BY CURRENCY AND LOCATION

Issuer

Issued In

Currency of Issue

Called

Canadian

Canada

Cdn$

Domestic bond

Canadian

Mexico

Pesos

Foreign bond

Canadian

France

U.S.$

Eurobond (Eurodollar)

Canadian

European Market

Cdn$

Eurobond (EuroCdn bond)

Canadian

U.S.

U.S.$

Foreign (Yankee) bond

Preferred Securities Preferred securities are very long-term subordinated debentures, and are sometimes called preferred debentures. The characteristics of these securities fall between standard debentures and preferred shares: •

They are very long-term instruments with terms in the range of 25–99 years.

•

They are subordinated to all other debentures, but rank ahead of preferred shares.

•

Interest can often be deferred at management’s discretion for up to five years.

•

They often trade on an exchange.


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Preferred securities pay interest, have better yields than standard debentures, and offer better protection of principal than preferred shares. However, there is some risk involved, since if the issuer defaults, preferred securities have a lower priority than other debentures. Issuers may also defer interest payments for a number of years, while the security holder will be taxed on this accrued unpaid interest yearly.

High-Yield Bonds Investment grade bonds refer to bonds issued by high-quality issuers such as the federal government, provincial governments and select corporations. Investment grade bonds are those considered to have adequate credit quality and an acceptable capacity for the payment of financial obligations. These bonds carry a credit rating of BBB from DBRS (or BBB- from S&P, or Baa3 from Moody’s) and higher (credit ratings are discussed below). High-yield or speculative bonds are considered non-investment grade. These bonds have a higher risk of default as they are deemed to have greater uncertainty over the repayment of their financial obligations. However, these bonds typically pay higher coupons and have higher yields to compensate investors for the added risk. CURRENT MARKET CONDITIONS FOR HIGH-YIELD BONDS

With interest rates and the yields on investment grade bonds at historically low levels, investors looking to improve their portfolio returns have sparked an increased demand for high-yield debt securities. As markets and the types of products available evolve, investors looking to improve portfolio returns can access high-yield bonds through mutual funds and exchange-traded funds that specialize in speculative bond investments.

WHAT ARE SOME OTHER FIXED-INCOME SECURITIES IN THE MARKETPLACE?

Bankers’ Acceptances A banker’s acceptance (BA) is a commercial draft (i.e., a written instruction to make payment) drawn by a borrower for payment on a specified date. A BA is guaranteed at maturity by the borrower’s bank. As with T-bills, BAs are sold at a discount and mature at their face value, with the difference representing the return to the investor. They trade in $1,000 multiples, with a minimum initial investment of $25,000, and generally have a term to maturity of 30 to 90 days, although some may have a maturity of up to 365 days. BAs may be sold before maturity at prevailing market rates, generally offering a higher yield than Canada T-bills.

Commercial Paper Commercial paper is an unsecured promissory note issued by a corporation or an asset-backed security backed by a pool of underlying financial assets. Issue terms range from less than three months to one year. Most corporate paper trades in $1,000 multiples, with a minimum initial © CSI GLOBAL EDUCATION INC. (2013)


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investment of $25,000. Like T-bills and BAs, commercial paper is sold at a discount and matures at face value. Commercial paper is issued by large firms with an established financial history. Rating agencies rank commercial paper according to the issuer’s ability to meet short-term debt obligations. Commercial paper may be bought and sold in a secondary market before maturity at prevailing market rates and generally offers a higher yield than Canada T-bills.

Term Deposits Term deposits offer a guaranteed rate for a short-term deposit (usually up to one year). Usually there are penalties for withdrawing funds before a certain period (for example, the first 30 days after purchase).

Guaranteed Investment Certificates Guaranteed Investment Certificates (GICs) offer fixed rates of interest for a specific term (longer than with a term deposit). Both principal and interest payments are guaranteed. They can be redeemable or non-redeemable. Non-redeemable GICs cannot be cashed before maturity, except in the event of the depositor’s death or extreme financial hardship. Interest rates on redeemable GICs are lower than standard GICs of the same term, since they can be cashed before maturity. Recently, banks have been customizing their GICs to provide investors with more choice. For instance, investors can choose a term of up to ten years, depending upon the amount invested (for less than a month, it must be a large amount). Investors can also choose the frequency of interest payments (monthly, semi-annual, annual or at maturity) and other features. Many GICs offer compound interest. Note that the Canada Deposit Insurance Corporation (CDIC) does not cover GICs of more than five years. Also, not all GICs are eligible for RRSPs. GICs can be used as collateral for loans, can be automatically renewed at maturity, or can be sold to another buyer privately or through an intermediary. GICs with special features include: •

Escalating-rate GICs: the interest rate increases over the GIC’s term.

•

Laddered GICs: the investment is evenly divided into multiple term lengths (for example, a five year $5,000 GIC can be divided into one-, two-, three-, four- and five-year terms of $1,000 each). As each portion matures, it can be reinvested or redeemed. This diversification of terms reduces interest rate risk.

•

Instalment GICs: an initial lump sum contribution is made, with further minimum contributions made weekly, bi-weekly or monthly.

•

Index-linked GICs: these guarantee a return of the initial investment upon expiry and some exposure to equity markets. They are insured by the CDIC. They may be indexed to particular domestic or global indexes or to a combination of benchmarks.

•

Interest-rate-linked GICs: these offer interest rates linked to the changes in other rates such as the prime rate, the bank’s non-redeemable GIC interest rate, or money market rates.


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Some banks have also developed GICs with specialized features, such as the ability to redeem them in case of medical emergency, or homebuyers’ plans, where regular contributions accumulate for a down payment.

Fixed-Income Mutual Funds and ETFs The demand for fixed-income mutual funds and exchange-traded funds (ETFs) that specialize in bonds has grown significantly over the past decade, largely due to equity market uncertainty and the interest rate environment. These managed products provide investors with easy access to a diversified portfolio of debt securities for both domestic and global markets that would be difficult for individual investors to replicate. These products also include other attractive features like professional investment management, liquidity and low investment costs. Fixed-income mutual funds and ETFs are particularly attractive for investors who have a limited amount of money to invest or who find investing in individual bonds too complex.

Complete the following Online Learning Activity Fixed-Income Securities The Government of Canada, provincial and municipal governments, and corporations all issue fixed-income securities and each of these issues has specific features. In this exercise, you will review the types of products that these institutions offer and then compare and contrast these products and their features. Complete the Fixed-Income Securities exercise to learn about the types of fixed-income securities different institutions offer to investors.

HOW TO READ BOND QUOTES AND RATINGS? A typical bond quote in a newspaper might look like this:

Issue

Coupon

Maturity Date

Bid

Ask

Yield

ABC Company

11.5%

July 1/28

99.25

99.75

11.78%

This quote shows that, at the time reported, an 11.5% coupon bond of ABC Company that matures on July 1, 2028, could be sold for $99.25 and bought for $99.75 for each $100 of par or principal amount. (Remember, prices are quoted as a percentage of par, rather than an aggregate dollar amount.) To buy $5,000 face value of this bond would cost $5,000 × 0.9975 = $4,987.50, plus accrued interest.



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Some financial newspapers publish a single price for the bond. This may be the bid price, the midpoint between the final bid and ask quote for the day, or an estimate based on current interest rate levels. Convertible issues are usually grouped together in a separate listing. In Canada, DBRS (formerly Dominion Bond Rating Service), Moody’s Canada Inc. and the Standard & Poor’s Bond Rating Service provide independent rating services for many debt securities. These ratings can help investors assess the quality of their debt holdings and confirm or challenge conclusions based on their own research and experience. Table 6.5 provides a brief overview of the rating scale of DBRS for long-term obligations. The definitions indicate the general attributes of debt bearing any of these ratings. They do not constitute a comprehensive description of all the characteristics of each category. Similar services in the U.S. have provided ratings on a ranked scale for many years. Investors closely watch these ratings. Any change in rating, particularly a downgrading, can have a direct impact on the price of the securities involved. From a company’s point of view, a high rating provides benefits, such as the ability to set lower coupon rates on issues of new securities. Ratings classify securities from investment grade through to speculative and can be used to compare one company’s ability to meet its debt obligations with those of other companies. The rating services do not manage funds for investors, buy and sell securities, or recommend securities for purchase or sale. TABLE 6.5

DBRS RATING SCALE FOR LONG-TERM OBLIGATIONS

Rating

Description

AAA

Highest credit quality. The capacity for the payment of financial obligations is exceptionally high and unlikely to be adversely affected by future events.

AA

Superior credit quality. The capacity for the payment of financial obligations is considered high. Credit quality differs from AAA only to a small degree. Unlikely to be significantly vulnerable to future events.

A

Good credit quality. The capacity for the payment of financial obligations is substantial, but of lesser credit quality than AA. May be vulnerable to future events, but qualifying negative factors are considered manageable.

BBB

Adequate credit quality. The capacity for the payment of financial obligations is considered acceptable. May be vulnerable to future events.

BB

Speculative, non investment-grade credit quality. The capacity for the payment of financial obligations is uncertain. Vulnerable to future events.

B

Highly speculative credit quality. There is a high level of uncertainty as to the capacity to meet financial obligations.


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TABLE 6.5

DBRS RATING SCALE FOR LONG-TERM OBLIGATIONS – Cont’d

Rating

Description

CCC/CC/C

Very highly speculative credit quality. In danger of defaulting on financial obligations. There is little difference between these three categories, although CC and C ratings are normally applied to obligations that are seen as highly likely to default, or subordinated to obligations rated in the CCC to B range. Obligations in respect of which default has not technically taken place but is considered inevitable may be rated in the C category.

D

A financial obligation has not been met or it is clear that a financial obligation will not be met in the near future or a debt instrument has been subject to a distressed exchange. A downgrade to D may not immediately follow an insolvency or restructuring filing as grace periods or extenuating circumstances may exist.

Source: DBRS Web Site, www.dbrs.com (Information is accurate as at time of publishing.)

Complete the following Online Learning Activity Bond Quotes and Ratings It is important to be able to interpret bond quotes and bond ratings because this information will help you make better investment decisions. In this activity you will interpret bond quotes and practise making investment decisions based on bond ratings. Complete the Bond Quotes and Ratings activity to practice interpreting bond quotes.



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Describe the fixed-income market and discuss the rationale for issuing debt instruments. •

2.

Companies use fixed-income securities to finance and expand their operations or to take advantage of operating leverage.

Define the terms used in transactions involving bonds, describe bond features, explain the use of a sinking fund and a purchase fund, and describe the protective provisions found in a bond indenture. •

There is a great deal of terminology to remember:

– Face or par value is the amount the bond issuer contracts to pay at maturity. – The coupon is the regular interest income that the bond pays. – Bonds that trade in the secondary market have a price and a quoted yield. – The remaining life of a bond is called its term to maturity. – The maturity date is the date at which the bond matures and the principal is repaid. – A bond is secured by physical assets in a trust deed written into the bond contract. – A debenture is secured by something other than a physical asset. The asset secured may be a general claim on residual assets or the issuer’s credit rating. •

A strip bond is created when a dealer acquires a block of high-quality bonds and separates the individual future-dated interest coupons from the rest of the bond. The bonds are then sold at significant discounts to their face value. Holders of strip bonds receive no interest payments; instead, the income earned is considered interest rather than a capital gain.

•

A callable bond gives the issuer the right, but not the obligation, to pay off the bond before maturity, either to take advantage of lower interest rates or to reduce debt when excess cash is available.

•

Most corporate bonds are issued with a Canada yield call that requires the issuer to call the bond at a price based on the greater of par or the price based on the yield of an equivalent term Government of Canada bond plus a yield spread.

•

A convertible bond gives the holder the option to exchange the bond for common shares of the issuing company. A convertible bond allows an investor to lock in a specific price (the conversion price) for the common shares of the company.


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3.

4.

•

Sinking funds are sums of money taken out of earnings each year to provide for the repayment of all or part of a debt issue by maturity. Sinking fund provisions are as binding on the issuer as any mortgage provision.

•

A purchase fund arrangement establishes a fund to retire a specified amount of the outstanding bonds or debentures through purchases in the market if these purchases can be made at or below a stipulated price.

•

Corporate bonds typically include protective covenants that secure the bond and make it more likely that investors receive their principal at maturity. These protective provisions are essentially safeguards in the bond contract to guard against any weakening in the security holder’s position.

Compare and contrast the types of Government of Canada securities. •

Marketable bonds have a specific maturity date and a specified interest rate, and are transferable, which means they can be traded in the market. The Government of Canada issues marketable bonds in its own name.

•

Treasury bills are short-term government obligations with original terms to maturity of three months, six months and one year. They are offered in denominations from $1,000 up to $1 million.

•

Canada Savings Bonds (CSBs) can be purchased only through the Payroll Savings Program between early October and November 1st of each year but are cashable at any time at their full par value plus any accrued interest earned for each full month elapsed since the issue date.

•

Canada Premium Bonds (CPBs) are very similar to CSBs but offer a higher interest rate when they are issued. Investors can purchase CPBs through most financial institutions and are cashable at any time at their full par value plus any accrued interest paid up to the last anniversary date of the issue.

Compare and contrast the different types of provincial government securities and municipal debentures. •

Provincial bonds are actually debentures because they are promises to pay and no provincial assets are pledged as security. The value of the bonds depends on the province’s ability to pay interest and repay principal.

•

Provincial bonds are second in quality only to Government of Canada bonds because most provinces have taxation powers second only to the federal government.

•

Municipalities typically raise capital from market sources through instalment debentures or serial bonds. Part of the bond matures in each year during the term of the bond.

•

Broadly speaking, a municipality’s credit rating depends on its taxation resources. All else being equal, a municipality with many different types of industry is a better investment risk than a municipality built around one major industry.



5.

6.

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Identify the different types of corporate bonds and describe their features. •

First mortgage bonds are the senior securities of a company because they constitute a first charge on the company’s assets, earnings and undertakings before unsecured current liabilities are paid.

•

A collateral trust bond is secured, not by a pledge of real property, as in a mortgage bond, but by a pledge of securities or collateral.

•

An equipment trust certificate pledges equipment as security instead of real property. These certificates are usually issued in serial form, with a set amount that matures each year.

•

Subordinated debentures are junior to other securities issued by the company and other debts assumed by the company.

•

Floating-rate bonds automatically adjust to changing interest rates. They can be issued with longer terms than more conventional issues.

•

A corporate note is an unsecured promise made by a borrower to pay interest and repay the funds borrowed at a specific date or dates. Corporate notes rank behind all other fixed interest securities of the borrower.

•

Foreign bonds are issued outside of the issuer’s country and denominated in the currency of the foreign country where issued, allowing the issuer access to sources of capital in many other countries.

•

Eurobonds are issued in a foreign market and are denominated in a currency other than that of the market in which the bonds are issued.

Describe the features of other fixed-income securities including bankers’ acceptances, commercial paper, term deposits and guaranteed investment certificates. •

A bankers’ acceptance is a short term debt guaranteed by the borrower’s bank that is sold at a discount and matures at face value.

•

Commercial paper is a one-year or less unsecured promissory note issued by a corporation and backed by financial assets, sold at a discount and matures at face value.

•

Term deposits offer a guaranteed rate for a short-term deposit (usually up to one year). There are generally penalties for withdrawing funds before a certain period (for example, the first 30 days after purchase).

•

Guaranteed investment certificates (GICs) offer fixed rates of interest for a specific term (longer than with a term deposit). Both principal and interest payments are guaranteed, and they can be redeemable or non-redeemable. Non-redeemable GICs cannot be cashed before maturity except in the event of the depositor’s death or extreme financial hardship.


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7.

Interpret bond quotes and summarize and evaluate bond ratings. •

A typical bond quote includes the issuing company, the coupon rate, the maturity date, the bid and ask price, and the yield on the bond.

•

In Canada, DBRS, Moody’s Canada Inc. and the Standard & Poor’s Bond Rating Service provide independent rating services for many debt securities. These ratings can help investors assess the quality of their debt holdings and confirm or challenge conclusions based on their own research and experience.






Chapter

7

Fixed-Income Securities: Pricing and Trading


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7 Fixed-Income Securities: Pricing and Trading

CHAPTER OUTLINE How are Price and Yield of a Bond Calculated? • Calculating the Fair Price of a Bond • Calculating the Yield on a Treasury Bill • Calculating the Current Yield on a Bond • Calculating the Yield to Maturity on a Bond What is the Term Structure of Interest Rates? • The Real Rate of Return • The Yield Curve What are the Fundamental Bond Pricing Properties? • The Relationship between Bond Prices and Interest Rates • The Impact of Maturity • The Impact of the Coupon • The Impact of Yield Changes • Duration as a Measure of Bond Price Volatility How does Bond Market Trading Work? • Clearing and Settlement • Calculating Accrued Interest What are Bond Indexes? • Canadian Bond Market Indexes • Global Indexes Summary

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LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Define present value and the discount rate, and perform calculations relating to the time value of money, bond pricing and yield. 2. Define a real rate of return and a yield curve, and evaluate three theories of interest rate determination. 3. Analyze the impact of fixed-income pricing properties on bond prices. 4. Summarize the rules and regulations of bond delivery and settlement. 5. Assess the role of bond indexes in the securities industry.

THE FIXED-INCOME MARKET IN ACTION Before they invest in or recommend fixed-income securities, investors and advisors must understand the potential risks and rewards. An important part of this process requires knowledge of how bond yields and prices are determined. One of the most important factors to keep in mind is the strong relationship that exists between prevailing interest rates and the prices of various fixed-income securities. Most people have invested, at one time or another, in Canada Savings Bonds. You buy the bond at one price, receive a regular stream of interest payments, hold the bond to maturity, and cash it in at face value. In fact, it is most common that investors buy a bond or other fixed-income security when they are first issued and hold them to maturity. Fixed-income securities can, however, be bought in the secondary markets. The price in the markets is affected by a number of factors, including economic conditions and changes in interest rates. Fixed-income securities generally react differently to economic factors than do equities, and it is important to understand the impact of various events that affect markets. How much should an investor pay for a particular security? This question applies as much to bonds as to equities, especially for investors seeking capital gains in the bond market. This chapter looks at how to determine the fair price for a fixed-income security and then at fixed-income pricing properties.


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KEY TERMS

7•4

Accrued interest

Liquidity preference theory

Bearer bonds

Market segmentation theory

Canadian Depository for Securities Limited (CDS)

Nominal rate

Current yield

Present value

Delivery

Registered bonds

Discount rate

Reinvestment risk

Duration

Yield curve

Expectations Theory

Yield to maturity (YTM)


SEVEN • FIXED-INCOME SECURITIES: PRICING AND TRADING

7• 5

HOW ARE PRICE AND YIELD OF A BOND CALCULATED? The most accurate method of determining the value of a bond is by calculating its present value—a technique for determining the value today of an amount of money to be received in the future. The present value method sets out to answer the question—what would you pay today to invest in a security that offered you a guaranteed sum of money in five years? In other words, what is the present value of this investment? Consider the following scenario. Suppose you had the choice of receiving $1,000 today or one year from today—which would you prefer? When you think about it, you know that if you had the $1,000 today you could invest it and earn interest so that you would have more than $1,000 a year from today. We can then say that the present value of an amount is worth less than its future value because of the opportunity of investing the proceeds today at a rate of interest. The question then is how much needs to be invested today at 5% to achieve that future value of $1,000? Here is a simplified way to determine the present value of this future amount. Present Value × (1 + Interest or Discount Rate) = Future Value Present Value × 1.05 = $1,000 Present Value = $1,000 ÷ 1.05 Present Value = $952.38

What this tells us: the present value of $952.38 invested today for one year at a 5% rate of interest would grow to a future value of $1,000. Application: You can verify this on your calculator by entering: $952.38 + 5% or $952.38 × 1.05.

There are four steps in calculating a bond’s present value: 1. 2. 3. 4.

Choose the appropriate discount rate (r). Calculate the present value of the bond’s coupon payments – i.e., income stream (C). Calculate the present value of the bond’s principal to be received at maturity. Add these present values together to determine its worth today.

The cash flow from a typical bond is made up of regular coupon payments and the return of the principal at maturity. Since a bond represents a series of cash flows to be received in the future, the sum of the present values of all of these future cash flows is what the bond is worth today.


7• 6


The general formula for calculating the present value of a bond is: PV

C1 1

1 r

C2 2

1 r

"

Cn P n

1 r

Where: PV

=

the present value of the bond

C

=

the coupon payment

r

=

the discount rate per period

n

=

the number of compounding periods to maturity

P

=

Principal received at maturity (i.e., the future value)

The math behind these calculations is not intended to be cumbersome; the next few sections will explain how to carry out and interpret the results.

In the examples that follow, we will use a 4-year semi-annual 9% coupon bond and a discount rate of 10%. Remember that bond prices are often quoted using a base value of $100. We will use $100 as the principal of our 4-year semi-annual 9% bond.

THE DISCOUNT RATE

The appropriate discount rate is chosen based on the risk of the particular bond. It is important to note that discount rate, interest rate, yield and yield to maturity are often used to refer to the same thing. The discount rate can be estimated by the yields currently applicable to bonds with similar coupon, term and credit quality. These yields are determined by the marketplace and change as market conditions change.

The discount rate refers to the rate at which you would discount a future value to determine the present value. For example, assume you had the opportunity to receive $100 in one-year’s time. You want to earn a return of 6% on your invested money, and need to figure out how much you should invest (or be willing to pay) today to receive $100 in one year. To answer the question, you would discount the future value of $100 by 6% to determine the fair price of $94.34. If you invested $94.34 at the beginning of the year and received $100 at the end of the year, you would have earned a yield of 6% ($100 / 1.06 = $94.34, and you can verify the answer by doing the reverse calculation: $94.34 + 6%).

Yields are often quoted as being equal to a Government of Canada bond with a similar term, plus a spread in basis points that reflects credit risk, liquidity and other factors. The discount rate should not be confused with the coupon rate on the bond. The coupon rate determines the income to be paid to the holder of the bond, and is set when the bond is issued and generally does not change.


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If the bond pays interest more than once a year, the coupon payments must be adjusted for the number of times interest is paid each year. Because most bonds pay interest twice a year, or semiannually, we need to make the following adjustments to our bond: Coupon = (9% ÷ 2) × $100 = 4.5% × $100 = $4.50 per period Compounding periods = 4 years × 2 payments per year = 8 compounding periods

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. We can use the following timeline to show the timing of the cash flows on our 4-year, 9% semiannual bond.

Future Value C 8 ($4.50) + $100 Principal C1 ($4.50)

C2 ($4.50)

C3 ($4.50)

C 4 ($4.50)

Year 1

Year 2

C5 ($4.50)

C6 ($4.50)

C7 ($4.50)

Year 3

Year 4

Present Value

The timeline shows that coupon payments are made twice per year and that at maturity, the bondholder receives both a coupon payment and the return of the principal or the par value of the bond. By discounting these cash flows back to the present we can solve for the present value of a bond. PRESENT VALUE OF A BOND

Let’s take a more detailed look at the formula for the present value of a bond. PV

C1 1

1 r

C2 2

1 r

"

Cn P n

1 r

The present value of a future amount to be received is calculated by dividing that future amount by (1 + interest rate) raised to the power of the number of compounding periods in the future that amount will be paid. This method is called discounting the cash flows—we are discounting those future cash flows so that we can place a present value on them. We can carry out the calculation either by hand or by using a financial calculator, however we arrive at a more precise answer much quicker using a financial calculator. We have included the step-by-step calculations in Exhibit 7.1 so that you gain an appreciation of what is involved with each calculation.


7• 8


For our 4-year, semi-annual 9% bond, we can set up the formula as: PV

4.50 1

1 .05

4.50 2

1 .05

"

4.50 7

1 .05

4.50 100 8

1 .05

Calculation Note You may be wondering how to approach calculations that involve (1 + r) n. The bracketed information is read as being to the power of ‘n’. So if we have (1.05) 8, the 1.05 is raised to the power of 8. Using a calculator simplifies the calculation as most are equipped with a y x or yexp key. Simply key in 1.05 press the y x or yexp key, enter 8 as the power and you have the answer of 1.4775.

1.

PV of the income stream: The present value of a bond’s income stream is the sum of the present values of each coupon payment. For our 9% four-year bond with a par value of $100, there would be eight remaining semi-annual coupon payments of $4.50 each. The present value of each of these coupons, added together, is the present value of the bond’s income stream. Using a financial calculator (we are using the Sharp EL-738 calculator model): Type 8 Press N Type 5 press I/Y Type 4.50 press PMT Type 0 press FV [lets the calculator know you are not interested in the principal] Press COMP press PV Answer: 29.0845

This tells us that the value of the stream of eight coupon payments is worth $29.08 today. 2.

Present value of the principal: Because the bond’s principal represents a single cash flow to be received in the future, we can calculate the present value of the principal of our 4-year semi-annual bond with a par value of $100 using a financial calculator: Type 8 Press N Type 5 press I/Y Type 0 press PMT [lets calculator know you are not interested in the coupons] Type 100 press FV Press COMP press PV Answer: 67.6839

The present value of the principal is approximately $67.68. This tells us that if you were to invest $67.68 at a semi-annual rate of 5% today, you will receive $100 in four years. You can verify this on your calculator by entering: $67.6839 + 5% + 5% + 5% + 5% + 5% + 5% + 5% + 5%



3.

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Present value of the bond: The fair price for a bond is the sum of its two sources of value: the present value of its principal and the present value of its coupons. In the example above, the coupons are worth $29.08 and the principal is worth $67.68. Therefore, at a discount rate of 10%, this bond has a present value of $96.77 ($29.0844 + $67.6839) today. We can also carry out the calculation for the present value of the bond in one easy step using a financial calculator: Type 8 Press N Type 5 press I/Y Type 4.50 press PMT Type 100 press FV Press COMP press PV Answer: 96.7684

What does the present value of $96.77 tell us? It is the price at which the bond will be quoted for trading in the secondary market; its fair value given current market conditions. Simply put, this is what an investor should pay for the bond today, no more or no less. Thus, the value of a bond is the sum of what its coupons are worth today, plus what its principal is worth today, based on an appropriate discount rate that reflects the risks of that particular bond. The appropriate discount rate changes with changing economic conditions and reflects the yield investors expect. EXHIBIT 7.1

CALCULATING THE PRESENT VALUE OF A BOND

Although a financial calculator simplifies the present value calculations, it is also important to have an understanding of how the calculations are carried out manually. 1. PV of the Principal The formula to calculate the present value of a single cash flow to be received in the future is: PV

FV (1 r )n

Because the bond’s principal represents a single cash flow to be received in the future, we can calculate the present value of the principal of our 4-year semi-annual bond with a par value of $100 as: PV

$100 (1 0.05)8

$100 1.47746

$67.6839


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EXHIBIT 7.1

CALCULATING THE PRESENT VALUE OF A BOND – Cont’d

2. Present value of the Income Stream We can calculate the present value of a coupon payment using the same formula as above: PV

$4.50 (1 0.05)1

$4.50 1.05

$4.2857 The present value of the coupon to be received six months from now is approximately $4.29 (you can verify this with your calculator by entering $4.2857 + 5% = $4.50). In the same example, the present value of the second coupon is: PV

$4.50 (1 0.05)2

$4.50 1.1025

$4.0816 The present value of the coupon to be received two six-month periods from now is approximately $4.08 (you can verify this with your calculator by entering $4.0816 + 5% + 5% = $4.50). Repeat this process for each of the coupon payments to be received, and add the present values together to obtain the present value of the income stream. In this example, it would be $29.08 (or $4.29 + $4.08 + $3.89 + $3.70 + $3.53 + $3.36 + $3.20 + $3.05). There is a faster way to calculate the present value of a series of time payments, using a calculation called the present value of an annuity. With this formula, the sum of the present value of all coupons is found all at once. The formula is: 1 ¡1 ¡ (1 r )n APV C ¡ ¡ r ¡ ¡¢

¯ ° ° ° ° ° °±

Where: APV = present value of the series of coupon payments C

= payment (the value of one coupon payment)

r

= the discount rate per period

n

= the number of compounding periods



EXHIBIT 7.1

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CALCULATING THE PRESENT VALUE OF A BOND – Cont’d

Applying the formula to our previous bond calculation problem, we get: 1 ¡1 ¡ (1 0.05)8 APV $4.50 ¡ ¡ 0.05 ¡ ¡¢

¯ ° ° ° ° ° °±

1 0.676839 ¯ ° $4.50 ¡ ¡¢ °± 0.05 0.323161¯ ° $4.50 ¡ ¡¢ 0.05 °± $4.50 q 6.4632 $29.0844 Present value of the Bond The fair price for a bond is the sum of its two sources of value: the present value of its principal and the present value of its coupons. Therefore, at a discount rate of 10%, this bond has a value of $96.77 ($29.0844 + $67.6839) today.

Complete the following Online Learning Activity Present value Gaining familiarity with the concept of present value is essential for your understanding of bond pricing relationships. Present value is simply today’s value of an amount to be received in the future, given a specific yield. In this activity, you will learn how to calculate the present value of a bond given different discount rates, maturity dates and coupons. Complete the Present Value activity

Calculating the Yield on a Treasury Bill Treasury bills are very short-term securities that trade at a discount and mature at par. No interest is paid in the interim, so the return is generated from the difference between the purchase price and the sale (or maturity) price. A simple formula for calculating this yield is: Yield

100 price 365 q q100 price term


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Example: If you bought an 89-day T-bill for a price of 98, the yield would be: Yield

100 98 365 q q100 98 89 2 365 q q100 98 89

8.3696%

Calculating the Current Yield on a Bond We can calculate the current yield of any investment, whether it is a bond or a stock, using the following formula: Annual Cash Flow q100 Current Market Price

Current Yield

Current yield looks only at cash flows and the current market price of the investment, not at the amount that was originally invested. Example: The 4-year, 9% bond, trading at a price of 96.77 from the examples above, would have a current yield of: $9/96.77 × 100 = 9.30%

Calculating the Yield to Maturity on a Bond The most popular measure of yield in the bond market is yield to maturity (YTM). YTM shows the total return you would expect to earn over the life of a bond starting today, assuming you are able to reinvest the coupons you receive at the same YTM that existed at the time you purchased the bond. The yield to maturity takes into account the current market price, its term to maturity, the par value to be received at maturity and the coupon rate. This calculation involves finding the implied interest rate (r) in the bond present value formula from the previous section: PV

C1 1

1 r

C2 2

1 r

"

Cn P n

1 r

In a YTM calculation, you know PV but you do not know r. Unlike a current yield, where the yield is calculated as the coupon income divided by current price, the YTM calculation makes the assumption that the investor will be repaid the par value of the investment at maturity. Therefore, YTM not only reflects the investor’s return in the form of coupon income, but includes any capital gain from purchasing the bond at a discount and receiving par at maturity, or any capital loss from purchasing the bond at a premium and receiving par at maturity.



7•13

Manually calculating YTM is a difficult task. The easy way to solve for YTM is to use a financial calculator. Example: Continuing with the 4-year, semi-annual 9% bond, trading at a price of 96.77, we can find the semi-annual YTM in the following way: Type 8 Press N Type 4.50 press PMT Type 96.77 press +/- press PV (minus sign in front of 96.77 denotes an outflow of funds from investor) Type 100 press FV Press COMP press I/Y Answer: 4.9997% or 5%

The semi-annual YTM on this bond is 5.0%. The annual YTM is 10% (5% x 2), which makes sense because the bond is trading at a discount to par. If you buy this bond today at the price of $96.77 and hold it to maturity you would receive 8 payments of $4.50 plus $100 at maturity. The YTM calculation factors in the $3.23 gain on this bond ($100 - $96.77), the coupon income, plus the reinvestment of the coupon income at this YTM. A financial calculator makes the YTM calculation quite easy. Exhibit 7.2 shows how to carry out the calculation manually using the approximate yield to maturity method. EXHIBIT 7.2

APPROXIMATE YIELD TO MATURITY—MANUAL CALCULATION

The formula for the approximate yield to maturity is: Interest income / Price change per compounding period q100 (Purchase price Par Value) u 2 We use +/- in the formula to show that you can buy a bond at a price above or below par. Let’s say you buy a bond at a discount to par, say at a price of 92, and hold it to maturity. At maturity, the bond matures at par and you realize a gain on the investment. In the formula, you would add this price appreciation to the interest income. The opposite holds if you buy a bond at a premium, say at 105, and hold it to maturity. In our formula, you would subtract the price decrease from the interest income. For example, let’s calculate the yield on the 4-year, semi-annual 9% bond, trading at a price of 96.77 that matures at 100. • The semi-annual interest or coupon income on this bond is $4.50. • What is the annual price change on this bond (based on $100 par)? The present value of the bond is 96.77 and will mature at 100. Therefore, it will increase in value over the remaining life of the bond by $3.23. Since there are eight compounding periods remaining in this bond’s term, the bond generates a gain in price of $0.4038 per period over the remaining eight compounding periods ($3.23 ÷ 8). • What is the average price on this bond (based on $100 par)? The purchase price is $96.77. The redemption or maturity value is $100. The average price is 98.385, or (96.77 + 100) ÷ 2.


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EXHIBIT 7.2

APPROXIMATE YIELD TO MATURITY—MANUAL CALCULATION – Cont’d

The approximate semi-annual YTM on this bond is:

$4.50 $0.4038 q100 96.77 100 u 2

$4.9038 q100 98.385

4.9842%

The annual YTM is 9.9684% (4.9842% x 2). You will notice that this result is very close to the YTM found using the calculator method. For accuracy, a financial calculator provides a more precise amount.

WHAT DOES THE YTM TELLS US AND WHY IS IT IMPORTANT?

When you buy a bond, the bond quote includes the price, the maturity date, the coupon rate, the bond’s current yield and the yield to maturity. This is all important information: the coupon rate tells you how much income you will receive each year and the current yield tells you how much interest income you receive in relation to the price being paid for the bond. The yield to maturity is the more important measure. In general, the YTM is an estimate of the average rate of return earned on a bond if it is bought today and held to maturity. To earn this rate of return, however, it is assumed that all coupon payments are reinvested in securities at a rate equal to the prevailing YTM at the time of purchase. In our example above, we can say that the bondholder will realize a return of 10.0% over the term of the bond if held to maturity and if the coupon payments are reinvested at this YTM. The yield to maturity provides us with a good estimate of the return on a bond. However, you should keep in mind that depending on the future trend in market rates, the true return on the bond could differ from the YTM calculation. This is referred to as reinvestment risk. REINVESTMENT RISK

Since 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. The longer the term to maturity, the less likely it is that interest rates will remain constant over the term. The risk that the coupons cannot be reinvested at the same interest rate that prevailed at the time the bond was purchased is called reinvestment risk. If all coupon payments are reinvested, on average, at a rate higher than the bond’s YTM at the time of purchase, the overall return on the bond will be higher than the YTM quoted at the time the bond was purchased. In this case, the YTM at the time of purchase will be understated. If, on the other hand, coupon payments are reinvested, on average, at a rate lower than the bond’s YTM at the time of purchase, the overall return on the bond will be lower than the YTM quoted at the time the bond was purchased. In this case, the YTM at the time of purchase will be overstated.



7•15

Only a zero coupon bond has no reinvestment risk, since there are no coupon cash flows to reinvest before maturity. Instead, these bonds are purchased at a discount from their face value. The price paid takes into account the compounded rate of return that would have been received had there been coupons.

Complete the following Online Learning Activity Calculating Bond Price In this first part of the module you’ve learned about the methods used to find the fair price of a bond using the present value method. Then you’ve learned about the various yield calculations for bonds and other fixedincome securities. Because fixed-income securities trade on the basis of yield, understanding how these yield measures are determined is an important part of learning about investing in bonds. Complete the Calculating Bond Prices to review the factors that affect bond prices and how bond prices are calculated. Complete the Calculating Yield to learn more about how yield is calculated. Complete the Bond Pricing Quiz to practice calculating bond prices and yields.

WHAT IS THE TERM STRUCTURE OF INTEREST RATES? To have a successful trading strategy, the investor needs some expertise in determining the future direction of interest rates. It is important to understand the factors that determine: • •

the general level of interest rates at any particular time the level of interest rates at different terms to maturity

The following section offers several explanations that have been proposed to explain why interest rates for different terms vary, creating different term structures or yield curves.

The Real Rate of Return In a general sense, interest rates are simply the result of the interaction between those who want to borrow funds and those who want to lend funds. There is at least one major theory behind the determination of interest rates: the inflation rate/real rate theory. The rate of return that a bond (or any investment) offers is made up of two components: • •

The real rate of return The inflation rate


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Because inflation reduces the value of a dollar, the return that is received, known as the nominal rate, must be reduced by the inflation rate to arrive at the actual or real rate of return. The real rate of return is determined by the supply of funds (supplied by investors) and the demand for loans (created by business). Businesses are more inclined to borrow to invest in, for example, new plant and equipment, when they believe that this investment will earn returns that are higher than the costs of borrowing. The supply of funds tends to rise when real rates are high, as investors are more likely to lend funds. The nominal rate for loans will be made up of the real rate, as established by supply and demand, plus the expected inflation rate. Nominal Rate = Real Rate + Inflation Rate

Two factors affect forecasts for the real rate: •

The real rate rises and falls throughout the business cycle. During a recession, the demand for funds will fall and the real interest rate will also fall. When rates fall far enough, the demand for funds will start to rise again. As the economy expands, demand for funds will continue to grow and the real interest rate will rise.

•

An unexpected change in the inflation rate also affects the real rate. An investor lending money will demand an interest rate that includes his or her expectations for inflation, thereby ensuring a satisfactory real rate. If the inflation rate is higher than expected, the investor’s real rate of return will be lower than expected.

Complete the following Online Learning Activity Interest Rates Interest rates play a key role in the pricing of bonds. In this activity you’ll learn more about the real rate of return and how it differs from the nominal rate. In addition you’ll review the role inflation plays in the relationship between the two. Complete the Real Rate of Return activity to learn more about the real rate of return.

The Yield Curve Not only do bond prices and yields fluctuate, but the relationship between short-term and longterm bond yields also tends to fluctuate. This relationship between bonds of varying terms to maturity is referred to as the term structure of interest rates. The term structure of interest rates can be easily plotted on a graph for similar long-term and short-term bonds and results in a line called a yield curve, which continually changes. A hypothetical yield curve for Government of Canada bonds is depicted in Figure 7.1.


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FIGURE 7.1

SHORT- AND LONG-TERM GOVERNMENT OF CANADA SECURITY YIELDS

5

Yield %

4

3

2

1

0

1 month

3 months 6 months 12 months

2 years

3 years

5 years

7 years

10 years

Long

Time to Maturity

The yield curve indicates the yield at a specific point in time for bonds having the same credit quality, but different terms to maturity. In Figure 7.1, for example, very short-term Government of Canada bonds are showing a yield of 1% while long-term bonds are showing yields around 4%. Three theories proposed to describe the shape of the yield curve are the expectations theory, the liquidity theory and the market segmentation theory. EXPECTATIONS THEORY

An investor who wants to invest money in the fixed-income market for a certain time period has a number of choices of terms. For example, if the investment is for two years, the investor could purchase a two-year bond, or invest in a one-year bond and then buy another one-year bond when the first one matures, or even buy a six-month bond and roll it over (i.e., invest it again) three more times during the two years. Since an efficient market ensures that each route will be equally attractive, the two-year interest rate must be equal to two successive and consecutive one-year rates, and the one-year rate must be an average of two consecutive six-month rates, and so forth. The Expectations Theory implies that the shape of the yield curve indicates investor expectations about the future of interest rates.


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If the two-year rate is 5%, the return on investment would be 1.05 x 1.05 = 1.1025 or 10.25% (or 1.052 = 1.1025) at the end of two years. If the one-year rate is currently 4%, and the investor decided to roll over her investment into another one-year bond a year later, what would the second year’s one-year bond return have to be so that the two consecutive one-year bonds produced the same return as the two-year bond? Two-year return = One-year return (year one) x One-year return (year two) (1 + 0.05) 2 = (1 + 0.04) x (1 + r) (1 + r) = 1.1025 / 1.04 1 + r = 1.06009 r = 0.06009 or 6% According to the equation above, with one-year rates at 4% and two-year rates at 5%, the investor expects rates on one-year bonds to increase from 4% to 6% a year from now, and she would be indifferent as to which investment she selected – either the two-year bond or two one-year bonds purchased consecutively.

An upward sloping yield curve indicates an expectation of higher rates in the future, while a downward sloping curve indicates an expectation that rates will fall in the future. A humped curve indicates that rates are expected to rise and then fall in the future. Therefore, the yield curve is said to reflect a market consensus of expected future interest rates. The yield curve in Figure 7.1, which slopes upward from left to right, indicates a market consensus that investors expect interest rates to rise. LIQUIDITY PREFERENCE THEORY

According to this theory, investors prefer short-term bonds because they are more liquid and less volatile in price. An investor who prefers liquidity will venture into longer-term bonds only if there is sufficient additional compensation for assuming the additional risks of lower liquidity and increased price volatility. According to this theory, an upward sloping yield curve (see Figure 7.1) reflects additional return for assuming additional (term) risk. Although the simplicity of this theory makes it appealing, it does not explain a downward sloping yield curve. MARKET SEGMENTATION THEORY

The various institutions that are major players in the fixed-income arena each concentrate their efforts in a specific term sector. For example, the major chartered banks tend to invest in the short-term market, while life insurance companies, because of their long investment horizon, mainly operate in the long-term bond sector. This theory postulates that the yield curve represents the supply of and demand for bonds of various terms, primarily influenced by the bigger players in each sector. This theory can explain all types of yield curves, from normal (i.e., upward sloping curve) to inverted (i.e., downward sloping curve) to humped. Figure 7.1 above is an example of a normal yield curve.



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Complete the following Online Learning Activity The Yield Curve It is essential to realize that yields on similar types of debt securities vary depending on their term. These differences can be plotted on a graph to create a yield curve. There are a number of explanations as to why such differences exist. In this activity you’ll review three of these popular theories: the expectations, liquidity preference and market segmentation theories. Complete the Yield Curve activity to review the term structure of interest rates.

WHAT ARE THE FUNDAMENTAL BOND PRICING PROPERTIES? In the section on calculating present value, we saw how to determine the appropriate price to pay for a bond or other fixed-income security. However, it is also important to know where that price is headed. The previous section on general interest rate levels and term structure may help you forecast generally where bond prices may be headed, but you should also understand the specific features of an individual bond that determine how that particular bond will react to interest rate changes. The yields in the following tables are calculated using precise present value techniques, including semi-annual compounding and full reinvestment of all coupons at the prevailing yield.

The Relationship between Bond Prices and Interest Rates The most important bond pricing relationship to understand is the inverse relationship between bond prices and interest rates (or bond yields)—as interest rates rise, bond prices fall and as interest rates fall, bond prices rise. It is also important to recognize that interest rates and bond yields are often used interchangeably. Each represents a rate of return on an investment. Therefore, as interest rates rise, the yields on competing investments must also rise, and vice versa. As we saw in the section on yield calculations, bond prices fall when bond yields rise. Table 7.1 shows a 7% five-year semi-annual coupon bond. When yields on this type of bond are 7%, this bond will be priced at par, or 100 (line 2). Suppose that yields on bonds of this type increase to 8%. This bond will drop in price to 95.94 (line 1). If yields instead drop to 6%, the price of this bond will rise above par to 104.27 (line 3). Bond prices and bond yields, then, are inversely related.


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TABLE 7.1

INTEREST RATE CHANGES AND BOND PRICES

7% Five-Year Bond Line

% Yield

% Change Yield

Price

Price Change

% Price Change

1

8

+14.29

95.94

-4.06

-4.06

2

7

0

100.00

0

0

3

6

-14.29

104.27

+4.27

+4.27

From Table 7.1, when interest rates rise and the bond yield rises to 8% to keep pace, the only way to create additional yield beyond what the 7% coupon rate already provides is to lower the price of the bond. To achieve a yield of 8%, the price of the bond must drop from 100 to 95.94. New buyers paying 95.94 would receive a combination of interest income ($7 per $100 of par value) and a gain on the price of the bond (based on the difference between the purchase price and eventual maturity price of par), thereby increasing the overall yield to 8%. Conversely, when interest rates fall and the bond yield falls to 6% to keep pace, the only way to reduce the yield below what the 7% coupon rate provides is to increase the price of the bond. To achieve a yield of 6%, the price of the bond must rise from 100 to 104.27. New buyers paying 104.27 would receive a combination of interest income (still $7 per $100 of par value, as coupon rate doesn’t change over the life of the bond) and a loss on the price of the bond, thereby reducing the overall yield to 6%.

The Impact of Maturity The next important relationship to recognize is that longer-term bonds are more volatile in price than shorter-term bonds. Table 7.2 compares a 7% five-year semi-annual coupon bond with a 7% ten-year semi-annual coupon bond. Note that if interest rates are 7%, both bonds will be priced at par to yield 7%. TABLE 7.2

INTEREST RATE CHANGES AND TERM

7% Five-Year Bond % Yield

% Change Yield

Price

Price Change

% Price Change

8

+14.29

95.94

-4.06

-4.06

7

0

100.00

0

0

6

-14.29

104.27

+4.27

+4.27


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TABLE 7.2

INTEREST RATE CHANGES AND TERM – Cont’d

7% Ten-Year Bond % Yield

% Change Yield

Price

Price Change

% Price Change

8

+14.29

93.20

-6.80

-6.80

7

0

100.00

0

0

6

-14.29

107.44

+7.44

+7.44

If interest rates rise to the point at which each bond yields 8%, both the five-year and the tenyear bond will drop in price. However, the five-year bond drops 4.06%, and the ten-year bond drops 6.80%. A similar pattern occurs when interest rates, and therefore yields, drop. Because there is greater uncertainty about the markets and interest rates the farther out into the future we go, the longer the term of the bond, the more volatile its price. The longer-term bond will rise more sharply (7.44% if yields drop to 6%) than the shorter-term bond (which rises only 4.27%). As a bond approaches its maturity over the years, it will become less volatile. For example, a bond originally issued with a ten-year maturity will, seven years later, have a three-year term, and will be priced as and trade as a three-year bond at that time.

The Impact of the Coupon Our next pricing relationship states that lower-coupon bonds are more volatile in price than highcoupon bonds. Table 7.3 compares a 7% five-year semi-annual coupon bond with a 6% five-year semi-annual coupon bond. All other factors are assumed to be constant, such as credit quality and liquidity, therefore the only difference between the two bonds is the coupon rate. Market rates start at 7%. TABLE 7.3

INTEREST RATE CHANGES AND COUPON


% Change Yield

Price

Price Change

% Price Change

8

+14.29

95.94

-4.06

-4.06

7

0

100.00

0

0

6

-14.29

104.27

+4.27

+4.27


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TABLE 7.3

INTEREST RATE CHANGES AND COUPON – Cont’d


% Change Yield

Price

Price Change

% Price Change

8

+14.29

91.89

-3.95

-4.12

7

0

95.84

0

0

6

-14.29

100.00

+4.16

+4.34

When yields rise, for example, from 7% to 8%, both bonds drop in price, but the lower coupon bond drops more (4.12%) than the higher-coupon bond (which drops 4.06%). This difference is significant when there is a considerable difference between coupons, or when large sums of money are invested. Even in this case of relatively similar coupons and a small change in yields, the difference in price change is $0.11 ($3.95 versus $4.06).

The Impact of Yield Changes Our last bond pricing relationship states that the relative yield change is more important than the absolute yield change. For example, a drop in yield from 12% to 10% will have a smaller impact on a bond’s price than a drop in yield from 4% to 2%. Although both represent a drop of 200 basis points, the former is a 17% change in yield, and the latter is a 50% change in yield. Thus, bond prices are more volatile when interest rates are low. This principle applies even when the change in yield is small. Returning to the sample 7% five year semi-annual coupon bond and a yield of 7% (the bond is priced at par). Table 7.4 demonstrates that a 1% drop in yield leads to a different (and greater) change in price than a 1% rise in yield. The price rises by 4.27% in the first scenario, and falls by 4.06% in the second. TABLE 7.4

RELATIVE INTEREST RATE CHANGES


% Change Yield

Price

Price Change

% Price Change

8

+14.29

95.94

-4.06

-4.06

7

0

100.00

0

0

6

-14.29

104.27

+4.27

+4.27



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Duration as a Measure of Bond Price Volatility Changes in interest rates represent one of the main risks faced by investors when holding fixedincome securities. We discussed the following relationships: •

The value of a bond changes in the opposite direction to changes in interest rates—i.e., as interest rates rise, bond prices fall and as interest rates fall, bond prices rise.

•

For 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.

•

For 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.

As we have seen, it is fairly easy to compare bonds with the same term to maturity or the same coupon, but how do we compare bonds with different coupon rates and different terms to maturity? For example, how can we determine whether a bond with a high coupon and a long term will be more or less volatile than a bond with a lower coupon and a shorter term? A given change in interest rates will impact the price of bonds with different features, coupons, maturities, protective covenants, etc. differently. For bondholders, being able to determine the impact of interest rate changes on bond prices will lead to better investment decisions. Fortunately, a calculation exists called duration, which combines both the impact of the coupon rate and the term to maturity into one calculation. Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. It is defined as the approximate percentage change in the price or value of a bond for a 1% change in interest rates. The higher the duration of the bond, the more it will react to a change in interest rates. Duration is simply an investment tool that helps investors determine the volatility or riskiness of a bond or a bond fund – i.e., how much the price of the bond will move up or down with changes in interest rates. In this way, a single duration figure for each bond can be compared directly with the duration of every other bond. Consider a bond with a duration of 10. According to our definition, the price of this bond will change by approximately 10% for each 1% change in interest rates. Let’s assume that the bond is currently priced at 105. If interest rates rise by 1% then the price of the bond will fall by approximately 10% to 94.50. This is calculated as 105 – (10% × 105). Since a higher duration translates into a higher percentage price change for a given change in yield, an investor will realize the greatest return from an expected decline in interest rates by investing in bonds with a higher duration. If he does this and interest rates do fall, he will earn a greater return than if he had invested in bonds with lower duration. The same is true when interest rates are expected to rise. To protect a bond portfolio from a dramatic decline due to an interest rate increase, investors should invest in bonds with low duration. We are not constrained to 1% interest rate changes. As long as the duration of the bond is known, the effect of any range of interest rate changes can be determined. For example, for a 50-basis-point or 0.5% change in interest rates, the approximate price change on our bond with a duration of 10 is 5% (10 × 0.5%); for a 0.25% change in interest rates, the approximate price change on the bond is 2.5% (10 × 0.25%) etc.


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Table 7.5 shows the impact interest rate changes have on bonds with different durations. As the table shows, the same interest change of 1% has a greater impact on the price of Bond A compared with the price change on Bond B. TABLE 7.5

IMPACT OF AN INTEREST RATE CHANGE ON BONDS WITH DIFFERENT DURATIONS

Both Bond A and Bond B are priced at

Bond A Duration = 10

Bond B Duration = 5

$1,000

$1,000

$900

$950

$1,100

$1,050

Interest rates rise by 1% • the price of Bond A falls by 10% • the price of Bond B falls by 5% Interest rates fall by 1% • the price of Bond A rises by 10% • the price of Bond B rises by 5%

Calculation of a bond’s duration is complicated. Moreover, a bond’s duration can change over longer holding periods and larger interest rate swings. Therefore, we have not shown its calculation here. Duration is explained more fully in CSI’s Investment Management Techniques (IMT), Portfolio Management Techniques (PMT), and Wealth Management Essentials (WME) courses.

Complete the following Online Learning Activity Bond Properties and Pricing There are a number of properties that affect the volatility and price of bonds. These factors include the term to maturity, the coupon, the yield and special features. In this activity you’ll review these factors and the impact they have on bond price. Complete the Bond Properties and Pricing activity to learn more about bond properties.


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HOW DOES BOND MARKET TRADING WORK? When a securities transaction has been confirmed, the change in legal ownership is effective immediately. However, payment for purchased securities does not have to be made until sometime later, and the securities do not have to be delivered until the end of this time period, called the settlement period. The length of the settlement period varies depending on the type of security. Table 7.6 presents a summary of settlement periods for various Government of Canada (GoC) and other fixed-income securities. TABLE 7.6

BOND SETTLEMENT PERIODS

Security

Settlement

GoC Treasury Bills

Same day

GoC bonds with a term of three years or less to maturity.

Second clearing day after the transaction takes place

GoC bonds with a term to maturity of more than three years and all other bonds, debentures, or other certificates of indebtedness.

Third clearing day after the transaction takes place

Clearing and Settlement Over time, the recognition of ownership of debt securities has taken on different forms. Table 7.7 describes the different methods in which debt securities have been issued. TABLE 7.7

DEBT SECURITIES OWNERSHIP

Ownership

Characteristics

History

Bearer Bonds

A certificate is produced and detachable coupons are attached to the residual principal payment. Investors “clip” the coupon and submit it to a bank or other financial institution to receive payment from the issuer on each coupon payment date. Same process is followed for the residual principal when due. Ownership is signified by physical possession.

The risk of losing the certificate was a concern, because they could be sold by anyone who had physical possession, whether or not the seller was considered the rightful owner. As an added protection from theft, other methods of registration were sought. Some (though not many) bearer bonds exist today.


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TABLE 7.7

DEBT SECURITIES OWNERSHIP – Cont’d

Ownership

Characteristics

History

Registered Bonds

Registered bonds bear the name of the rightful owner and can be sold or transferred only when the owner signs the back of the certificate. Coupon payments are mailed to the registered owner.

This added layer of protection solved the issue of theft and loss of certificates. But the evolution of the bond market led to demand for greater liquidity as well as cheaper and faster ways to bring issues to the market.

Bonds registered in book-based format

Rather than physical certificates, a book-based format is an electronic record keeping system used by depositories that keep track of ownership and settlement of securities transactions. In Canada, the national provider of these services is CDS Clearing and Depository Services Inc.

Most bond issues around the globe are now issued in a book-based format, with depository, trade clearing and settlement services provided by participating clearing providers.

Calculating Accrued Interest Most bonds pay interest twice a year, on the same month and day as the maturity date and exactly six months later. For example, if a bond’s maturity date is February 15, 2019, interest will be paid every February 15 and every August 15 until maturity. Some Eurobonds pay annually and some provincial and corporate bonds pay monthly. It is possible, however, to purchase bonds on almost any day. An investor could purchase the above bond on August 1 of any year, hold it for two weeks, and receive a full six months’ worth of interest. This is not equitable to the previous bondholder, who may have held the bond for five and a half months and received no interest. Accrued interest is the amount of interest built up during the previous holding period. It is paid at the time of purchase from the buyer to the previous holder to ensure the transaction between buyer and seller is equitable. Interest accrues from the day after the previous interest payment date up to and including the day of settlement. The client who buys a bond pays the purchase price plus the interest that has accrued or accumulated since the last interest date. This interest is regained if the bond is held until the next interest payment date, or if the bond is sold in the meantime, resulting in accrued interest being paid to the seller. The amount of accrued interest is found by using three numbers: • • •

The principal amount The coupon rate The time period

The amount is based on the par amount purchased or sold. Even though the bond may have been purchased at a premium or a discount, interest is always based on par value. Also, the rate at which interest accrues is the coupon rate of the bond, not its yield.


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Example: Nicolas purchases an 8% Government of Canada bond, due to mature March 15, 2020, and a principal amount of $200,000. He purchased the bond on Tuesday, May 6 of the current year, and the last coupon was paid on March 15 of the current year. This makes March 16 the first day of accrued interest. The settlement date for this transaction is May 9 (according to Table 7.6). The number of days of accrued interest for this transaction, between March 15 and May 9 is: March 16–31

16 days

April

30 days

May

9 days

Total

55 days

Notes: (a) Include March 16 and May 9, but not March 15. (b) If the year is a leap year, the client is entitled to an extra day’s accrued interest in February. Nevertheless, the practice is to base the interest calculation on a 365-day year. Par Amount $200, 000

q Coupon Rate q Time Period q

8.00 100

q

55 365

$2, 410.96

Because of the variation in the number of days in a calendar month, the calculation of accrued interest can result in an amount greater than half a year’s interest payment. In such cases, accrued interest is calculated on the basis of the full amount of the coupon, less one or two days, as the case may be. The amount of accrued interest owed to a seller or payable by a purchaser is shown on the confirmation contract that each receives.

Complete the following Online Learning Activity Accrued Interest In this activity you’ll focus on a key settlement requirement in bond trading— accrued interest. When a bond is bought or sold on the secondary market it may have accrued interest attached. Part of the purchase price of the bond is the accrued interest. Any accrued interest must be paid to the seller at settlement. Complete the Accrued Interest activity to review the mechanics of calculating accrued interest.


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WHAT ARE BOND INDEXES? An index measures the relative value and performance of a group of securities over time. Most people are familiar with stock indexes, such as the S&P/TSX Composite Index. While stock indexes have been around for well over 100 years, bond indexes have been around only since the early 1970s. Bond indexes are generally used in three ways: • • •

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 PC Bond, a business unit of the TMX Group, offers a comprehensive set of Canadian bond indexes. The best known of these indexes is the DEX Universe Bond Index, which tracks the broad Canadian bond market. The Index consisted of bonds representing a full cross-section of government and corporate bonds. All Canadian dollar-denominated investment-grade bonds with a term to maturity of one year or more are eligible for inclusion in the index. The bonds in the index are grouped into sub-indexes in different combinations according to whether they are government or corporate bonds, their time to maturity, and the bond rating (for corporate bonds only). The DEX Universe Bond Index measures the total return on bonds in Canada, including realized and unrealized capital gains, and the reinvestment of coupon cash flows. It is a capitalizationweighted index, with each bond held in proportion to its market value.

Global Indexes A number of securities firms and other organizations have created bond indexes that track the many global markets. A sample includes:

Global Bond Indexes

• Barclays Capital Aggregate Bond Index

U.S. Bonds

• Barclays Capital Aggregate Bond Index • Salomon BIG • Merrill Lynch Domestic Master • CPMKTB - The Capital Markets Bond Index



Government Bonds

• Salomon Smith Barney World Government Bond Index • J.P. Morgan Government Bond Index • Access Bank Nigerian Government Bond Index • FTSE UK Gilts Index Series • MAX Hungarian Government Bond Index Series

Emerging market bonds

• J.P. Morgan Emerging Markets Bond Index

High-yield bonds

• CSFB High Yield II Index (CSHY)

• JPMorgan GBI-EM Index

• Merrill Lynch High Yield Master II • Bear Stearns High Yield Index (BSIX)

Complete the following Online Learning Activity Fixed-Income Securities Review This last activity reviews the key concepts of this chapter, including: • pricing principles • the term structure of interest rates • bond properties • clearing and settlement • accrued interest Complete the Fixed-Income Securities Review w activity.


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Define present value and the discount rate, and perform calculations relating to the present value of a future cash flows, bond pricing and yield. •

Present value is the value today of an amount of money to be received in the future and is the most accurate method of determining an appropriate price for a bond.

•

The discount rate is the interest rate used to calculate present value. In general it represents the minimum interest rate an investment should provide after factoring in risk.

•

The fair price for a bond is the sum of the present value of its coupons and the present value of its principal.

•

Treasury bills are purchased at a discount and mature at their full par value. The difference between the purchase price and the maturity value represents the return on the security. The yield on a Treasury bill is calculated as: 100 price 365 q q100 price term

•

The current yield of any investment, whether it is a bond or a stock, is the income yield on that security relative to its current market price. The current yield is calculated as follows: Annual cash flow q100 Current market price

•

A bond’s yield to maturity incorporates both interest income and any capital gain or loss resulting from holding the bond to maturity. A financial calculator simplifies the YTM calculation. The approximate yield to maturity on a bond is calculated as: Interest income / Price change per compounding period q100 (Purchase price Par Value) u 2

•

The yield to maturity (YTM) is calculated based on the assumption that all interest received from coupon bonds is reinvested (or compounded) at the YTM prevailing at the time the bond was purchased. The risk that the coupons cannot be reinvested at that rate is called reinvestment risk.



2.

3.

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Define a real rate of return and a yield curve, and evaluate three theories of interest rate determination. •

The real rate of return is the return on an investment adjusted for the effects of inflation. Because inflation reduces the value of a dollar, the quoted or nominal return must be reduced by the inflation rate to arrive at the actual or real rate of return.

•

The yield curve is a graphical depiction of interest rates by term to maturity and shows how interest rates on debt securities differ depending on the term to maturity.

•

The expectations theory states that the shape of the yield curve is a reflection of market consensus expectations for future interest rates. For example, an upward sloping curve reflects the expectation that interest rates will rise in the future.

•

According to the liquidity preference theory, investors must be compensated for assuming the risk of holding longer-term debt securities, and this compensation is in the form of a yield or liquidity premium.

•

According to the market segmentation theory, investors concentrate their debt holdings in a particular term to maturity. For example, an institutional investor may focus its holdings on bonds with terms of two to five years, while another investor may have a preference for long-term bonds.

Analyze the impact of fixed-income pricing properties on bond prices. •

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

•

For two bonds with the same term to maturity and the same yield, the price of the bond with the higher coupon rate is less volatile than the price of the bond with the lower coupon rate.

•

For two bonds with the same coupon rate and same yield, the price of the bond with the longer term to maturity is more volatile than the price of the bond with the shorter term to maturity.

•

Duration is a measure of the sensitivity of a bond’s price to changes in interest rates. It is defined as the approximate percentage change in the price or value of a bond for a 1% change in interest rates. The higher the duration of the bond, the more it will react to a change in interest rates.


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4.

5.

Summarize the rules and regulations of bond delivery and settlement. •

Trading in Government of Canada Treasury bills is settled on the same day as the transaction.

•

Government of Canada bonds with a term to maturity of three years or less settle on the second clearing day after the transaction takes place.

•

Government of Canada bonds with a term to maturity of more than three years and all other bonds, debentures, or other certificates of indebtedness settle on the third clearing day after the transaction takes place.

•

Interest on a bond accrues from the day after the previous interest payment date up to and including the day of settlement. The client that buys a bond pays the previous holder the purchase price plus the interest that has accrued since the last interest date.

Assess the role of bond indexes in the securities industry. •

An index measures the relative value and performance of a group of securities over time.

•

Bond indexes are generally used as a guide to the performance of the overall bond market or a segment of that market, and as a performance measurement tool to assess bond portfolio managers. Bond indexes are also used to construct bond index funds.






Chapter

8

Equity Securities: Common and Preferred Shares


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8 Equity Securities: Common and Preferred Shares CHAPTER OUTLINE What are Common Shares? • Benefits of Common Share Ownership • Capital Appreciation • Dividends • Voting Privileges • Tax Treatment • Stock Splits and Consolidations • Reading Stock Quotations What are Preferred Shares? • The Preferred’s Position • Why Companies Issue Preferred Shares • Why Investors Buy Preferred Shares • Preferred Share Features • Straight Preferreds • Convertible Preferreds • Retractable Preferreds • Floating-Rate Preferreds • Foreign-Pay Preferreds • Other Types of Preferreds

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What are Stock Indexes and Averages? • Canadian Market Indexes • U.S. Stock Market Indexes • International Market Indexes and Averages Summary

LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Discuss the benefits of common share ownership, describe how dividends are taxed, declared and claimed, and describe the impact of stock splits and consolidations on shareholders. 2. Discuss the position, advantages, disadvantages and special provisions of preferred shares, differentiate among the types of preferred shares, describe their features, and perform related calculations. 3. Differentiate between a stock market index and an average, and summarize the important stock market indexes and averages.

INVESTING IN EQUITIES Equity securities, particularly common stocks, are an important part of most investors’ portfolios. History has shown that the return on stocks has exceeded the return on bonds over the long term. In addition, long-term common stock returns have consistently outpaced inflation, providing long-term protection from a loss of purchasing power. At the close of trading each day, investors and advisors want to know how the markets performed. To measure performance, market participants look to the various stock market indexes that have developed over time. For the most part, these indexes track the performance of a basket of common shares that represents the most visible and easily accessible of investments. Common shares form the backbone of many investment portfolios and are a major component of pension funds, mutual funds and hedge funds. Unlike many other types of investments, there are a number of inherent rights, advantages and disadvantages of common share ownership with which investors must be familiar.


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Closely related, but with some key differences, are preferred shares. Preferred shares are a staple investment in the Canadian market largely because of the fixed-income stream that the investment generates. With an investment in common shares, what you see is mostly what you get – an ownership position in a company. Preferred shares are a little different in that there is a variety of features and structures, characteristics that make them appeal to different investors for various reasons. You will find that you are familiar with many of the preferred share features discussed in this chapter because they are very similar to the different features available in bonds. In this first chapter on equity securities, we look at some of the basic features, advantages and disadvantages of investing in common and preferred shares before introducing the important role played by Canadian, U.S. and global stock market indexes.

KEY TERMS

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Arrears

Ex-dividend date

Callable preferreds

Floating-rate preferreds

Canadian Depository for Securities Limited (CDS)

Foreign-pay preferreds

Capital gain

Non-callable preferreds

Capital loss

Odd lot

Consolidations

Participating preferred

Convertible preferreds

Retained earnings

Cum dividend

Restricted shares

Deferred preferred

Retractable preferred

Delayed floaters

S&P/TSX Composite Index

Dividend record date

Soft retractable preferred

Dividend reinvestment plan

Standard Trading Unit

Dividend tax credit

Stock dividends

Dividends

Stock split

Dollar cost averaging

Street certificates

Dow Jones Industrial Average (DJIA)

Variable rate preferreds

Ex-dividend

Voting rights


EIGHT • EQUITY SECURITIES: COMMON AND PREFERRED SHARES

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WHAT ARE COMMON SHARES? Common shareholders are the owners of a company and initially provide the equity capital to start the business. If the venture prospers, the shareholders benefit from the growth in value of their original investment and the flow of dividend income. The prospect of a small investment growing to many times its original value attracts investors to common shares. On the other hand, if the business fails, the common shareholders may lose their entire investment. This possibility of total loss explains why common share capital is sometimes referred to as venture or risk capital. SUMMARY OF COMMON SHARES

Position on asset claims in case of bankruptcy

Senior creditors (such as banks), bond and debenture holders and preferred shareholders all have prior claims on the company’s assets in case of bankruptcy. Common shares, therefore, have a relatively weak position on asset claims.

Dividends

Unlike debt interest, common share dividends are payable at the discretion of the Board of Directors. There is no guarantee of dividend income.

Evidence of Ownership

Shares are most often registered in street certificate form, meaning they are registered in the name of the securities firm rather than the beneficial owner. This increases the negotiability of the shares, making them more readily transferable to a new owner.

Clearing and Settlement

CDS Clearing and Depository Services Inc (CDS) offers computerbased systems to replace certificates as evidence of ownership in securities transactions. This system almost eliminates the need to handle securities physically.

Trading Units

Stocks trade in uniform lot sizes on stock exchanges. A standard trading unit is a regular trading unit which has uniformly been decided upon by the exchanges. The usual unit of trading for most stocks is 100 shares. A group of shares traded in less than a standard trading unit is called an odd lot.

Benefits of Common Share Ownership The right to buy or sell common shares in the open market at any time is an attractive feature and a relatively simple matter with few legal formalities. When a company first sells its shares to investors, the proceeds from the sale go to the company. When these outstanding shares are subsequently sold by their holders, the selling price is paid to the seller of the shares and not to the corporation. Shares, therefore, may be transferred from


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one owner to another without affecting the operations of the company or its finances. From the company’s point of view, the effect of a sale is simply that a new name appears on its list of shareholders. The following are some of the benefits of common share ownership: • • • • • • • • •

Potential for capital appreciation The right to receive any common share dividends paid by the company Voting privileges, including the right to elect directors, to approve financial statements and auditor’s reports, and vote on other important issues Favourable tax treatment in Canada of dividend income and capital gains Marketability – shareholdings can easily be increased, decreased or sold, for most public companies The right to receive copies of the annual and quarterly reports, and other mandatory information pertaining to the company’s affairs The right to examine certain company documents such as the by-laws and register of shareholders at specified times The right to question management at shareholders’ meetings Limited liability

Capital Appreciation For many investors, the prospect of capital appreciation is the main attraction of common shares. Common shares may increase in value as retained earnings (earnings kept within the company rather than paid out to shareholders) increase the size of shareholder’s equity, making the stock more attractive to investors. Increasing profits and increasing dividend payments can also result in a higher demand for the stock, thereby leading to the stock’s capital appreciation. It is important to keep in mind that not all common shares fulfill these expectations, and even those that increase shareholder equity, earn profits and increase dividend payments will not necessarily increase in value every year. There are many other factors that can affect a company’s stock price, and careful analysis is required to ensure a profitable investment. Stock price analysis is the focus of Chapter 13.

Dividends A company’s net earnings are available for distribution as dividends, or may be retained within the company and reinvested in the business, or a combination of the two. Dividend policy is determined by the Board of Directors, who are guided primarily by the goals of the company, the size of the company, the industry in which it participates, and the financial position of the company. For example, mature companies, such as banks, may pay out a substantial percentage of their earnings as dividends to shareholders, while growing companies such as those in the technology field may need to keep a high proportion of earnings within the company to fund the large amount of research and development that are crucial to their success. To maintain its operations and finance future growth opportunities, most companies will retain a portion of earnings each year. In the long run, this policy may work to the benefit of shareholders if it results in increased earnings. © CSI GLOBAL EDUCATION INC. (2013)


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Reductions or omissions of dividends do occur, particularly in poor economic times, and although they may be temporary, they do emphasize the risks of common share investment. REGULAR AND EXTRA DIVIDENDS

Some companies paying common share dividends designate a specified amount that will be paid each year as a regular dividend. The term regular indicates to investors that payments will be maintained, barring a major collapse in earnings. Some companies may also pay an extra dividend on the common shares, usually at the end of the company’s fiscal year. The extra is a bonus paid in addition to the regular payout – but the term extra cautions investors not to assume that the payment will be repeated the following year. DECLARING AND CLAIMING DIVIDENDS

Companies may pay dividends quarterly, semi-annually or annually. But, unlike interest on debt, dividends on common shares are not a contractual obligation. The Board of Directors decides whether to pay a dividend, the amount and the payment date. An announcement is made in advance of the payment date. If the shares are registered in the name of the owner, dividend payment cheques are mailed directly to the owner. For shares registered in street certificate form, dividend payments are made to the securities firm whose name appears on the certificate. The dividends are then credited to the accounts of the firm’s clients who own the shares. EX-DIVIDEND AND CUM DIVIDEND

Many companies place advertisements in financial newspapers announcing the declaration of a dividend. Following is an example of a typical dividend announcement. EXAMPLE

NOTICE OF DIVIDEND

The Board of Directors of ABC Inc. voted to pay on July 2, 20XX to shareholders of record at the close of business on June 13, 20XX a dividend of $0.75 per each share of common stock. The transfer books will not be closed. Payment will be made in Canadian funds.

The purpose of the interval between June 13 and July 2 is to give the company time to prepare the dividend cheques for mailing to recorded shareholders. During this interval, a purchaser of these shares will not receive the dividend that has just been declared and the stock is said to be ex-dividend. When a stock is actively traded, the record of shareholders is continually changing. For convenience, the company names a date known as the dividend record date. All shareholders recorded as of this date will be entitled to the dividend. The dividend record date is usually two to four weeks in advance of the payment date in order to allow time for cheque preparation. To determine whether the seller or the buyer is entitled to the dividend when a sale takes place around the time of the dividend payment, the stock exchange names an ex-dividend date. On and after this date, the stock sells ex-dividend; that is, the seller retains the dividend and the buyer is not entitled to it. The ex-dividend date is set at the second business day before the dividend record date. Since trades settle on the third business day after a trade, a purchaser of shares two


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days before the record date would not have the trade settle until the day after the record date, and would therefore not be a shareholder of record for purposes of receiving the dividend. The following example shows how the shares trade. EXAMPLE

TRADING EX- AND CUM DIVIDEND

Using the dates in the previous example, and assuming that all are business days, the shares would trade as follows: Date Traded

Date Settled

Ex- or Cum Dividend

Monday June 9

Thursday June 12

Cum Dividend

Tuesday June 10

Friday June 13

Cum Dividend

Wednesday June 11

Monday June 16

Ex-dividend

Thursday June 12

Tuesday June 17

Ex-dividend

Friday June 13

Wednesday June 18

Ex-dividend

Monday June 16

Thursday June 19

Ex-dividend

The major Canadian stock exchanges publish dividend announcements in their daily releases to securities firms in the following form:

Payment

When Payable

Shareholder’s of Record*

Ex-Dividend Date

A Company

.25

June 15

May 14

May 12

B Company

.50

August 5

July 15

July 13

* or Shareholders of Record Date

The person who buys the stock on the day that it goes ex-dividend does not get the declared dividend, but will of course receive subsequent dividends as long as the shares are held. The person who buys the stock the day before it goes ex-dividend, however, does receive the dividend, and in this case the stock is said to be cum dividend (meaning with dividend). The last day a stock trades cum dividend is the third business day before the dividend record date; in other words, it is the day before the first ex-dividend date. DIVIDEND REINVESTMENT PLANS

Some major companies give their preferred and common shareholders the option of participating in an automatic dividend reinvestment plan. In such a plan, the company diverts the shareholders’ dividends to the purchase of additional shares of the company. Reinvested dividends are taxable to the shareholder as ordinary cash dividends even though the dividends are not received as cash.



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Share purchases in most dividend reinvestment plans are made on the open market under the direction of a trustee. Participating shareholders are periodically sent a statement showing the number of shares, including fractional shares in some cases, bought under the plan and at what price. The provision in some plans for crediting participating shareholders with applicable fractions of shares is unique. Normally fractions of shares cannot be purchased in the market by a shareholder. Since under a reinvestment plan the company uses authorized dividends to purchase additional shares in bulk, a saving in commission is achieved. An individual shareholder trying to buy the same small number of shares would normally pay a higher commission, particularly if odd lots were involved. In effect, a dividend reinvestment plan is an automatic savings plan which solves the problem of reinvesting small amounts of cash. Participating shareholders acquire a gradually increasing share position in the company, and because purchases by the plan are made regularly, shareholders can reduce the average cost paid per unit, a process known as dollar cost averaging. STOCK DIVIDENDS

Sometimes the dividend may be in the form of additional stock rather than cash. Stock dividends are typically paid by a rapidly growing company that needs to retain a high degree of earnings to finance future growth. The advantage to the company is that cash is conserved for expansion purposes while shareholders receive additional shares, which can be sold if they require the cash. These stock dividends would be recorded on the Statement of Retained Earnings in the same fashion as cash dividends. Since stock dividends are treated as regular cash dividends for tax purposes, many investors, given the option, elect to receive dividends in cash.

Voting Privileges Voting rights are an important feature of common shares. Through the right to vote at the annual meeting and at special or general meetings, shareholders exercise their rights as owners to control the destiny of the corporation. They elect the directors who guide and control the business operations of the corporation through its officers. Many matters of an unusual, nonrecurring nature, such as the sale, merger or liquidation of the business and the amendment of the charter, must receive shareholder approval before action is taken. However, many companies have two or even three different types of shares, often designated as Class A or B. Because all classes may not have voting rights and may differ in other respects such as dividend entitlement, it is important to know their respective features. RESTRICTED SHARES

Restricted shares are shares which give the shareholder the right to participate to an unlimited degree in the earnings of a company and in its assets on liquidation, but do not have full voting rights. There are three categories of restricted or special shares: •

Non-voting – shares which have no right to vote, except perhaps in certain limited circumstances;


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•

Subordinate voting – shares which carry a right to vote, where there is another class of shares outstanding that carry a greater voting right on a per share basis; and

•

Restricted voting – shares which 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.

In recent years, the number of companies issuing restricted shares has increased substantially. Some investors have become concerned and have resisted reorganizations which involve the creation of restricted shares. Canadian securities regulators have introduced policies regarding these shares. In Ontario, for example, the details of these policies are set out in Ontario Securities Commission Policy 1.3. Investment advisors should be able to identify restricted shares and understand the implications of the differences in the voting rights of such shares in order to advise their clients properly. STOCK EXCHANGE REGULATIONS OF RESTRICTED SHARES

The stock exchanges have urged companies having or issuing restricted shares to put in place provisions to ensure that the holders of restricted shares are treated fairly. Some of the regulations published by the stock exchanges and securities commissions are: •

Restricted shares must be identified by the appropriate restricted share term

•

Disclosure documents such as information circulars, annual reports and financial statements which are sent to voting shareholders must be sent to holders of restricted shares and must describe the restrictions on the voting rights of the restricted shares

•

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 as such

•

Holders of restricted shares must be given notice of, be invited to attend and be permitted to speak at shareholders’ meetings

•

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

Advisors should be aware of the protection offered to restricted shareholders, as the extent of such protection may vary.

Tax Treatment The tax system in Canada provides some benefits to investors holding common shares: •

A dividend tax credit is available that makes the purchase of dividend-paying shares of taxable Canadian companies relatively attractive compared to interest paying securities.

•

The current exemption from tax of 50% of capital gains provides investors with a tax inducement to buy shares.



•

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Stock savings plans entitle residents of some provinces to deduct up to specified annual amounts from (or obtain a tax credit for) the cost of certain stocks purchased in their respective provinces during the year.

DIVIDENDS FROM TAXABLE CANADIAN CORPORATIONS

The pre-tax yield from common and preferred shares is normally below the yields available from debt investments. This is due to the tax treatment of interest received versus dividends received. When a company pays interest on its debt, the interest is paid with the company’s pre-tax dollars because interest is considered a tax-deductible cost of doing business. When bond or debenture holders receive interest, it is treated as taxable income in their hands. When a company pays dividends on its shares, the dividends are paid with after-tax dollars because dividends, being a share of a company’s profits, are not considered a tax-deductible cost of doing business. When shareholders receive dividends, the dollars involved have already been subject to tax in the company’s hands prior to payout. To alleviate double taxation, the federal government allows shareholders of Canadian companies to receive tax relief through the dividend tax credit. The dividend tax credit results in a lower tax payable on dividend income compared to tax payable on interest income. This procedure is applicable to dividends received from resident taxable Canadian corporations. No similar preferential treatment is applicable to interest income, foreign dividends or dividends from non-taxable Canadian corporations. TAX ON FOREIGN DIVIDENDS

Individuals who receive dividends from non-Canadian sources usually receive a net amount from these sources, as taxes are usually deducted at source. Such investors may be allowed a deduction from the Canadian income tax otherwise payable. The allowable credit is essentially the lesser of the foreign tax paid and the Canadian tax payable on the foreign income, subject to certain adjustments. Details on foreign tax deductions are available from the Canada Revenue Agency (CRA). CAPITAL GAINS AND LOSSES

Investors are taxed on any capital gains or losses earned from their investments. Basically, a capital gain arises from the sale (or the deemed sale) of a capital property for more than its cost. A capital loss arises from the sale of a capital property for less than its cost. Any capital gains earned must be reported, and 50% of the gains must be included in income for that year and taxed at the investor’s marginal tax rate (the tax rate that would have to be paid on any additional dollars of taxable income earned). Capital losses can be used to reduce any capital gains that have been earned, but generally cannot be used to reduce any other income.


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FOR INFORMATION PURPOSES ONLY

An investor buys 1,000 ABC common shares at a market price of $10 a share and then sells them five years later at a price of $15 a share. Cost of the shares

1,000 × $10 = $10,000

Proceeds from the sale

1,000 × $15 = $15,000

Capital Gain on the sale Taxable Capital Gain

= $ 5,000 50% × $5,000 = $ 2,500

The investor would then pay tax at his personal tax rate on the $2,500 and not on the full $5,000 gain. Note that we have excluded commissions on this transaction.

Stock Splits and Consolidations Most companies believe it is good corporate strategy to keep the market price of their shares in a popular price range, say $10 to $20, and may use a stock split or subdivision to bring a highpriced stock into this range or a consolidation, to bring a low-priced stock more attractive. STOCK SPLITS

When a split becomes effective, the market price of the new shares reflects the basis of the split. Example: In a four-for-one split, the market price of shares selling at $100 (pre-split basis) will sell somewhere in the $25 range after the split. An investor who owned 1,000 shares of the company would now own 4,000 shares.

The split itself does not affect the dollar value of a company’s equity, nor the proportion and value of a shareholder’s stake (from the example above, note that the investment value of the investor’s holding remains unchanged: $100 × 1,000 shares pre split = $25 × 4,000 shares after the split). Equity per share would be reduced, as the total number of shares outstanding would increase, but the equity section of the statement of financial position would remain unchanged. REVERSE SPLIT OR CONSOLIDATION

When the market price of shares are too low, reverse stock splits or consolidations can occur with the result that market price rises to reflects the basis of the consolidation, and each shareholder’s total shareholdings in a company are reduced accordingly. Example: If a reverse split of one new share for ten old were implemented, a shareholder owning 100 shares of stock would own only 10 new shares after the reverse split. If the shares were selling at $0.25 before the reverse split, the new shares would probably trade near $2.50 per share. The total dollar value of the holdings would not be affected: $0.25 × 100 shares pre consolidation = $2.50 × 10 shares after the consolidation.

Reverse splits occur most frequently when a company’s shares have fallen in value to a level that is unattractive to investors with large amounts of capital. They are utilized when a company is in danger of being delisted by a stock exchange as the company’s share price has fallen below the exchange’s minimum share price rule. A reverse split raises the market price of the new shares and can put the company in a better position to raise new capital. © CSI GLOBAL EDUCATION INC. (2013)

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Reading Stock Quotations There are two kinds of stocks traded during the day under review: those that are listed and thus traded on the stock exchanges, and the unlisted stocks that trade on the over-the-counter market. A typical quotation for stocks traded in Canada during the day under review is shown here:

52 Weeks High

Low

Stock

Div.

High

Low

Close

Change

Volume

12.55

9.25

BEC

.50

10.65

10.25

10.35

+.50

6,000

This type of quotation is complex but very useful and may vary in format depending on the media source. This quotation means that: •

BEC common has traded as high as $12.55 per share and as low as $9.25 during the last 52 weeks.

•

BEC common has paid dividends totalling $0.50 per share during the last 52 weeks (sometimes an indicated dividend rate may be shown if the company pays regular dividends and has recently increased a dividend payment).

•

During the day under review, BEC common shares traded as high as $10.65 and as low as $10.25.

•

The last trade of the day in this stock was made at $10.35.

•

The closing trade price was $0.50 higher than the previous trading day’s closing trade price. (Therefore, BEC shares closed at $9.85 on the previous trading day.)

•

A total of 6,000 BEC common shares traded that day.

Market prices used in stock quotations apply to “standard trading units” and exclude commission expense for trades in listed stocks.

Complete the following Online Learning Activity Common Shares In this activity you will review the key features and benefits of common shares from the point of view of both the issuer and the investor. Features and benefits include, among others, voting privileges, tax implications and dividend payments. Understanding the features and benefits of these types of shares will help you decide if a particular common share is a good investment. Complete the Common Shares activity.


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WHAT ARE PREFERRED SHARES? Shares can have a number of designations including common, ordinary, subordinated, Class A and preferred. In recent years the name given to shares has become less helpful in determining the attributes attached to the shares. It is necessary to go beyond the name to determine the true characteristics of a company’s shares. The notes to a company’s audited financial statements can be useful in this regard. In this chapter, references to preferred shares apply to all shares not classified as common or restricted shares.

The Preferred’s Position It is important to keep in mind that bond and debenture holders are creditors, while preferred shareholders rank afterwards and are part owners along with common shareholders. Preferred shareholders are usually entitled to a fixed dividend payment subject to the discretion of the Board of Directors. Some companies issue more than one class of preferred stock, and when this occurs, each class is separately identified. (Note that in this example, and the ones that follow, reference is sometimes made to preference shares. These shares generally hold the same meaning as preferred shares, but can rank ahead of the different classes of preferred shares that a company has outstanding.) Example: ABC Corporation Limited has three preference share issues outstanding: a $2.50 Series Class A Preference; a $2.60 Series Class A Preference; and a $2.70 Series Class B Preference. If various outstanding preferred share issues rank equally as to asset and dividend entitlement, the shares are described as ranking pari passu.

PREFERENCE AS TO ASSETS

Preferred shares are usually given a prior claim to assets ahead of the common shares in the event of bankruptcy or dissolution of a company. Claims of creditors and debtholders rank ahead of preferred shareholder claims. The preferred share investor is therefore better protected than the common shareholders but junior to the claims of creditors and debtholders. The common shareholder has to be content with anything that is left after all creditor, debtholder and preferred shareholder claims have been met. This preference as to assets clause is found in most preferred share issues. Since preferred shareholders usually have no claim on earnings beyond the fixed dividend, it is fair that their position is buttressed by a prior claim on assets ahead of the common shares. PREFERENCE AS TO DIVIDENDS

Preferred shares are usually entitled to a fixed dividend expressed either as a percentage of the par or stated value, or as a stated amount of dollars and cents. Example: DEF Limited’s $50 par value 5.6% First Preferred Series U shares pay a fixed annual dividend of $2.80 per share ($50 par value x 5.6% = $2.80 annual dividend).



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Dividends are paid from earnings – current or past. However, unlike interest on a debt security, dividends are not obligatory and are payable only if declared by the Board of Directors. If the Board omits the payment of a preferred dividend, there is very little the preferred shareholders can do about it. However, the charters of some companies provide that no dividends are paid to common shareholders until preferred shareholders have received full payment of dividends to which they are entitled. While directors have the right to defer the declaration of preferred dividends indefinitely, in practice dividends are paid if justified by earnings. Failure to declare an anticipated preferred dividend has unfavourable repercussions. Besides weakening investor confidence, the general credit and future borrowing power of the company suffer. Since most preferred shares can be considered fixed-income securities, they do not offer, from an investment standpoint, the same potential for capital appreciation that common shares provide. Should interest rates decline, the preferred will increase in price, much like a bond; but good corporate earnings will have no effect on the dividend rate or equity allocation. Thus, the dividend rate is of prime importance to the preferred shareholder.

Why Companies Issue Preferred Shares In comparison with debt, preferred shares are usually more expensive for a company because dividends paid are not a tax-deductible expense. However, when all considerations are weighed, there may be sufficient advantages to justify a new preferred share issue. PREFERRED ISSUE VERSUS DEBT ISSUE

From a company’s viewpoint, preferreds do not create the demands that a debt issue creates. Preferreds do not usually have a maturity date, although some may have a purchase fund. If a preferred dividend payment is omitted, no assets are seized by preferred shareholders. The company has flexibility in deciding whether or not to declare a preferred dividend. Dividends are never omitted without good reason. But to preserve working capital in an emergency, a company’s directors may decide to omit a preferred dividend without jeopardizing the company’s solvency. A corporation will choose to issue preferreds rather than debt if: • • • • •

It is not feasible for it to market a new debt issue. Existing assets may already be 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/equity ratio is high. Preferreds will 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 SHARES VERSUS COMMON SHARES

When a company has decided it will not or cannot issue bonds or debentures, it may find conditions are not favourable for selling common shares either. The stock market may be falling or inactive, or business prospects may be uncertain. However, in such circumstances, preferred


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shares might be marketed as a compromise acceptable to both the issuing company and investors. Preferreds also offer the advantage of avoiding the dilution of equity that results from a new issue of common shares.

Since preferred shares typically do not have any claim on shareholder’s equity beyond the par value of the preferred shares, the issuance of preferred shares does not affect the common shareholders’ equity claims and therefore does not reduce the proportional ownership of common shareholders.

Why Investors Buy Preferred Shares Preferred shares are bought largely by income-oriented investors. Today, conservative individual investors, seeking income, purchase preferred shares to take advantage of the previously mentioned dividend tax credit. Institutional investors who may be concerned with taxes are attracted to the preferential tax treatment of preferreds as well. Canadian companies also purchase preferred shares as an income investment. Dividends paid by one resident taxable Canadian company to a similar company are not taxable in the hands of the receiving company. This is not the case with debt interest.

Preferred Share Features Table 8.1 describes the features that could be built into any of the types of preferred shares just described. Some features strengthen the issuer’s position, others protect the purchaser’s position. TABLE 8.1

PREFERRED SHARE FEATURES

Type of Feature

Definition

Cumulative

If a company’s Board of Directors votes not to pay one or more preferred dividends when due, the unpaid dividends accumulate or pile up in what is known as arrears. All arrears of cumulative preferred dividends must be paid before common dividends are paid or before the preferred shares are redeemed Investors should determine if a cumulative feature is present before buying preferred shares.

Non-cumulative

On non-cumulative preferreds, the shareholder is entitled to payment of a specified dividend in any year, only when declared. Arrears do not accrue and the preferred shareholder is not entitled to “catch-up” payments if dividends resume. For this reason, the dividend position of non-cumulative preferred shares is very weak.



TABLE 8.1

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PREFERRED SHARE FEATURES – Cont’d

Type of Feature

Definition

Callable

Callable preferreds can be called or redeemed by the issuer at a stated time and at a stated price. Callable preferreds usually provide for payment of a small premium above the amount of per share asset entitlement fixed by the charter, as compensation to the investor whose shares are being called in. The company will typically try to buy shares for cancellation on the open market or through invitations for tenders addressed to all holders. The price paid under these circumstances generally must not exceed the par value of the preferred shares plus the premium provided for redemption by call.

Non-callable

Non-callable preferred shares cannot be called or redeemed as long as the issuing company is in existence. This feature is restrictive from the issuer’s standpoint, in that it freezes a part of the capital structure for the life of the company. This feature is, therefore, rare.

Voting Privileges

Virtually all preferred shares are non-voting so long as preferred dividends are paid on schedule. However, once a stated number of preferred dividends have been omitted, it is common practice to assign voting privileges to the preferred.

Purchase Fund

A purchase fund is advantageous to preferred shareholders because it means that if the price of shares declines in the market to or below a stipulated price, the fund will make every effort to buy specified amounts of the security for redemption. Preferred shares with a purchase fund have a potential built-in market support through the fund’s purchasing efforts.

Sinking Fund

A sinking fund will often attempt to retire shares in the open market when the shares trade at or below a stipulated price, much like a purchase fund. If the shares cannot be purchased in the open market, the issuer is required to call or redeem the securities from investors to ensure the stipulated amount of securities are retired each year.

Straight Preferreds These are preferred shares with normal preferences as to asset and dividend entitlement ahead of the common shares. Straight preferreds may have any of the features described previously. They pay a fixed dividend for as long as they remain outstanding and the shares trade in the market on a yield basis. As with the market price of bonds and debentures, if interest rates rise, the fixed dividend payment becomes less valuable and the market price of straight preferreds will fall, and if interest rates decline, the fixed dividend payment becomes more valuable and the market price of straight preferreds will rise.


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Example: A company issues preferred shares with a par value of $50 and a fixed dividend rate of 3% (i.e., an annual fixed dividend payment of $1.50 per share). If interest rates then rise, new fixed income issuers will issue securities that pay higher yields to compensate for higher market interest rates. As a result, the yield of 3% on the previously issued preferred share is now seen to be too low. To compensate, the price of the preferred share will fall below $50. The drop in price of the previously existing preferred share will provide interested buyers a higher yield, since yield is calculated as dividend divided by current market price. The reverse is true when interest rates fall.

From the standpoint of the purchaser, straight preferred shares provide: • • • • • • •

Greater safety than common shares through preference to dividend and asset entitlements A tax advantage to individuals through the dividend tax credit and to corporations which receive preferred dividends from taxable Canadian companies on a tax-exempt basis Less safety than a debt investment since dividends are not a legal obligation No voting privileges (unless a stated number of dividend payments are in arrears) No maturity date Poorer marketability than common shares because there are usually fewer preferred shares than common outstanding Limited appreciation potential compared to common shares. The price at which the preferred could be redeemed by the issuer will limit any appreciation that might occur as a result of a decline in interest rates.

Convertible Preferreds Convertible preferreds are similar to convertible bonds and debentures because they enable the holder to convert the preferred into some other class of shares (usually common) at a predetermined price(s) and for a stated period of time. More recently, preferred shares have been issued where both the holder and the issuer have conversion privileges. Conversion terms are set when the preferred is created and normally specify the number of common shares into which each preferred is convertible. The preferred price is set at a modest premium (perhaps 10% to 15%) above its converted value. The purpose of the premium is to discourage an early conversion, which would defeat the purpose of the convertible offering. Virtually all conversion privileges expire after a stated period of time, usually five to twelve years from the date of issue. Example: GHI Inc., 4.70% Non-Cumulative Preferred Shares, Series J are convertible by the holder on a minimum of 65 days’ notice beginning July 31, 2021, and on the last day of January, April, July and October of each year into common shares. The conversion rate is determined by using a formula that considers the conversion date, declared and unpaid dividends, and the weighted average trading price of the common shares on the TSX over a specified period. These shares are also convertible by the company beginning April 30, 2015 under various terms.

Usually the convertible preferred will sell at a premium above the price it might be expected to sell at, based on the conversion terms. This premium can be expressed as a dollar amount or as a percentage. Expressing the premium as a percentage makes comparisons between preferreds easier. The premium on the preferred shares is usually offset by their higher yield compared to the underlying common shares. Over a period of years, the preferred’s higher yield will “pay back” to the investor the premium required to purchase it.


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Exhibit 8.1 illustrates a hypothetical example of a convertible preferred share payback. EXHIBIT 8.1

CONVERSION COST PREMIUM AND PAYBACK – For information purposes only Market Price

Preferred Issue

Preferred Common

Pre-tax Yield Preferred

Common

3.2%

1.5%

($2/$62.5)

($0.2775/$18.50)

Conversion Years to Cost Repay Difference Premium Premium

ABC Corp. Cumulative Redeemable Convertible

$62.50

$18.50

+1.70

12.61%

7.42

Class A Preferred, Series 2 Preferred dividend = $2.00 Common dividend = $0.2775 (Each Series 2 preferred is convertible into three common shares at any time.)

Sample calculation (excluding commission) of a conversion cost premium using ABC Corp.

1. To buy one ABC Corp. Series 2 preferred share that could be converted into 3 common shares costs $62.50. 2. To buy 3 common shares would cost $55.50 (3 × $18.50). 3. Therefore, the conversion cost dollar premium is $62.50 – $55.50 = $7.00. In other words, if you decided to obtain the common shares by purchasing preferred shares that convert into common shares, you would end up paying $7.00 more than if you had simply purchased the common shares directly from the market. As a per cent of the common share price, the premium is:

$7.00 q100 12.61% $55.50 4. Since you paid in theory 12.61% more for the common shares by purchasing the convertible preferred shares (as opposed to directly purchasing common shares from the market), the question now is how long will it take for you to pay back that premium from the additional income you receive from the convertible preferred share purchase. Years to pay back the premium from the convertible’s higher dividend stream:

% Premium 12.61 12.61 7.42 years Convertible yield Common yield 3.20 1.50 1.70

Convertible preferreds are issued either in markets where a straight preferred is difficult to sell or in a situation where a high level of dividend coverage is lacking. Because of the added benefit of a conversion feature, the dividend on a convertible is often less than that of a comparable straight preferred.


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From the standpoint of the purchaser, convertible preferred shares: •

Provide a two-way security: the holder is in a more secure position than the common shareholder and yet can realize a capital gain if the market price of the common rises sufficiently

•

Usually provide a higher yield than the underlying common shares

•

Provide the right to obtain common shares through conversion without paying a commission

•

Usually provide a lower yield than a comparable straight preferred

•

Sometimes convert into less (or more) than a standard trading unit of common shares which in turn may be a little more difficult to sell than a standard trading unit

•

Revert to a straight preferred when the conversion period expires if conversion has not taken place

Exhibit 8.2 demonstrates how common share prices affect the price of convertible preferred shares. EXHIBIT 8.2

HOW COMMON SHARE PRICES AFFECT CONVERTIBLE PREFERREDS – For information purposes only

When the price of the common shares rises above the conversion price, the market action of the preferred mirrors the market action of the common shares. Investors should also be aware that convertible preferred shares are vulnerable to a decline in price if the price of the common shares is above the conversion price and then declines. ABC Corp. issues a convertible preferred share with a par value of $50 that can be converted into 2 common shares, resulting in a conversion price of $25 per common share. At the time of issue, the common shares trade at $15 per share. Convertible Price (i) Common share price trades at $15 The price of the common share is below the conversion price of the preferred share ($15 per common share x 2 = $30, which is below $50). Changes in the common share price does not impact the price of the convertible preferred as long as the price of the common share remains below the convertible price.

$50

(ii) Common share price drops from $15 to $10 per share Since the price of the common share is lower than the conversion price of the convertible preferred, there is little to no change in the price of the convertible preferred based on the change to the common shares.


$50

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EXHIBIT 8.2

HOW COMMON SHARE PRICES AFFECT CONVERTIBLE PREFERREDS – For information purposes only – Cont’d

Convertible Price (iii) Common share price increases to $35 per share As soon as the common share price reaches the conversion price, the price of the preferred starts to mirror the price of the common share and rise to $70 ($35 per common share x 2 shares = at least $70 convertible preferred share price).

$70

(iv) Common share price drops from $35 to $30 The preferred share is directly affected by the $5 drop in price of the common shares and drops $5 per common share ($30 per common share x 2 shares = at least $60 convertible preferred share price).

$60

An investor who purchased the convertible preferred share at $70 when the common share price was above the conversion price would have suffered a loss of approximately 14% when the underlying common share dropped by $5 per share. An investor who purchased the convertible preferred share at $50 when the common share was trading at only $15 would see little to no change in the price of the convertible preferred share when the common shares dropped by $5 per share.

Retractable Preferreds A retractable preferred shareholder can force the company to buy back the retractable preferred for cash on a specified date(s) and at a specified price(s). Some are issued with two or more retraction dates. The principle of retraction, or pulling back, is identical to that described in Chapter 6 for retractable bonds and debentures. The holder of a retractable preferred can create a maturity date for the preferred by exercising the retraction privilege and tendering the shares to the issuer for redemption. The term soft retractable preferred refers to those retractables where the redemption value may be paid in cash or in common shares, generally at the election of the issuer. Example: JKL Inc., Series 14, Cumulate Class A Preference Shares are retractable on the first of each March, June, September and December at $100 per share.

From the standpoint of the purchaser, retractable preferred shares: •

Provide a predetermined date(s) and price(s) to tender shares for retraction. The shorter the time interval to the retraction date, the less vulnerable is the stock’s market price to increases in interest rates. Whereas a straight preferred will decline in price if interest rates rise, a retractable preferred will not fall significantly below its retraction price as the retraction date approaches

•

Provide a capital gain if purchased at a discount from the retraction price and subsequently tendered at the retraction price


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•

Will sell above the retraction price and at least as high as the call price if interest rates decline sufficiently

•

Do not retract automatically. The retraction privilege will expire, if no action is taken by the holder during the election period(s)

•

Become straight preferred shares if not retracted when the election period(s) expires. If this occurs in a period of high or rising interest rates, the stock’s market value will decline. The shares will sell on a straight yield basis after the retraction privilege expires.

Floating-Rate Preferreds Identical in concept to variable or floating rate debentures, floating- or variable-rate preferreds pay dividends in amounts that fluctuate to reflect changes in interest rates. If interest rates rise, so will dividend payments, and vice versa. Floating-rate preferreds are issued: •

During periods in the market when a straight preferred is hard to sell and the issuer has rejected making the issue convertible (because of potential dilution of equity) or retractable (because holders could force redemption on a specified date); and

•

When the issuer believes interest rates will not go much higher than they are at the date of issuance of the new issue. The company, in any event, is prepared to pay a higher dividend if interest rates rise. Of course, if interest rates decline, the issuer will pay a smaller dividend (subject in most cases to a guaranteed minimum rate). Example: MNO Corp. Floating Rate Cumulative Series II shares are entitled to cumulative preferential cash dividends. The quarterly dividend rate is one quarter of 70% of the prime rate times $25. The dividend rate is set on the last business day of the preceding month.

Some preferred shares may have delayed floating-rate features. Known as delayed floaters, fixedreset or fixed floaters, these shares entitle the holder to a fixed dividend for a predetermined period of time after which the dividend becomes variable. From the standpoint of the purchaser, variable rate preferreds provide: •

Higher income if interest rates rise, but lower income if interest rates fall

•

A variable amount of annual income that is difficult to predict accurately but which will reflect prevailing interest rate levels

•

An investment with a market price less responsive to changes in interest rates compared to the market prices of straight preferred shares. The dividend payout of a variable rate preferred is tied to changes in interest rates on a predetermined basis. Accordingly, the preferred’s market price is less sensitive to changes in interest rates.



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Foreign-Pay Preferreds Most Canadian preferreds pay dividends in Canadian funds. However, it is possible for a company to create and issue preferreds with dividends and certain other features payable in or related to foreign funds. These are known as foreign-pay preferreds. Example: PQR 5.95% Non-cumulative Class B Series 10 shares pay an annual dividend of US$1.4875.

The key factor to selecting a foreign-pay preferred is the desirability of receiving dividends in a currency other than Canadian funds. There is additional risk in the form of foreign currency risk. •

If the foreign currency increases in value compared to the Canadian dollar, your dividend will increase.

•

If, however, the Canadian dollar increases in value compared to the foreign currency, your dividend will decrease in value when you convert it to Canadian funds.

One of the advantages of this type of preferred share is that, although the dividend is received in a foreign currency, because it is paid by a Canadian company, the dividend is eligible for the dividend tax credit.

Other Types of Preferreds New products are constantly being introduced to the marketplace. Many of these new products are custom-made for the issuer or the buyer (usually institutional). There are other types of preferreds that are not as common as those mentioned above but do trade, such as participating preferreds and deferred preferreds. The investor and the advisor must always investigate the security, in order to confirm the features of that particular issue. Participating preferred shares have certain rights to a share in the earnings of the company over and above their specified dividend rate. Example: STU Inc. Non-cumulative Participating Voting Preferred shares participate equally with subordinate voting shares in any further dividends after $0.009375 per share has been paid on the subordinate voting shares. The shareholder can also participate in any distribution of assets.

Deferred preferred shares do not pay out a regular dividend. Instead, the shares mature at a preset future date and the return is based on the purchase price and the redemption value paid out at maturity. On the maturity date, the difference between the purchase price and the redemption value is referred to as the “dividend premium” (and this represents a cumulative amount equal to the dividends that would have been received had the investor purchased a preferred share that paid a regular annual dividend). The dividend premium is not eligible for the dividend tax credit. The amount of the dividend premium is taxable as ordinary income. If the shares are sold prior to redemption, the income is treated as a capital gain (or loss). These shares allow investors to defer taxes paid on income earned until a later date and are attractive to investors who do not have an immediate need for regular income. The shares are also attractive for investors who want to receive compounded growth in a registered account, such as an RRSP, as taxes are deferred to a later period.


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Complete the following Online Learning Activity Preferred Shares Companies may issue preferred shares in addition to common shares. Preferred shares have benefits similar to those of common shares but also offer unique benefits to investors. In this activity you will review the key features of each type of preferred share and compare and contrast preferred with common shares. Complete the Preferred Shares activity. Complete the Preferred Shares quiz.

WHAT ARE STOCK INDEXES AND AVERAGES? Stock indexes or averages are indicators used to measure changes in a representative grouping of stocks, such as the S&P/TSX Composite Index or the Dow Jones Industrial Average (DJIA). These indicators are important tools and are used to: • • • •

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

A stock index is a time series of numbers used to calculate a percentage change of this series over any period of time. Most stock indexes are value-weighted and are derived by using the total market value (i.e., market capitalization) of all stocks used in the index relative to a base period. The total market value of a stock is found by multiplying its current price by the number of shares outstanding. Each day, the total market value of all stocks included in the series is calculated, and this value is compared to the initial base value to determine the percentage change in the index. Example: The S&P/TSX Composite Index closed at a value of 11,562 on September 23, 2011, and at a value of 12,385 on September 20, 2012. The change in the Index translates into a gain of 7.12% for the period.

In a value-weighted index, such as the S&P/TSX Composite Index or the S&P 500, companies with large market capitalizations dominate changes in the value of the index over time while companies with small market capitalizations have less of an impact. A stock average is the arithmetic average of the current prices of a group of stocks designed to represent the overall market or some part of it.



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Within a stock index, each stock has a relative weight based on the stock’s total market capitalization. In contrast to a market-weighted stock index, stocks included in an average are composed of equally weighted items (i.e., no specific weights are applied when constructing the average). A stock’s relative weight within an index can change every day, whereas a stock’s weight within an average is always the same. However, stock averages are price-weighted, which means that movements in the average are tied directly to changes in the prices of the various stocks included in the average. This occurs because some prices are higher than others and will naturally have a greater influence on the average as a whole. Example: Even though no specific weights are applied when constructing the average, a stock that trades at $100 per share and falls by half to $50 will have a greater impact on the average than a stock that trades at $10 per share and drops by half to $5.

Canadian Market Indexes In Canada, the Toronto Stock Exchange and the TSX Venture Exchange compile and publish indexes of stock prices for a variety of industry classifications. These indexes, their dividend yields, and the price-earnings ratios based on the S&P/TSX Composite Index can be found in the TSX Monthly Review, the Bank of Canada Review, and in financial newspapers in Canada and elsewhere. THE S&P/TSX COMPOSITE INDEX

The Toronto Stock Exchange began its first stock price indexes in 1934. Many changes and revisions have been made to the Index over the years. Figure 8.1 illustrates the growth of the market since 1990.


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FIGURE 8.1

YEAR-END CLOSES, S&P/TSX AND S&P/TSX 60 INDEXES

S&P/TSX

S&P/TSX 60 900

14,000

S&P/TSX Composite Index S&P/TSX 60 Index 12,000

800

10,000 700 8,000 600 6,000 500 4,000 400

2,000

0

300 1990

1995

2000

2005

2010

Source: Bloomberg

The S&P/TSX Composite Index measures changes in the total market capitalization of the stocks in the Index. A stock’s weight within the Index changes if its price or the number of shares outstanding changes. The Index has a floating number of stocks. To be included in the Index, a stock must meet specific criteria based on price, length of time listed on the exchange, trading volume, capitalization and liquidity. The stocks are also classified by industry into ten sectors, based on the Global Industry Classification Standard (GICS). This standard was developed jointly by S&P and MSCI (Morgan Stanley Capital International Inc.) for use in all their indexes and is accepted worldwide. An Index has been created for each sector. There are also three subsector indexes, specific to the Canadian market: Diversified Mining, Real Estate and Gold. Table 8.2 lists the ten major industry sector indexes within the S&P/TSX Index.



TABLE 8.2

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10 SECTORS OF THE S&P/TSX COMPOSITE INDEX

Financials

Telecommunication Services

Energy

Information Technology

Materials

Consumer Staples

Industrials

Utilities

Consumer Discretionary

Health Care

Based on market capitalization, some sectors are weighted more heavily than others in the S&P/TSX Composite Index. For example, while Financials and Energy account for approximately 57% of the weight on the index, Health Care, Utilities and Information Technology account for less than 6% combined. To interpret the indexes, it is important to understand the distinction between point changes and percentage changes. Based on the starting level of 250 for an index, for example, a 1% change in the index is equivalent to 2.5 index points (calculated as 0.01 × 250). Similarly, a 1% change in other widely quoted indexes is not the same in terms of net point changes. For example, a 1% change is approximately: • •

105 points when Tokyo’s Nikkei 225 is trading around 10,500 10 points when the S&P 500 is trading around 1000

Therefore, as indexes move up and down, the percentage change is a more accurate reflection of market performance than net point changes. Also, when a percentage change of the S&P 500 is compared to a percentage change in the S&P/TSX, currency values should be taken into account. An investment in the S&P 500 is in U.S. dollars, whereas an investment in the S&P/TSX would be made in Canadian dollars. THE S&P/TSX 60 INDEX

The S&P/TSX 60 Index includes the 60 largest companies that trade on the TSX as measured by market capitalization and is broken down into 10 sectors that cover all S&P/TSX Index subgroups. All stocks listed on this index must also be included in the S&P/TSX Composite Index. THE S&P/TSX VENTURE COMPOSITE INDEX

The S&P/TSX Venture Composite Index is a Canadian benchmark index for the public venture capital marketplace. Managed by Standard & Poor’s, it is a market capitalization-based index meant to provide an indication of performance for companies listed on the TSX Venture Exchange. The index does not have a fixed number of companies, and is revised quarterly based on specific criteria for inclusion and maintenance policies. TSX Venture Exchange-listed companies are eligible for inclusion in the S&P/TSX Venture Composite Index if they are incorporated under Canadian federal, provincial or territorial jurisdictions and represent a relative weight of at least


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0.05% of the total index market capitalization. Stocks eligible for inclusion must generally be listed on the TSX Venture Exchange for at least 12 full calendar months as of the effective date of the quarterly revision.

U.S. Stock Market Indexes THE DOW JONES INDUSTRIAL AVERAGE

Although normally around 2,300 issues trade daily on the New York Stock Exchange, the most publicity is given to the trading performance of the 30 issues that make up the Dow Jones Industrial Average. The DJIA has been criticized because so few companies are included in this average, which means that it is not a truly representative indicator of broad market activity. Also, since it is price weighted, when a higher-priced stock rises, it may distort the average. Even with the DJIA’s shortcomings, many people still use it as if it were an overall indicator of market performance. The DJIA is calculated by adding the prices of each of the 30 issues in the average and dividing by a specially calculated divisor. The divisor was initially the number of stocks in the average – originally 14 (12 railways, 2 industrials). Because of obvious distortion through stock splits (a 2-for-1 split would mean a $100 share would become $50 in the average after the split), the divisor was adjusted downward for each split. It is important to view the DJIA in perspective. Because it comprises such a small number of components, day-to-day changes may appear more dramatic than they actually are. Also, since the DJIA is composed of blue-chip stocks with a typically lower risk profile, it tends to underperform the broader market over the longer term. THE S&P 500

Because the Dow Jones average is not completely satisfactory as an indicator of broad market performance, other market indexes have been developed, such as the Standard & Poor’s 500 Stock Composite Index. This index is based on a large number of industrial stocks, some financial stocks, some utility stocks, and a smaller number of transportation stocks, which are weighted in the index by their market capitalization. Since the S&P 500 is weighted by market capitalization, more heavily weighted stocks have a greater effect on the value of the index. The S&P has become the main gauge for measuring the investment performance of institutional investments in the United States because of its broad industry coverage and the method of weighting the index. Many institutional investors have created investment funds that track the S&P 500. OTHER U.S. STOCK MARKET INDEXES

This list is by no means exhaustive, but includes the most well-known indexes. Many other U.S. indexes exist.



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The NYSE Composite index:

The NYSE Composite index is a market capitalization index that includes all the listed common equities on the New York Stock Exchange. There are additional indices for industrial, transportation, utility, and financial corporations.

The AMEX Market Value Index:

This market-weighted index is based on all the stocks listed on the American Stock Exchange (about 800). It includes the reinvestment of dividends, so it is a total return index.

The NASDAQ Composite Index:

The NASDAQ index is a market-weighted index of more than 4,000 stocks that are traded over the counter. This index is dominated by smaller capitalization companies. Its market value is only about 13% of the NYSE-listed companies.

The Value Line Composite Index:

Value Line is a composite index of about 1,700 stocks that is calculated by taking an average of the daily percentage change in each stock within the index. This equal-weighted index attempts to cover all the stocks for which there are daily quotations available. It was created by Wilshire Associates and is the broadest available barometer of all the U.S. indexes. Wilshire has also created other indexes.

International Market Indexes and Averages As the economy becomes more global, it makes sense for investors to diversify their equity portfolios by investing not only in various industries and stocks, but in different countries. As the economies of more and more countries mature, their equity markets grow in size and sophistication, and it becomes easier for foreign investors to enter. During most of the 1980s, most funds that invested outside Canada preferred the large, liquid global stock markets, some of which are noted below.

Nikkei Stock Average (225) Price Index:

This is the Tokyo Stock Exchange average. The average is calculated like the Dow Jones average and is updated every 15 seconds. The index is well known both inside and outside Japan.

The FTSE 100 Index:

This index consists of the 100 largest listed companies listed on the London Stock Exchange and is one of the most widely followed indexes in the United Kingdom. It is calculated using the market capitalization of the stock and is recalculated on a minute-by-minute basis.

The DAX:

The DAX consists of 30 major Frankfurt Stock Exchange blue-chip stocks and is the most widely followed index on the German securities market. The index is weighted by market capitalization. Dividends and income from subscription rights are reinvested in the index.


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The CAC 40 Index:

The CAC 40 Index is based on 40 of the largest 100 companies listed on the Paris Stock Exchange. It is calculated on a market capitalization basis.

The Swiss Market Index:

The Swiss Market Index (SMI) is Switzerland’s blue-chip index, which makes it the most important in the country. The index is made up of 20 of the largest and most liquid stocks on the Swiss market, ranked by market capitalization.

However, in the past twenty-five years, interest has developed in riskier, more exotic markets such as those of China, India, Turkey, Sri Lanka, Taiwan, Korea and Mexico, which also have stock indexes.

Complete the following Online Learning Activity Market Indexes and Averages Market indexes and averages can be used to measure the overall performance or health of the market and to compare individual stock performance against the market. In this activity you will review how indexes and averages are calculated and review examples of each. Complete the Indexes and Averages activity.



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2.

Discuss the benefits of common share ownership, describe how dividends are taxed, declared and claimed, and describe the impact of stock splits and consolidations on shareholders. •

The benefits of common share ownership can include capital appreciation, the right to receive common share dividends paid by the company, voting privileges, favourable tax treatment of dividends and capital gains, marketability through ease of disposition and acquisition, the right to receive financial data and other relevant information in a standardized format, the right to examine relevant and specific company documents, the right to attend and ask questions at shareholders meetings, and limited liability.

•

The board of directors decides whether to pay a dividend, the amount and the payment date.

•

Individuals that have legal ownership of the shares before the ex-dividend date will receive the dividend; these individuals are the shareholders of record.

•

Dividends received in unregistered accounts are subject to taxation, including those reinvested in dividend reinvestment plans and stock dividends.

•

A dividend tax credit is available on dividends paid from taxable Canadian corporations. Dividends paid on foreign equities are also subject to taxation but receive no favourable tax treatment.

•

A stock split increases the number of shares outstanding, while a consolidation reduces the number of shares outstanding. The market price of the underlying stock is adjusted to reflect the split or consolidation on the day it occurs.

Discuss the position, advantages, disadvantages and special provisions of preferred shares, differentiate among the types of preferred shares, describe their features, and perform related calculations. •

Preferred shareholders occupy a position between the company’s creditors (including bondholders) and the company’s common shareholders, if any.

•

Benefits of preferred shares can include preference as to assets and dividends ahead of common shareholders in the event of bankruptcy or dissolution of the company (although behind creditors and bondholders), and usually an entitlement to a fixed dividend payable out of retained earnings, subject to the discretion of the Board of Directors.

•

Preferred shares are usually more expensive for a company than issuing debt because dividends paid are not a tax-deductible expense.


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•

Preferred shares are typically issued instead of debt securities when it is not practical or feasible to issue new debt, market conditions are temporarily unreceptive to new debt issues, the company’s current debt-to-equity ratio is high, the company does not want to assume legal obligations related to debt, or a low apparent tax rate makes it cost effective to pay dividends from after-tax profits.

•

Holders of cumulative preferred shares have the right to accumulate unpaid dividends in arrears and to have all accumulated dividends paid before dividends are paid on common shares or before the preferred shares are redeemed.

•

Holders of non-cumulative preferred shares are entitled to payment of a specified dividend in any year but only when declared.

•

Issuers of callable preferred shares have the right to call or redeem preferred issues at a stated time and at a stated price.

•

Non-callable preferred shares cannot be called or redeemed as long as the issuing company is in existence.

•

Preferred shares are usually non-voting as long as preferred dividends are paid on schedule; however, once a stated number of preferred dividends have been omitted, it is common practice to assign voting privileges to the preferred shareholders.

•

A purchase or sinking fund will attempt to buy preferred shares in the market if the price of the shares declines to or below a stipulated price.

•

Straight preferred shares have normal preferences as to asset and dividend entitlement, pay a fixed dividend rate, and trade in the market on a yield basis.

•

Convertible preferred shares enable the holder to convert the preferred shares into some other class of shares (usually common) at a predetermined price and for a stated period of time.

•

A retractable preferred shareholder can force the company to buy back the retractable preferred shares on a specified date(s) and at a specified price(s).

•

Floating- or variable-rate preferred shares pay dividends in amounts that fluctuate to reflect changes in interest rates.

•

Foreign-pay preferred shares pay dividends in a foreign currency or in relation to a foreign currency.

•

Participating preferred shares have certain rights to a portion of company earnings over and above their specified dividend rate.

•

Deferred preferred shares do not pay out a regular dividend. Shares mature at a preset future date with the return based on the difference between the purchase price and the redemption value paid out at maturity.



3.

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Differentiate between a stock market index and an average, and summarize the important stock market indexes and averages. •

A stock index is a time series of numbers used to calculate a percentage change in the series over any period of time.

•

A stock average is the arithmetic average of the current prices of a group of stocks designed to represent the overall market or some part of it.

•

The most important domestic stock market indexes include the S&P/TSX Composite Index, the S&P/TSX 60 Index, and the S&P/TSX Venture Composite Index.

•

The most important U.S. stock market indexes and averages include the Dow Jones Industrial Average, the S&P 500, the New York Stock Exchange Indexes, the Amex Market Value Index, the NASDAQ Composite and the Value Line Composite.

•

International indexes of significance include the Nikkei Stock Average (225) Price Index, United Kingdom FTSE 100 Index, German DAX, France CAC 40 Share Price Index, and the Swiss Market Index.






Chapter

9

Equity Securities: Equity Transactions


9 •1

9 Equity Securities: Equity Transactions

CHAPTER OUTLINE What are Cash Accounts? • Cash Account Rules • Free Credit Balances What are Margin Accounts? • Long Margin Accounts • Margining Long Positions What is Short Selling? • How Short Selling is Done • Dangers of Short Selling How do Trading and Settlement Procedures Work? • Trading Procedures How are Securities Bought and Sold? • Types of Orders Summary

9 •2


LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Define and distinguish between cash and margin accounts. 2. Explain how to establish margin requirements for long and short positions and the impact price changes have on margin requirements. 3. Describe the process of short selling and discuss the risks associated with short selling. 4. Describe the trading and settlement procedures for equity transactions. 5. Define and distinguish among the types of buy and sell orders.

SECURITIES TRANSACTIONS IN PRACTICE Now that we have a better understanding of the types of securities that trade in the market, we turn our attention in this chapter to the mechanics of trading securities. Learning about investment theory and other industry considerations is a critical part of being a successful advisor or investor. However, the mechanical process by which investments are acquired, held and disposed of is equally important. On the surface, buying or selling a stock on the Toronto Stock Exchange seems fairly straightforward, but there is more to it than simply calling a broker or discount brokerage and placing an order to buy 100 shares of CP Rail. The investor has the option of buying the shares on margin or short selling stock. The investor can also place a limit price on the trade, place the trade at the market, or add other conditions to the purchase. These are important considerations because they affect the process of making an investment decision and ultimately the investment strategy being pursued. There are, of course, risks, advantages and disadvantages to the chosen trading strategy. This chapter focuses on equity transactions – margin, short selling, and the various buy and sell orders investors use to trade stocks.


9 •3

KEY TERMS

9 •4

All or none order

Margin account

Any part order

Margin Call

Cash account

Market order

Day order

Professional (PRO) order

Good through order

Settlement date

Good till cancelled order

Short position

Limit order

Short sale

Long position

Stop buy order

Margin

Stop loss order


NINE • EQUITY SECURITIES: EQUITY TRANSACTIONS

9 •5

WHAT ARE CASH ACCOUNTS? A securities transaction through a dealer member must be made in either a cash account or a margin account. •

•

Cash 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, which is prescribed by industry rules and specified in the contract. The normal settlement date is prescribed as the following business days after the transaction date: –

Government of Canada Treasury bills – same day as the transaction takes place

–

Government of Canada bonds with a term of three years or less – two business days after

–

All other securities – three business days after

Margin accounts: In contrast, margin accounts are for clients who wish to buy and/or sell securities on credit and initially pay only part of the full price of the transaction. In such cases, the dealer member lends the remainder of the transaction price to the client, charging interest on the loan.

It is important to recognize the difference between cash accounts and margin accounts. When a client opens a cash account, the member does not grant credit and the explicit understanding is that the client will pay for the security in full on the settlement date. On the other hand, when a client opens a margin account, it is on the explicit understanding that the member is granting credit based on the market value and quality of the securities held long and/or short in the account. The client pays only a portion of the purchase price and the dealer member lends the balance to the client. Here is some market terminology we use throughout the remainder of the chapter: •

A long position represents actual ownership in a security. For example, an investor who buys common shares to initiate a position would have a long position in the stock. To close the long position, the investor would sell the stock in the market.

•

In contrast, a short position is created when an investor sells a security that he or she does not own. For example, an investor who doesn’t own shares, but borrows the shares from her broker and sells the shares in the market to initiate a position would have a short position in the stock. To close the short position, the investor would buy back the stock from the market, and return the stock to the broker.

Cash Account Rules In most cases, a dealer’s computerized accounting system will flag settlement dates for clients’ transactions. The system will also keep track of the dates when accounts become overdue and the amounts of capital that must be maintained by the member to carry these overdue accounts. At a certain point, the account will become restricted and trading activity will no longer be permitted until the account is settled.


9 •6


Dealer members may adopt more stringent rules to minimize the amount of capital being unprofitably tied up in carrying delinquent cash accounts. IAs must know industry and their own dealer’s requirements as well as acceptable methods of settling both normal cash account transactions and those where restrictions have later been imposed.

Free Credit Balances Free credit balances are uninvested funds held in client accounts that the dealer member may use as a financing source for its business. These funds are, however, payable on demand to their clients. The exchanges and IIROC require that every statement of account given or sent to a customer by a dealer member contain the following written notice: Any free credit balances represent funds payable on demand which, although properly recorded in our books, are not segregated and may be used in the conduct of our business.

WHAT ARE MARGIN ACCOUNTS? Margin accounts require only partial payment for purchases, with the dealer member loaning the client the unpaid portion of the market value of the securities at prevailing interest rates. The client is required to make an initial deposit of a specified portion of the value of securities purchased. The word margin refers to the amount of funds the investor must personally provide. The margin plus the loan provided by the dealer member together make up the total amount required to complete the transaction. There are two different types of margin positions: •

A long margin position allows the investor to partially finance the purchase of securities by borrowing money from the dealer.

•

A short margin position allows the investor to sell securities short by arranging for the dealer to borrow securities to cover the short position.

Not every investment firm allows margin accounts, and those that do are required to obtain an authorized Margin Account Agreement Form from a potential margin client before business is transacted. Interest on the margin loan is calculated daily on the debit balance in the account and charged monthly. Dealer members usually charge margin clients interest based on the rates members are charged on loans made to them by the chartered banks.

Long Margin Accounts The amount of credit which a dealer member may extend to customers on the purchase of securities (both listed and unlisted) is strictly regulated and enforced. Examiners conduct spot checks in addition to regular field examinations to ensure that members keep clients’ accounts properly margined.


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Table 9.1 shows the maximum loan values which IIROC dealer members may extend for long positions in equity securities listed on a recognized exchange in Canada. TABLE 9.1

MAXIMUM EQUITY LOAN VALUES – For information purposes only

On Listed Equities Selling:

Maximum Loan Values

At $2.00 and over

50% of market value

At $1.75 to $1.99

40% of market value

At $1.50 to $1.74

20% of market value

Under $1.50

No loan value

Securities Eligible for Reduced Margin*

70% of market value

* Note that these loan values are IIROC maximums. Many firms choose to set more stringent requirements – for example many firms do not allow clients to take margin positions on stocks that trade under $3.

IIROC produces a quarterly list of “securities eligible for reduced margin”. Inclusion is restricted to those securities that demonstrate both sufficiently high liquidity and low price volatility based on meeting specific price risk and liquidity risk measures.

Margining Long Positions When a long position is established on margin, sufficient funds (or securities with excess loan value) must be in the account to cover the purchase. The dealer member lends some of these funds to the client, with the client being responsible for the balance. Thus, margin is the amount put up by the client, and the minimum margin required equals the initial cost of the transaction minus the member’s loan. The sum of the margin and the loan must always be equal to the original purchase price, at a minimum. If the loan drops due to a fall in the price of the security, the client must immediately provide additional funds in the account to cover the shortfall up to the original purchase price. This is known as a “margin call”. On the other hand, if the security price rises, the loan rises accordingly and the client has access to additional funds in the account immediately. This is called “excess margin”. The margin requirement is always the difference between the original purchase price and the loan.


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The following are some examples of margin transactions; in all cases, commissions are excluded from the calculations. EXAMPLE

MARGIN TRANSACTION IN A LISTED EQUITY – For information purposes only

Assume a client buys 1,000 shares of listed ABC Company on margin when it sells for $25 per share at a loan rate of 50%. ($) Total cost to buy ABC shares

25,000

Less:

12,500

Member’s maximum loan (50% of $25 x 1,000)

Equals: Margin (which is put up by the client)

12,500

(A)

(B)

Outcome: The client has put up $12,500 to buy $25,000 of ABC shares. The dealer lended the rest of the money to the client. (i) The price of the stock declines

($)

Assume the price of ABC’s shares declines to $22 Original cost of ABC shares (A above)

25,000

Less:

11,000

Member’s revised maximum loan (50% of $22 x 1,000)

Equals: New margin requirement

14,000

Less:

12,500

Client’s original margin deposit (B above)

Equals: Net margin deficiency (for which a margin call is issued to the client)

1,500

Outcome: With the price of the security falling to $22, the amount of money the dealer is willing to lend dropped to $11,000 (50% of the market price). Since the original purchase price must be in the account at all times, the margin requirement has increased to $14,000. The client originally put up initial margin of $12,500, which means there is a $1,500 shortfall. The dealer member issues a $1,500 margin call and the client must deposit this amount immediately into the account.

(ii) Example of Excess Margin in Account

($)

Assume this time the price of ABC’s shares – instead of declining from $25 to $22– had increased from $25 to $29. Original cost of ABC shares (A above)

25,000

Less:

14,500

Member’s revised maximum loan (50% of $29 x 1,000)

Equals: New margin requirement

10,500

Less:

12,500

Client’s original margin deposit (B above)

Equals: Excess margin in account

2,000

Outcome: With the price of the security rising to $29, the amount of money the dealer member is willing to lend is $14,500 (50% of the market price). This reduces the margin requirement to $10,500 ($25,000 - $14,500 = $10,500). Since the client put up initial margin of $12,500 there is now excess margin of $2,000 in the account. The client may use this excess margin at his or her discretion.



9•9

The $2,000 can be used as margin toward the purchase of another security, or withdrawn from the account. It is not, however, an idle amount of cash that can be removed without consequence. The client is still borrowing money from the dealer member, on which interest will be charged. If the excess margin is left in the account, the amount borrowed would still be the $12,500 (25,000 – $12,500) loaned initially by the dealer. What has changed is the amount of money the dealer is willing to lend: because the collateral value of the shares has increased, the member will now lend $14,500 instead of $12,500. By withdrawing the $2,000 margin surplus, the client will be borrowing (and paying interest on) this larger amount. MARGIN RISKS

It is important to recognize that borrowing funds to invest involves more risk than simply buying and paying for a security in full from a cash account. Here are some of the risks associated with using a margin account: •

Margin increases market risk: borrowing to buy securities magnifies the outcome, either in a positive or negative way.

•

Loan and interest must be repaid: the client must pay interest during the period the security is margined and must repay the loan at the end, regardless of the value of the security.

•

Margin calls must be paid without delay.

•

The dealer can sell securities from the account to secure its loan without the client’s consent: if the security has fallen in price and the client fails to meet the margin call, the dealer can sell the security without notice and the client will suffer a loss.

Clients with margin accounts should avoid the practice of margining close to prevailing price limits (i.e., keeping a minimum amount of margin on deposit in the account). Where additional funds or securities with excess loan value are on deposit, a cushion of protection is provided against the inconvenience of having to respond to a margin call after a minor adverse price fluctuation. It also reduces the possibility that the dealer will be forced to sell outt the margin account in the event of a drastically adverse price fluctuation.

WHAT IS SHORT SELLING? Short selling is defined as the sale of securities that the seller does not own. Profits are made whenever the initial sale price exceeds the subsequent purchase cost. With long positions, an investor purchases a security and then holds it in the hope of selling it later at a higher price. With short selling, the order of the transactions is reversed. The investor sells the security first, and then waits in the hope of buying it back later at a lower price. Since the seller does not own the securities sold, the seller in effect creates a “deficit” or short position where he or she owes securities, and the subsequent purchase covers or “repays” this deficit.


9 •10


Short selling is generally carried out in the belief that the price of a stock is going to fall. The short seller feels bearish towards a particular security and sells it short, hoping to buy it back later at a lower price. If the sale is made at a higher price than the subsequent purchase, the investor has made a profit.

How Short Selling is Done A client wishing to short a security would first contact his or her IA and declare the intention to sell short. The IA’s firm would then lend the securities to be shorted to the client, and the client would sell them into the market in the same manner as a long position would be sold—the only difference being that the short sale must be declared at the time of the trade. The proceeds of the short sale are then deposited in the client’s account, and the client is required to deposit enough margin into the account, in addition to the sale proceeds, to bring the account balance up to the required minimum. As an example, if an investor sells a stock short at $10.00 per share, the investor would have to put up margin of $5.00 per share in addition to the proceed of the sale. Since the investor is borrowing stock from the dealer and putting up less money than the minimum required balance, the element of leverage exists for short sales. In fact, short selling has unlimited risk in that the security sold short could rise, at least theoretically, to infinity. Therefore, short selling is considered riskier than purchasing an outright long position, and such basic precautions as stop buy orders should be considered (stop buy orders are explained later in the chapter). After the short position is established, the investor then waits for an opportune moment to cover the sale with a purchase at a lower price. Of course, since the price could also rise and lead to losses, regular monitoring of the position is advisable. When the short seller finally purchases the stock originally sold short, the stock is returned to the lender. Alternatively, the ultimate lender of the shorted security may ask that the security be returned. If no other lender can be found, the seller will be forced to buy back the security at whatever the current price is, regardless of whether the investor will suffer a loss from having to cover at unfavourable prices. EXHIBIT 9.1

SHORT SELLING – SIMPLIFIED STEPS

Step 1:

You call your broker and instruct her to sell ABC short.

Step 2:

Your broker lends you the ABC shares and you immediately sell ABC into the market.

Step 3:

The proceeds from the short sale are deposited in your account.

Step 4:

The required margin is then deposited into your account.

Step 5 :

The share price of ABC falls and you want to close your position. You buy ABC back at the lower price and return the stock to your broker. You have covered the short with the repurchase of ABC and the position is closed.


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MARGINING SHORT POSITIONS

In contrast to a long position, margin is always required for a short position due to the risk factors involved in short selling. In fact, the client borrows the stock from the dealer member; no money is loaned to the client in a short sale. Instead, the client must put up more than the value of the short sale – essentially, the client deposits additional money into her account to cover potential losses from a short sale. Table 9.2 shows the minimum margin requirements for short sales. TABLE 9.2

MINIMUM CREDIT BALANCE REQUIREMENTS – For information purposes only

On Listed Equities Selling:

Minimum Credit Balance

At $2.00 and over

150% of market value

At $1.50 to $1.99

$3.00 per share

At $0.25 to $1.49


Under $0.25

100% of market plus $0.25 per share

Securities Eligible for Reduced Margin


EXAMPLES

MARGIN REQUIRED TO SELL SHORT – For information purposes only

(i) Assume that a client wishes to sell short 100 shares of listed FED Company Ltd. at its current market price of $5.00. The client must put up margin of $250.00, as the following calculation demonstrates. ($) Minimum account balance required: 150% of $5.00 x 100 shares

750.00

Less:

500.00

Proceeds from short sale 100 x $5.00

Equals: Minimum margin required

250.00

(ii) Assume that, later on, the price of FED’s shares declines to $4.00. The client will have more margin in the account than the required minimum. ($) Minimum account balance required: 150% of $4.00 x 100 shares

600.00

Less:

500.00

Proceeds from short sale 100 x $5.00

Equals: Minimum margin required Since the client has already deposited margin of $250.00, the account now has excess margin of $150.00. This amount may be withdrawn, or used to purchase more securities, or left in the account to cover possible margin calls should FED’s price begin to rise.


100.00

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EXAMPLES

MARGIN REQUIRED TO SELL SHORT – For information purposes only – Cont’d

(iii) Assume that FED’s shares continue to decline to $1.60. The account balance required is now governed by a different category. Minimum account balance required: $3.00 per share (see Table 9.2) × 100 shares Less:

Current account balance: Proceeds from short sale ($500)plus margin already deposited ($250)


300.00 750.00 nil

Since the account balance required is less than the short sale proceeds, no additional margin is required. (iv) If the price of FED’s shares advanced to $6.00 instead of declining, the client would receive a margin call as follows. Minimum account balance required (based on current price of shorted security): 150% of $6.00 × 100 shares Less:

Proceeds from short sale (excluding commission) (based on original price of shorted security) 100 × $5.00

900.00 500.00


400.00

Less:

250.00

Amount already deposited

Equals: Margin deficiency (for which a margin call is issued to the client)

150.00

PROFIT OR LOSS ON SHORT SALES

The profit or loss on a short sale transaction is calculated in the same way as on a long transaction. It is simply the difference between the purchase and sale prices, or between the sale proceeds and the purchase cost. For example: PROFIT OR LOSS ON SHORT SALES

(i) Assume a client sells short 100 shares of FED Company Ltd. at its current market price of $5.00. Later on, the price of FED’s shares declines to $1.60, and the client wishes to calculate the paper profit. ($)

Proceeds of the short sale Less:

Cost of buying 100 FED in the market at $1.60 per share should the client decide to cover the short sale

Equals: The client’s pre-tax profit on the short sale Since the price has dropped and the client is able to purchase the shares at a lower price than they were previously sold at, there is a paper profit.


500.00 160.00 340.00

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PROFIT OR LOSS ON SHORT SALES – Cont’d

(ii) Assume instead that the price of FED’s shares rises to $6.00, and the client wishes to calculate the paper profit or loss. Proceeds of the short sale Less:

Cost of buying 100 FED in the market at $6.00 per share should the client decide to cover the short sale 600.00

Equals: The client’s loss on the short sale

500.00 600.00 100.00

Since the price has risen, there is paper loss rather than a profit. The price of the purchase would be higher than the price of the sale if the position were covered at current prices.

TIME LIMIT ON SHORT SALES

There is no time limit on how long a short sale position may be maintained, provided that the stock does not become de-listed or worthless. As well, the position remains open as long as equivalent amounts of the shorted security can be borrowed by the short seller’s dealer and adequate margin is maintained in the short account. For short sales of listed securities, borrowing can be arranged between dealers to facilitate the delivery required by the short sale. Why do other dealers loan securities to the clients of dealers who are selling short? The answer is that as security for the loan of securities, the loaning dealer receives the use of the money put up by the short seller. Such funds can be employed free of interest in the dealer’s business or can be used to earn interest. COVERING A SHORT POSITION

If the short seller’s dealer finds at some point that there is no replacement stock it can borrow to maintain or carry a client’s short position, then the client must buy the necessary shares and cover the short sale. This has to be done whether the short seller wants to buy back the shorted security or not, and regardless of the prevailing market price of the shorted security. The danger of loss from short selling shares with thin marketability is particularly acute because it can be more difficult for the short seller’s dealer to borrow sufficient stock to maintain a short position for a prolonged period of time. Because of this potential problem, experienced traders normally confine short sales to shares of companies having a large number of shares outstanding that are widely held by many shareholders. DECLARING A SHORT SALE

All of the exchanges require their members, when accepting an order for the sale of a security, to ascertain whether the sale is a short or a long sale. IAs entering an order for a short sale of a security for anyone must clearly mark the sell-order ticket Short or S, so that the trading department may process the order properly. The TSX Venture Exchange and the TSX compile and publicly report total short positions in applicable securities twice a month.


9 •14


Dangers of Short Selling Amongst the difficulties and hazards of short selling are the following: •

There can be difficulties in borrowing a sufficient quantity of the security sold short to cover the short sale.

•

The short seller is responsible for maintaining adequate margin in the short account as the price of the shorted security fluctuates.

•

The short seller is liable for any dividends or other benefits paid during the period the account is short.

•

Buy-in requirements (the obligation to buy back the stock after selling it short) become effective if adequate margin cannot be maintained by the client and/or if the originally borrowed stock is called by its owner and no other stock can be borrowed to replace it.

•

It is difficult to obtain up-to-date information on total short sales on a security. (The exchanges do not report short positions on a daily basis and no data is available on unlisted short sales.)

•

Price action in a shorted security may become volatile should a buying rush materialize when a number of short sellers try to cover their short sales at the same time.

•

There is the theoretical possibility of unlimited loss if a shorted stock starts a dramatic rise in price. After all, the most that a purchaser of a security can lose is the entire purchase price. There is no maximum loss that a short seller can incur because there is no limit to how high the price of a stock can advance.

Complete the following Online Learning Activity Margin Requirements In this activity you will have the opportunity to review the processes of buying long on margin and of selling short. Even though the processes are quite similar, the strategies are very different from an investment perspective. Complete the Trading on Margin activities to review the key differences in these strategies. Complete the Trading on Margin activity. Complete the Trading on Margin quiz.



9 •15

HOW DO TRADING AND SETTLEMENT PROCEDURES WORK? Stock exchange trades may involve the investment dealer acting as agent or as principal. Our description of roles which investment dealers may play begins with a traditional trade which involves two customers and two investment dealers acting as agents. Following this, we will describe some of the many other ways in which transactions are now commonly structured.

Trading Procedures Referring to Chart 9.1, assume that XYZ’s common shares are listed for trading on a stock exchange. No matter which exchange the trade takes place on, the major steps are the same. All trades involve both a buyer and a seller (positions 1 and 2 in our chart) who may live next door to, or across the country from, each other. Perhaps after consultation with their investment advisors (3 and 4), the buyer has decided to acquire 100 XYZ shares and the seller wishes to sell 100 XYZ shares he owns. Both phone their IAs for a current price quotation. Their IAs learn, through communication links with the exchange, that XYZ common is currently $10.50 bid and $10.75 asked, and both IAs report this quotation to their clients. The prospective buyer thus knows the lowest price at which anyone is currently willing to sell one standard trading unit (100 shares) of XYZ stock is $10.75 a share. The seller knows the highest per share price anyone presently is willing to pay for a standard trading unit is $10.50. A sale is possible if the buyer is willing to pay the seller’s price or if the seller is willing to accept the buyer’s price. Assume the two clients then instruct their IAs to get the best possible current price for XYZ (a market order). The orders are relayed to the stock trading departments at each dealer member. The exchange’s data transmission system reports the trade over the exchange’s ticker and provides the buying and selling dealers with specific details of the trade (e.g., time of trade and identity of the other member). Details are relayed to the IAs who originated the transactions and the IAs phone their clients to confirm the transaction. Each dealer mails a written confirmation to its client that day or the next business day at the latest.


9 •16


CHART 9.1

SIMPLIFIED CONCEPTION OF A TRADITIONAL RETAIL SECURITIES TRANSACTION

5 Stock Exchange (Listed Securities)

3 1 Buyer

Investment Advisor Dealer Member A

• • • • •

Common Shares Preferred Shares ETFs Income Trusts Options & Futures

4

6

Investment Advisor Dealer Member B

2 Seller

Alternative Trading systems or OTC (Unlisted Securities) • Bonds • Money Market instruments • Unlisted common and Preferred Shares

SETTLEMENT PROCEDURES

Once a transaction has occurred, the buyer and seller will each receive a confirmation and they must “settle” the transaction. The buyer’s confirmation shows details of the purchase and the amount payable including commission. If the buyer has sufficient funds on deposit with the firm (either for payment in full with a cash account or for initial margin requirements in a margin account), the amount will be withdrawn from the account. Otherwise, the buyer must provide sufficient funds by the settlement date (three business days after the trade date). The buyer’s broker then makes payment for the purchase to the seller’s broker. The seller’s confirmation also shows details of the sale as well as the amount to be received by the seller after commission is deducted. In Canada, stock and bond certificates are not in the form of paper but held electronically to a very large extent by a clearing corporation. At the end of each trading day, the clearing corporation settles all purchases and sales of stock and bonds among dealers. The entries are made in the dealer’s book of record showing who owns the stocks and bonds, and who owes money to pay for them. OTHER TRANSACTION MODELS

The preceding discussion described a trade using a traditional agency transaction model. This agency model is just one of the many ways in which a transaction may occur. Chart 9.2 shows simplified models of other common ways in which transactions are structured. Transaction A is a summary of the agency transaction described in Chart 9.1. The two counterparties are customers of different dealers.


9 •17


Transaction B shows a common agency transaction in which a single dealer matches a buy order and a sell order between two of its customers. In this situation, the transaction price is based on the market price as determined on the exchange, even though the trade occurs first and its occurrence is recorded on the exchange after it is done. Many trades between large institutional customers are conducted in this manner. This kind of trade is commonly known as a cross. Transaction C illustrates a trade in which the client’s order is filled directly by the dealer from inventory. The price at which the trade occurs is based on the current market value as determined on the exchange. In this form of transaction, the dealer acts as principal rather than as agent. Because of the possibility of conflict of interest, there are detailed regulations which define the conduct of the dealer’s traders and the prices at which the transactions should occur. CHART 9.2

OTHER TRANSACTION MODELS

A Stock Exchange Customer A

Dealer Member A

or Alternative Trading Systems (ATS)

Dealer Member B

Customer B

Dealer Member B

Customer B

Dealer Member B

Customer B

or Over-the-counter (OTC)

B Stock Exchange Customer A

Dealer Member A

or Alternative Trading Systems (ATS) or Over-the-counter (OTC)

C Stock Exchange Customer A

Dealer Member A

or Alternative Trading Systems (ATS) or Over-the-counter (OTC)


9 •18


HOW ARE SECURITIES BOUGHT AND SOLD? There are many types of buy and sell orders, common to both listed and unlisted trading, which investment advisors are called upon to execute for clients. These include: • • • • • •

market orders, limit orders, and day orders good till cancelled orders all or none orders and any part orders good through orders stop loss and stop buy orders pro orders EXHIBIT 9.2

THE BID AND ASK PRICE

When trading securities on the market, buyers always want to pay the lowest price possible for stocks they want and sellers always try to get the highest price possible for stocks they own. This creates two prices for a single security: a bid and an ask price. Recall from Chapter 1 that the bid or offer price is the highest price a buyer is ready to pay for a stock while the ask price is the lowest price a seller will accept to sell her stock.

Types of Orders Market Order: An order to buy or sell a specified number of securities at the prevailing market price. All orders not bearing a specific price are considered market orders, which could mean paying the offer (when buying) or accepting the bid (when selling). In any case, the trader will try to obtain a lower offer or a higher bid than the prevailing level.

ABC Common Stock

Bid

Ask

$19.90

$20.10

“Buy me 1,000 shares of ABC at market.” This order will be filled at the current ask price and the buyer will pay $20.10 for ABC Stock. “Sell 1,000 shares of ABC at market.” This order will be filled at the current bid price and the seller will receive $19.90 for her ABC stock.


9 •19


Limit Order: An order to buy or sell securities at a specific price or better. The order will only be executed if the market reaches or betters that price.

ABC Common Stock

Bid

Ask

$19.90

$20.00

“Buy 1,000 ABC at $20 or less” would be filled if the order could be executed at $20 or less. In this case, the order will be executed because at least one seller is ready to sell at ABC Stock at $20. The order would be cancelled at the end of the trading day (if no limit was specified) if the stock remained above $20. “Sell 1,000 ABC at $20 or more” would be filled if the order could be executed at $20 or more. In this case, the order cannot be executed right away because buyers are willing to pay only $19.90.

Day Order: An order to buy or sell that expires if it is not executed on the day it is entered. All orders are considered to be day orders unless otherwise specified.

“Buy 1,000 shares of ABC for my account at $20 or less.” No time limit is specified, therefore the order is valid until the close of business on that day, or until filled, whichever is sooner.

Good Till Cancelled (GTC) Order: An order to buy or sell that remains in effect until it is either executed or cancelled. Many firms will not allow GTC orders and will insist on an end date, after which the order may be renewed on the client’s instructions. This type of order is the same as an open order.

“Sell 1,000 shares of ABC whenever the price reaches $20 or more.” The order stays open until the bid price of ABC reaches $20 or more, at which time it will be filled.

To avoid an unwieldy build-up of GTC (or open) orders on the firm’s trading books, many firms will limit a GTC order for a specified time (e.g., 30 days) and then ask if the client wishes to renew it. All or None (AON) Order: An order whereby the entire amount of stock must be bought or sold or no part of the order will be executed. An order may be given under this heading that states the minimum number of shares (to be bought or sold) that is acceptable to the client.

“Buy 2,500 shares of ABC at $20 on an all or none basis.” There may not be 2,500 shares of ABC selling at $20. Even if there are 2,000 shares selling for $20, the client will not accept only part of the total shares ordered. If 2,500 shares of ABC cannot be found at this price, no shares of ABC will be purchased for the client.


9 •20


Any Part Order: The exact opposite of an AON order in which the client will accept all stock in odd lot or standard trading units up to the full amount of the order.

“Buy 2,500 shares of ABC at $20 or less on an any part basis.” There may be 1,500 shares of ABC available at the time the order is placed, followed by 500 later in the trading day and then 500 shares on the following trading day. The order will be filled in these three stages.

Good Through Order: An order to buy or sell that is good for a specified number of days and then automatically cancelled if it has not been filled by the end of the trading session on the date specified in the order. “Sell 1,000 shares of ABC if the price reaches $20 or more on or before March 30.” The order is open until filled at $20 or more, or until the close of business on March 30, whichever is first.

Stop Loss Order: An order to sell a security when the price of one standard trading unit of the security declines to or falls below a certain amount, thus limiting the loss or protecting a paper profit. Stop loss orders become market orders when the stop price is reached.

“Sell my ABC stock if the price drops to $24.50 or below.” Assume the ABC shares trade at $30 and client Bill Smith purchased the stock at this price. Smith decides that should ABC decline unexpectedly, it would be preferable to limit his loss to $5.50 per share (ignoring commission). He places a stop loss order on 100 shares of ABC at $24.50. If the price of ABC declines so that at least one standard trading unit traded at $24.50 or below, his 100 shares would automatically be sold as a market order. In placing his stop loss order, he would hope that should it be executed, he would be sold out at $24.50, but there is no assurance of this. Since the order becomes a market order, it would simply be filled at the best possible price available at the time.

If in the same example, Bill Smith had paid $20 per share for BEF (prior to the stock advancing to $30), he could have put in a stop loss order at $24.50. This would allow him to protect at least part of his paper profit should the stock decline unexpectedly before he could act.



9 •21

Stop Buy Order: An order to buy a security only after it has reached a certain price. This type of order may be used to protect a short position or to ensure that a stock is purchased while its price is rising. It is the opposite of a stop loss order.

ABC stock is currently trading at $30 per share and a client decides that he would like to buy it – but only if it moves up to $35. A limit buy order of $35 would immediately be filled because the trader is obliged to buy the stock at $35 “or better” and the prevailing market is $30. But by entering the order as a stop buy at $35, the stock will not be purchased until it trades at $35 or above. ABC stock is currently trading at $30 per share and a client decides to short it at that price. He would like to limit his loss to $5 per share so he enters a stop buy order at $35. The stop buy order is triggered only if the price of ABC shares trades at $35 or above. The stop buy order offers insurance – if the share price rises instead of falls ABC will be purchased at $35 a share to limit the potential loss to $5 per share. Note: It is important to realize the inherent dangers of stop buy and stop loss orders. IAs should try to obtain definite upward and downward price limits from clients entering stop orders. Some dealer members will not accept a stop order without a price limit.

Professional (Pro) Order: A fundamental trading regulation to protect the public relates to the priority given to clients’ orders. Where the order of a client competes with a non-client order at the same price, the client’s order is given priority of execution over the non-client order. A nonclient order is an order for an account in which a partner, director, officer, shareholder, IA or, in some cases, other employee of a member holds a direct or indirect interest or an arbitrage order. This rule is applied within dealer members in its dealings with clients so that client orders have priority over “pro orders.” Pro orders are orders for the accounts of partners, directors, officers, shareholders, IAs and, in some cases, specified employees. Tickets for such orders must be clearly labelled Pro or N-C (non-client) or Emp (employee) orders. Under the preferential trading rule, this type of order is executed after a client’s order if both orders compete at the same price for the same security.

An order is placed to sell 100 shares of ABC at $20. In this case, the account holder is an employee of the dealer member. Thus, the order must be marked PRO (or EMP/N-C). If any client orders to sell ABC at $20 are outstanding, these will be filled before the employee’s order.


9 •22


Complete the following Online Learning Activity Buy and Sell Orders Even if an investor is only interested in the outright purchase and sale of shares, the advisor must determine the type of order to be placed since that decision can have a significant effect on the share price. Review the different types of buy and sell orders in this exercise. Complete the Buy and Sell Orders activity.



9 •23


2.

3.

Distinguish between cash 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. Clients with cash accounts can hold only long positions.

•

Clients with margin accounts can buy and/or sell securities on credit and initially pay only part of the full price of the transaction. In such cases, the dealer member lends the remainder of the transaction price to the client, charging interest on the loan.

Explain how to establish margin requirements for long and short positions and the impact price changes have on margin requirements. •

A long margin position allows the investor to partially finance the purchase of securities by borrowing money from the dealer. An investor enters a long position with the expectation that the underlying stock price will rise.

•

A short margin position allows the investor to sell securities he or she does not own by arranging with the dealer to borrow securities to cover the position.

•

When a long position is established on margin, sufficient funds (or securities with excess loan value) must be in the account to cover the purchase.

•

Margin is the amount put up by the client (not the amount borrowed or loaned), and the minimum margin required equals the initial cost of the transaction minus the loan.

•

The loan value of securities in an account is strictly regulated and depends on the loan value status of the individual securities.

•

No loan is made to the client in a short sale. The client must maintain a margin amount that is more than the value of the short sale, although the proceeds of the short sale can be used as part of the margin amount if not withdrawn from the account.

Describe the process of short selling and discuss the risks associated with short selling. •

Short selling is the sale of securities that the seller does not own and is generally carried out in the belief that the price of a stock is going to fall.

•

The short seller’s dealer lends the securities to be shorted to the client, and the client sells the securities in the market, declaring the trade to be a short sale.

•

The proceeds of the short sale are deposited in the account, and the client is required to deposit sufficient additional funds to bring the account balance to a required minimum level.


9 •24


•

Profits are made when the initial sale price exceeds the subsequent repurchase cost once the short position is closed out.

•

There is no limit on how long a short sale position can be maintained, provided the stock does not become de-listed or worthless.

•

The risks associated with short selling include: – Difficulties in borrowing or continuing to borrow the securities sold short – Maintaining adequate margin if the price of the shorted security fluctuates – Liability for dividends or other benefits paid while the security is sold short – Potential volatility in the price if a large number of short sellers cover their position – The potential for unlimited loss if the price of the security rises rather than falls

4.

5.

Describe the trading and settlement procedures for equity transactions. •

Once a buy order and sell order are matched and a trade is completed on an exchange, the exchange’s data transmission system reports the trade over the ticker and provides the buying firm with trade details.

•

A confirmation with details about the settlement (i.e., date, amount, location) is sent to the buyer and seller once the transaction has occurred.

•

Cross trades occur when a dealer matches buy and sell orders internally instead of on an exchange.

•

Principal transactions (i.e., new issues or orders filled out of a dealer’s inventory) are done outside of an exchange.

•

In all cases, the buyer provides payment and the seller delivers the security by the settlement date. The mechanism and time frame for settlement depend on the type of securities traded.

Define and distinguish among the types of buy and sell orders. •

A market order is an order to buy or sell a specified number of securities at the prevailing market price.

•

A limit order is an order to buy or sell securities at a specific price or better.

•

A day order is an order to buy or sell that expires if it is not executed on the day it is entered.

•

A good till cancelled (GTC) order is an order to buy or sell that remains in effect until it is either executed or cancelled.

•

An all or none (AON) order must be filled for the entire number of shares specified. No smaller amount will be accepted, nor will a succession of trades adding to the total amount specified.



9 •25

•

An any part order can be filled by any combination of odd lot or standard trading units up to the full amount of the order (opposite of AON order).

•

A good through order is an order to buy or sell that is good for a specified number of days and then automatically cancelled if it has not been filled by the end of the trading session on the date specified.

•

A stop loss order is an order to sell a security when the price of one standard trading unit of the security declines to or falls below a certain price (the stop price), and it becomes a market order when the stop price is reached.

•

A stop buy order is an order to buy a security only after it has reached a certain price (the stop price), and it becomes a market order when the stop price is reached.

•

Professional (pro) orders are orders for the accounts of partners, directors, officers, shareholders, investment advisors and, in some cases, specified employees.






Chapter

10

Derivatives


10 •1

10 Derivatives

CHAPTER OUTLINE What is a Derivative? • Features Common to All Derivatives • Derivative Markets • Exchange-Traded versus OTC Derivatives What are the Types of Underlying Assets? • Commodities • Financials Who are the Users of Derivatives? • Individual Investors • Institutional Investors • Corporations and Businesses • Derivative Dealers What are Options? • Option Exchanges • Option Strategies for Individual and Institutional Investors • Option Strategies for Corporations What are Forwards and Futures? • Key Terms and Definitions • Futures Exchanges • Futures Strategies for Investors

10 •2


What are Rights and Warrants? • Rights • Warrants Summary

LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Describe what a derivative is and explain the differences between over-the-counter and exchangetraded derivatives. 2. Identify the types of underlying assets on which derivatives are based. 3. Describe the participants in and uses of derivative trading. 4. Describe what options are and how they are traded, and evaluate call and put option strategies for individual and in-stitutional investors and corporations. 5. Describe what forwards are, distinguish futures contracts from forward agreements, and evaluate futures strategies for investors and corporations. 6. Define and describe rights and warrants, explain why they are issued, and calculate the value of rights and warrants.


10 •3

THE ROLE OF DERIVATIVES In the past two decades, there has been phenomenal growth in the creation and use of various derivative instruments. The source of this growth, to a large extent, has been the increase in the volatility of interest rates, exchange rates and commodity prices. Financial deregulation, advances in information technology and breakthroughs in financial engineering have also contributed to the growth. Depending on the position taken, derivatives make it possible to enhance overall portfolio returns and to hedge or reduce exposure to different sources of risk. For many investors, particularly smaller retail investors, derivatives are considered risky, complex investments. This viewpoint can be attributed to what derivatives are: specialized financial instruments created by market participants. They are not assets like stocks and bonds because their value is derived from an underlying asset, such as a financial security or a commodity. Institutional investors and portfolio managers rely on derivatives and consider them quite sensible investments to enhance returns and protect against the inherent risk in the market. Certainly, the frenzied trading that the financial press often reports about oil and gas futures, foreign currencies, pork bellies and gold does sound exciting. We have all heard stories about a commodity trader somewhere in the world betting the right way on a position in natural gas, for example, and making a fortune. Clearly, derivatives can be viewed in a variety of ways. They can be used as wildly speculative or rigorously conservative investment vehicles, as well as in strategies that fall between these two extremes. This chapter focuses on the building blocks of derivatives. The key to understanding these products is becoming comfortable with the terminology, the contractual obligations being assumed and the type of strategy being pursued.

10 •4


KEY TERMS American-style option

In-the-money

Assigned

Long-Term Equity AnticiPation Securities (LEAPS)

At-the-money

Marking-to-market

Call option

Naked call

Canadian Derivatives Clearing Corporation (CDCC)

Offering price

Cash-secured put write

Offsetting transaction

Commodity futures

Open interest

Covered call

Opening transaction

Cum rights

Option premium

Default risk

Out-of-the-money

Derivative

Performance bond

European-style option

Put option

Exercise

Record date

Exercise price

Right

Expiration date

Strike price

Ex-rights

Subscription price

Financial futures

Sweetener

Forward

Time value

Forward agreement

Trading unit

Futures contract

Underlying asset

Good-faith deposit

Warrant

Hedging


10 •5

10 •6


WHAT IS A DERIVATIVE? A derivative is a financial contract between two parties whose value is derived from, or dependent upon, the value of some other asset. The other asset, known as the derivative’s underlying asset or underlying interest or security, can be a financial asset, such as a stock or bond, a currency, or even an interest rate, a futures contract or an equity index. It can also be a real asset or commodity, such as crude oil, gold or wheat. Because of the link between the value of a derivative and its underlying asset, derivatives can act as a substitute for, or as an offset to, a position in the underlying asset. As such, derivatives are often used to manage the risk of an existing or anticipated position in the underlying asset, as well as to speculate on the value of the underlying asset. While some derivatives have complex structures, they all fall into one of two basic types: options or forwards. •

Options are contracts between two parties: a buyer and a seller. The buyer of an option 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 obligated to complete the transaction if called upon to do so. An option that gives its owner the right to buy the underlying asset is known as a call option; the right to sell the underlying asset is known as a put option.

•

Forwards are also contracts between a buyer and a seller. With forwards, however, both parties obligate 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 obligated to participate in the future trade.

Despite this fundamental difference between options and forwards, all derivatives share some features.

Features Common to All Derivatives All derivatives are contractual agreements between two parties, often known as counterparties. One counterparty is the buyer, and the other is the seller. The agreements spell out the rights and/or obligations of each party. Derivatives have a price. Buyers try to buy derivatives as cheaply as possible while sellers try to sell them for as much as possible. All derivatives 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.


TEN • DERIVATIVES

10 •7

Another feature of derivatives is that, unlike financial assets such as stocks and bonds, derivatives can be considered a zero-sum game. In other words, aside from commission fees and other transaction costs, the gain from an option or forward contract by one counterparty is exactly offset by the loss to the other counterparty: every dollar gained by one party represented a dollar lost by the counterparty on the other side of the contract.

Derivative Markets In Chapter 6, you learned that most bonds trade in the over-the-counter (OTC) market and a small number trade on organized exchanges. In Chapter 1, you learned that stocks and derivatives trade on exchanges and OTC markets as well. Whereas the primary difference between exchangetraded and OTC stocks and bonds is trading mechanics, the difference between exchange-traded and OTC derivatives is much more pronounced. OVER-THE-COUNTER DERIVATIVES

The OTC derivatives market is an active and vibrant market that consists of a loosely connected and lightly regulated network of brokers and dealers who negotiate transactions directly with one another primarily over the telephone and/or computer terminals. As explained in Chapter 1, the OTC market is dominated by financial institutions, such as banks and brokerage houses, that trade with their large corporate clients and other financial institutions. This market has no trading floor and no regular trading hours. At nights and during weekends and holidays, some traders and support staff are still working at their trading desks. One of the attractive features of OTC derivatives to the corporations and institutional investors that use them is that contracts can be custom designed to meet specific needs. As a result, OTC derivatives tend to be somewhat more complex than exchange-traded derivatives, as special features can be added to the basic properties of options and forwards. EXCHANGE-TRADED DERIVATIVES

A derivative exchange is a legal corporate entity organized for the trading of derivative contracts. The exchange provides the facilities for trading, either a trading floor or an electronic trading system or, in some cases, both. The exchange also stipulates the rules and regulations governing trading in order to maintain fairness, order and transparency in the marketplace. Derivative exchanges evolved in response to the OTC issues of standardization, liquidity and credit risk. There are two derivative exchanges in Canada: the Montréal Exchange (the Bourse de Montréal) and ICE Futures Canada. The Montréal Exchange lists options on stocks, bonds and indexes, and futures (forwards that are exchange-traded) on bonds and indexes. ICE Futures Canada lists futures and future options on agricultural goods such as canola and western barley.

Exchange-Traded versus OTC Derivatives Readers may ask how organized exchanges and OTC markets successfully co-exist when the interests that underlie derivative instruments in both markets are basically the same. One would think that over time, one of the two markets would prevail. The co-existence has proven successful and long-lasting because the two markets differ in significant ways, each market offering advantages to users depending on their particular needs.


10 •8


STANDARDIZATION AND FLEXIBILITY

One of the most important differences between exchange-traded and OTC derivatives is flexibility. In the OTC market, the terms and conditions of a contract can be tailored to the specific needs of their users. The users may choose the most appropriate terms to meet their particular needs. In contrast, for exchange-traded derivatives, the exchange specifies the contracts that are available to be traded on the exchange; each contract has standardized terms and other specifications, which may or may not meet the needs of certain derivative users. PRIVACY

Another important difference is the private nature of OTC derivatives. In an OTC derivative transaction, neither the general public nor others (including competitors) know about the transaction. On exchanges, all transactions are recorded and known to the general public, although the exchanges do not announce, nor do they necessarily know, the identities of the ultimate counterparties to every transaction. LIQUIDITY AND OFFSETTING

Because they are private and custom designed, OTC derivatives cannot be easily terminated or transferred to other parties in a secondary market. In many cases, these contracts can only be terminated through negotiations between the two parties. By contrast, the standardized and public nature of exchange-traded derivatives means that they can be terminated easily by taking an offsetting position in the contract (Offsetting means closing the position by taking the exact opposite position in the contract – i.e., if you buy a call option on XYZ you would sell a call option on XYZ with exactly the same features to offset the position). DEFAULT RISK

Another downside to the private nature of OTC derivatives is that default or credit risk is a major concern. Default risk is the risk that one of the parties to a derivative contract cannot meet its obligations to the other party. Given this risk, many derivative dealers in the OTC market do not deal with customers that are unable to establish certain levels of creditworthiness. In addition, the size of most contracts in the OTC market may be greater than most investors can manage. For this reason, the OTC market is restricted to large institutional and corporate customers. Individual investors are generally limited to dealing in exchange-traded derivatives. Default risk is not a significant concern with exchange-traded derivatives. Clearinghouses, which are set up by exchanges to ensure that markets operate efficiently, guarantee the financial obligations of every party and contract. The clearing corporation becomes, in effect, the buyer for every seller and the seller for every buyer. The Canadian Derivatives Clearing Corporation (CDCC) is responsible for clearing Montréal Exchange futures and option trades and ICE Clear Canada has sole responsibility for clearing ICE Futures Canada trades. REGULATION

A final difference between OTC and exchange-traded derivatives arises out of the fact that OTC contracts are private and exchange-traded contracts are public. While derivative transactions on exchanges are extensively regulated by the exchanges themselves and government agencies,


10 • 9

TEN • DERIVATIVES

OTC derivative transactions are generally unregulated. On the one hand, the largely unregulated environment in the OTC markets permits unrestricted and explosive growth in financial innovation and engineering. Generally, no government approval is needed to offer new types of derivatives. The innovative contracts are simply created by parties that see mutual gain in doing business with each other. There are no costly constraints or bureaucratic red tape. On the other hand, the regulated environment of exchange-traded derivatives brings about fairness, transparency and an efficient secondary market. Table 10.1 summarizes these and other differences between exchange-traded and OTC derivatives. TABLE 10.1

DIFFERENCES BETWEEN EXCHANGE-TRADED AND OVER-THE-COUNTER DERIVATIVES

• Exchange-Traded

• Over-the-Counter

• Traded on an exchange

• Traded largely through computer and/or phone lines

• Standardized contract • Transparent (public)

• Terms of the contract agreed to between buyer and seller

• Easy termination prior to contract expiry

• Private

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

• Early termination more difficult

• Performance bond required, depending on the type of derivative

• Performance bond not required in most cases

• No third-party guarantor

• Heavily regulated

• Contracts are generally not marked-tomarket; basis (marking-to-market) gains and losses are generally settled at the end of the contract

• Delivery rarely takes place

• Much less regulated

• Commission visible

• Delivery or final cash settlement usually takes place

• Gains and losses accrue on a day-to-day

• Used by retail investors, corporations and institutional investors

• Fee usually built into price • Used by corporations and financial institutions


10 •10


WHAT ARE THE TYPES OF UNDERLYING ASSETS? There are generally two major categories of underlying assets for derivative contracts – commodities and financial assets. A brief summary follows outlining the assets that underlie derivative contracts traded on organized exchanges in the U.S. and Canada. In the OTC markets, the choice of underlying assets is limited only by the imagination and needs of market participants.

Commodities Commodity futures and options are commonly used by producers, merchandisers and processors of commodities to protect themselves against fluctuating commodity prices. Most of these commodities, like soybeans, crude oil and copper, are used mainly for consumption purposes while others, like gold, are used primarily for investment purposes. Speculators also use commodities to profit from the fluctuating prices. Depending on the commodity, prices are affected by supply and demand, agricultural production, weather, government policies, international trade, demographic trends, and economic and political conditions. The following are the types of commodities that underlie derivative contracts: •

Grains and oilseeds such as wheat, corn, soybeans and canola

•

Livestock and meat such as pork bellies, hogs, live cattle and feeder cattle

•

Forest, fibre and food such as lumber, cotton, orange juice, sugar, cocoa and coffee

•

Precious and industrial metals such as gold, silver, platinum, copper and aluminum

•

Energy products such as crude oil, heating oil, gasoline, natural gas and propane

Other than the energy category, most commodity derivatives are exchange-traded contracts.

Financials The last two decades have witnessed an explosive growth in derivatives, especially in financial derivatives. This growth has been fuelled by: • • • •

increasingly volatile interest rates, exchange rates and equity prices financial deregulation and intensified competition among financial institutions globalization of trade and the tremendous advances in information technology extraordinary theoretical breakthroughs in financial engineering

The most commonly used financial derivatives are summarized below. EQUITIES

Equity is the underlying asset of a large category of financial derivatives. The predominant equity derivatives are equity options – which are options on individual stocks. These derivatives are traded mainly on organized exchanges such as the Bourse de Montréal in Canada, and the Chicago Board Options Exchange (CBOE), International Securities Exchange (ISE), Boston Options Exchange (BOX), and American Stock Exchange (AMEX) in the U.S.


TEN • DERIVATIVES

10 •11

INTEREST RATES

Exchange-traded interest rate derivatives are generally based on interest rate-sensitive securities rather than on interest rates directly. In Canada, underlying assets include bankers’ acceptances and Government of Canada bonds. All interest rate futures trading in Canada takes place at the Bourse de Montréal. In the OTC market, interest rate derivatives are generally based on well-defined and well known floating interest rates. Examples of such underlying rates include LIBOR or the London Interbank Offer Rate (the interest earned on Eurodollar deposits in London) and the yields on Treasury bills and Treasury bonds. Because these OTC derivatives are based on an interest rate rather than an actual security, the contracts are settled in cash. CURRENCIES

The most commonly used underlying assets in currency derivatives are the U.S. dollar, British pound, Japanese yen, Swiss franc and Euro. The types of contracts traded include currency futures and options on organized exchanges and currency forwards and currency swaps in the OTC market. There are no currency derivative contracts listed on any Canadian exchanges.

WHO ARE THE USERS OF DERIVATIVES? Derivative users can be divided into four groups: individual investors, institutional investors, businesses and corporations, and derivative dealers. The first three groups are the end users of derivatives. These parties use derivatives either to speculate on the price or value of an underlying asset, or to protect the value of an anticipated or existing position in the underlying asset. The latter application, a form of risk management, is known as hedging. The last group, derivative dealers, are the intermediaries in the markets, buying and selling to meet the demands of the end users. Derivative dealers do not normally take large positions in derivative contracts. Rather, they try to balance their risks and earn profits from the volume of deals they do with their customers.

Individual Investors For the most part, individual investors are able to trade exchange-traded derivatives only. They are active investors in exchange-traded options markets and, to a lesser extent, futures markets. Individual investors should only use derivatives if they fully understand all of their potential risks and rewards. Furthermore, investors should consider speculative strategies only if they have a high degree of risk tolerance, because there is the potential to suffer large losses in derivative trading. Risk management strategies, on the other hand, can be beneficial to all investors, from the most conservative to the most aggressive. Individual investors in Canada can trade exchange-traded derivatives directly by opening a special type of account with a full-service or discount brokerage firm registered to offer such accounts. To deal with investors in exchange-traded derivatives, investment advisors at full-service firms and investment representatives at discount firms must be properly licensed.


10 •12


Institutional Investors Institutional investors that use derivatives include mutual fund managers, hedge fund managers, pension fund managers, insurance companies and more. Like individual investors, institutional investors use derivatives for both speculation and risk management. Unlike individual investors, most institutional investors are able to trade OTC derivatives in addition to exchange-traded derivatives.

From a risk management perspective, hedging is the attempt to eliminate or reduce the risk of either holding an asset for future sale or anticipating a future purchase of an asset. Hedging with derivatives involves taking a position in a derivative with a payoff that is opposite to that of the asset to be hedged. For example, if a hedger owns an asset, and is concerned that the price of the asset could fall in the future, a short derivative position in the asset would be appropriate. A decline in the price of the asset will result in a loss on the asset being held, but would be offset by a profit on the derivative contract. In general, speculation is inconsistentt with the objective of risk management because it increases risk instead of reducing it. Specifically, speculation involves a future focus, the formulation of expectations, and the willingness to take positions in order to profit. In other words, speculators bet on the direction of the market and take positions accordingly to profit from a certain predicted movement of the market.

Other common applications for the use of derivatives include market entry and exit, arbitrage, and yield enhancement.

Market Entry and Exit

Quickly exiting and entering a market in the conventional way – buying and selling the actual stocks – can be inefficient and more costly than one might imagine. There are costs associated with trading, including commission fees, bidask spreads and other administrative fees. These transaction costs can be quite high in some cases, and may impact on the decision to enter or exit a market. In addition, buying or selling a large quantity of certain securities may produce adverse price pressures on the market. This represents a hidden cost to the transaction. A large sell order may push the price down so that less money will be received from selling the securities. Conversely, a large buy order may bid up the price so that it will cost more than the current available price to complete the transaction. These adverse price effects could be especially severe in thinly traded equity or bond markets. For example, the manager of a global equity fund may want to switch out of British stocks and into French and German stocks for only a few months. When market conditions subsequently change, a reverse switch and other shifts of funds are quite possible. In these cases, it is usually more efficient and costeffective to carry out the switch temporarily using derivatives rather than trading in the underlying assets directly.


10 •13

TEN • DERIVATIVES

Yield Enhancement

Yield enhancement is an investment strategy generally used to boost returns on an underlying investment portfolio by taking a speculative position based on expectations of future market movements. The most popular method of enhancing an investment’s yield is by selling options against the position.

Arbitrage

An arbitrage opportunity refers to a scenario where the same asset or commodity is traded at different prices in two separate markets. By purchasing low in one market and selling high in the other market simultaneously, an investor locks in a fixed amount of profit at no risk. For example, suppose an arbitrageur spots an exploitable market mispricing and attempts to profit by buying in the cheap market and selling in the rich market. If the two transactions are effected simultaneously, then there is no investment or risk involved in the arbitrage. But, in practice, the transactions are usually only nearlyy simultaneous.

Corporations and Businesses Corporations that use derivatives come in all shapes and sizes, but for the most part they tend to be larger companies that make use of borrowed money, have multinational operations that generate or require foreign currency, or produce or consume significant amounts of one or more commodities. Corporations and businesses use derivatives primarily for hedging purposes. In particular, these users tend to focus on derivatives that help them hedge interest rate, currency and commodity price risk. Corporations that hedge with derivatives do so because they would rather focus their efforts on running their primary business instead of trying to guess where interest rates, currencies or commodity prices are going. On the other hand, if a hedger anticipates buying an asset in the future, and is concerned that the price could rise by the time the purchase is made, buying a forward contract or a call option would be appropriate. A price increase will result in a higher price being paid by the hedger, but this would be offset by a profit on the forward or call option. A hedger starts with a pre-existing risk that is generated from a normal course of business. For example, a farmer growing wheat has a pre-existing risk that the price of wheat will decline by the time it is harvested and ready to be sold. In the same way, an oil refiner that holds storage tanks of crude oil waiting to be refined has a pre-existing risk that the price of the refined product may decline in the interim. To reduce or eliminate these price risks, the farmer and the refiner could take short derivative positions that will profit if the price of their assets declined. Any losses in the underlying assets would be offset by gains in the derivative instruments. That being said, any gains in these assets would be offset by derivative losses of roughly the same size, depending on the type of derivative chosen and the overall effectiveness of the hedge.


10 •14


The decision to hedge increasingly is becoming a corporate-level decision. Where once the use of derivatives by a company was poorly understood and cause for concern, it is now expected that a company’s Board of Directors use derivatives in an appropriate fashion as a risk management tool. The following exhibit illustrates this shift in attitude. Although it often seems like a simple decision, the determination of whether or not to hedge and how to hedge can often be complex. Hedging does not always result in the complete elimination of all risks. EXHIBIT

HEDGING OR NOT HEDGING: A LEGAL MATTER?

There can be many good reasons for hedging and sometimes good reasons for not hedging. To hedge or not to hedge? Corporate boardrooms are not the only place this intriguing question is debated and answered. This question is increasingly decided in courtrooms. Take the case of Farmers Cooperative (FC), a grain elevator co-op in Indiana. It engaged in the business of buying, storing and selling grain. In the late 1970s, FC’s profits had declined steadily. Acting on the advice of its accountant, FC’s Board of Directors authorized FC’s manager to begin hedging using futures contracts. FC continued to experience substantial operating losses, as less than one per cent of grain sales were actually hedged. Shareholders figured that a proper hedge would have saved the company large amounts of money, so they sued the Board of Directors. The plaintiffs argued that the Board breached its duty by using an inexperienced manager and by failing to supervise the manager. The plaintiffs also argued that the Board members failed to learn enough about hedging to protect the shareholders’ interests. The plaintiffs won the lawsuit and the directors were ordered to pay over $400,000 to the plaintiffs. A lesson to be learned? Directors must be informed or must get informed about the advantages and disadvantages of hedging and how derivative markets work. They must also supervise management to ensure that a hedging program is executed properly. Ignorance cannot be used as a legal defence.

Derivative Dealers The last group of users is the derivative dealers. Derivative dealers play a crucial role in the OTC markets by taking the other side of the positions entered into by end users. Dealers in the exchange traded market take the form of market makers that stand ready to buy or sell contracts at any time. In Canada, the primary OTC derivative dealers are the “big six” banks and their investment dealer subsidiaries, as well as the Canadian subsidiaries of large foreign banks and investment dealers. Exchange-traded market makers include banks and investment dealers as well as professional individuals.


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TEN • DERIVATIVES

Complete the following Online Learning Activity Who are the Users of Derivatives? The number of investors using derivative is extremely high. Can you identify the users of derivatives and why would they choose derivatives over other types of securities? Complete the Who are the Users of Derivatives and Why Do They Use Them activity.

WHAT ARE OPTIONS? An option is a contract between two parties, a buyer (also known as the long position or holder) and a seller (also known as the short position or the writer). This contract gives certain rights or obligations to buy or sell a specified amount of an underlying asset, at a specified price, within a specified period of time. The buyer has the right but is not obligated to exercise her contract, while the seller is obligated to fulfill his part of the contract if called upon to do so. An option that gives its holder the right to buy and its writer the obligation to sell the underlying asset is known as a call option, while an option that gives its holder the right to sell and its writer the obligation to buy the underlying asset is referred to as a put option. The following table and exhibit summarize the expectations, the rights and obligations associated with the four basic option positions and the terminology used in the marketplace. TABLE 10.2

THE FOUR BASIC OPTION POSITIONS

Call Option

Buyer (Long Position)

Writer (Short Position)

Put Option

Pays premium to the writer.

Pays premium to the writer.

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

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

Expects the price of the underlying asset to RISE.

Expects the price of the underlying asset to FALL.

Receives premium from the buyer.

Receives premium from the buyer.

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

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 FALL.

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


10 •16


EXHIBIT

DESCRIBING AN OPTION

When traders and investors discuss options, they usually describe the specific option they are talking about by quickly summarizing the option’s most salient features into one phrase. The following syntax is typically used: “{Number of Option Contracts} + {Underlying Asset} + {Expiration Month} + {Strike Price} + {Option Type}” For example, if an investor wanted to buy 10 exchange-traded call options on XYZ stock with an expiration date in December and a strike price of $50, the investor would say that he wanted to “buy 10 XYZ December 50 calls.” Just as he would if he were buying a stock, the investor would also indicate the price at which he is willing to pay. He could buy them “at market,” in which case he agrees to accept the best price currently available, or he could enter a limit order by specifying the highest price at which he is willing to pay.

It is important to become familiar with the many different terms used when discussing options:

Strike Price:

The strike price (or exercise price) is the price at which the underlying asset can be purchased or sold in the future. The buyer and the seller agree upon this future price at the time the option contract is entered into.

Option Premium:

To obtain the right to buy or sell the underlying asset, option buyers must pay sellers a fee, known as the option price or option premium. Once the premium has been paid, the option buyer has no further obligation to the writer, unless the buyer decides to exercise the option. Therefore, the most that the buyer of an option can lose is the premium paid. On the other hand, writers of options must always stand ready to fulfill their obligation to buy or sell the underlying asset.

Expiration Date:

Exchange-traded options expire at specific and pre-established dates. For example, the expiration months for a series of options on ABC stock may be January, April, July and October. This means that there are four different sets of options for ABC stock, each of which expires in a different month. Typically the day the option expires is the Saturday following the third Friday of the expiration month. Traditionally, options are listed with relatively short terms of nine months or less to expiration.

Trading Unit:

An option’s trading unit describes the size or amount of the underlying asset represented by one option contract. For example, all exchange-traded stock options in North America have a trading unit of 100 shares. Therefore, the holder of one call option has the right to buy 100 shares of the underlying stock, while the holder of one put option has the right to sell 100 shares. Options on other underlying assets have a variety of trading units.


10 •17

TEN • DERIVATIVES

The premium of an option is always quoted on a “per unit” basis, which means that the premium quote for a stock option is the premium for each share of the underlying stock. To calculate the total premium for a contract, multiply the premium quote by the option’s trading unit. For example, if a stock option is quoted with a premium of $1, it will cost the buyer $100 for each contract. American-Style and European-Style Options:

Options that can be exercised at any time up to and including the expiration date are referred to as American-style options. If the option can be exercised only on the expiration date, it is referred to as a European-style option. All exchangetraded stock options in North America are American-style options. Most index options are European-style options.

LEAPS:

These options are called Long-Term Equity AnticiPation Securities (LEAPS). LEAPS are simply long term option contracts and offer the same risks and rewards as regular options.

Opening Transaction:

When an investor establishes a new position in an option contract, it is called an opening transaction. An opening buy transaction results in a long position in the option, while an opening sell transaction results in a short position in the option. On or before an option’s expiration date, one of three things will happen to all long and short option positions. 1. Offsetting the position Positions may be liquidated prior to expiration by way of an offsetting transaction, which, in effect, cancels the position. Offsetting a long position involves selling the same type and number of contracts, while offsetting a short position involves buying the same type and number of contracts. Unless they are specifically designed to be transferable, OTC options can only be offset through negotiations between the long and short parties. Exchangetraded options, however, can be offset simply by entering an offsetting order on the exchange on which the option trades. 2. Exercise the option The party holding the long position can exercise the option. When this happens, the party holding the short position is said to be assigned on the option. For the owners of call options, the act of exercising involves buying the underlying asset from the assigned writer at a price equal to the strike price. For the owners of put options, exercising involves selling the underlying asset to the assigned put writer at a price equal to the strike price. 3. Let the option expire worthless The party holding the long position can let the option expire. Buyers of options have rights, not obligations. If they do not want to exercise their options before they expire, they do not have to; it is totally up to them. In this case, the option buyer lost money with the premium paid, and the option writer made money with the premium received.


10 •18


In-the-Money:

Owners of options will exercise only if it is in their best financial interest, which can only occur when an option is in-the-money. • A call option is in-the-money when the price of the underlying asset is higher than the strike price. If this is the case, the call option holder can exercise the right to buy the underlying asset at the strike price and then turn around and sell it at the higher market price. • A put option is in-the-money when the price of the underlying asset is lower than the strike price. If this is the case, the put option holder can exercise the right to sell the underlying asset at the higher strike price, which would create a short position, and then cover the short position at the lower market price.

Out-of-theMoney and At-the-Money:

Owners of options will definitely not exercise if they are out-of-the-money or at-the-money. • A call option is out-of-the-money when the price of the underlying asset is lower than the strike price. • A put option is out-of-the-money when the price of the underlying asset is higher than the strike price. • Call and put options are at-the-money when the price of the underlying asset equals the strike price. In either of these cases, it is not in the financial best interest of an option holder to exercise. If a call option is out-of-the-money, it does not make financial sense for the call option holder to buy the underlying asset at the strike price (by exercising the call) when it can be purchased at a lower price in the market. Similarly, if a put option is out-of-the-money, it does not make financial sense for the put option holder to sell the underlying asset at the strike price (by exercising the put) when it can be sold at a higher price in the market. Since there is generally no advantage to exercising an at-the-money option (for which the strike price equals the market price of the underlying asset), at-themoney options are normally left to expire worthless.


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TEN • DERIVATIVES

Intrinsic Value:

Intrinsic value is the value of certainty. The in-the-money portion of a call or put option is referred to as the option’s intrinsic value. For example, if XYZ stock is trading at $60, a call option on XYZ stock with a strike price of $55 has $5 of intrinsic value. Similarly, a put option on XYZ with a strike price of $65 has $5 of intrinsic value. Intrinsic Value of an In-the-Money Call Option = Price of Underlying – Strike Price $5 = $60 – $55 Intrinsic Value of an In-the-Money Put Option = Strike Price – Price of Underlying $5 = $65 – $60 If an option is nott in-the-money, it has zero intrinsic value. For example, a call option on XYZ with a $65 strike price has no intrinsic value when XYZ is trading at 60$, as does a put option with a strike price of $55. Intrinsic value is a relatively easy concept to understand: it is the amount that the owner of an in-the-money option would earn by immediately exercising the option and offsetting any resulting position in the underlying asset. Time value, on the other hand, is a more nebulous concept.

Time Value:

Simply put, time value represents the value of uncertainty. Option buyers want options to be in the-money at expiration; option writers want the reverse. The greater the uncertainty about where the option will be at expiration – either inthe-money or out-of-the-money – the greater the option’s time value. Prior to the expiration date, most options trade for more than their intrinsic value. The amount that an option is trading above its intrinsic value is known as the option’s time value. For example, if a call option on XYZ with a strike price of $55 is trading for $6 when XYZ stock is trading at $60, the option has $1 of time value. Time Value of an Option = Option Price – Option’s Intrinsic Value $1 = $6 – $5 If you re-arrange the equation for the time value of an option, you’ll see that the price of any option is simply the sum of its intrinsic and time values. Option Price = Intrinsic Value + Time Value


10 •20


Option Exchanges In Canada, the Montréal Exchange lists options on individual stocks, stock indexes, financial futures and exchange traded funds (ETFs). ICE Futures Canada lists options on agricultural futures. Exchange-traded option prices and trading information are reported in the business press the next day, just like stocks. Table 10.3 provides an illustration. TABLE 10.3

EQUITY OPTION QUOTATION

XYZ Inc.

17.75

Bid

Ask

Last

Opt Vol

Mar.

$17.50

3.80

4.05

3.95

50

1595

$17.50P

2.35

2.60

2.40

5

3301

$17.50

1.10

1.35

1.25

41

3403

$17.50P

.95

1.05

1.00

30

1058

$20.00P

1.85

2.00

1.90

193

1047

319

10,404

Sept.

Dec. Total

Opt Int

Explanation XYZ Inc. The underlying for the option. 17.75

The closing market price of the underlying.

Mar.

The options’ expiration month (March, September, December).

$17.50

The exercise price of each series.

$17.50P

The option is a put.

3.80

The closing bid price for each XYZ option expressed as a per share price.

4.05

The closing asked price for each XYZ option expressed as a per share price.

3.95

The last sale price (last premium traded) of an option contract for the day expressed as a per share price. For example, the 3.95 figure for the XYZ March 17.50 calls is the last sale price for this series on the trading day in question.

Opt Vol

The total trading day’s volume in all series of XYZ’s options (50 + 5 + 41 + 30 + 193 = 319). The trading volume for each series is listed in the column below. For example, 50 XYZ March 17.50 calls were traded on the day shown, representing 5,000 underlying XYZ (50 x 100).

Op Int

The open interest – the total number of option contracts in the series that are currently outstanding and have not been closed out or exercised. For example, the figure 1595 refers to the open interest for the XYZ March 17.50 calls. The figure 10,404 refers to the open interest of all series of XYZ options, including the series that did trade as well as the series that did not trade.


10 •21

TEN • DERIVATIVES

Option Strategies for Individual and Institutional Investors The range and complexity of options trading strategies are practically limitless. This section illustrates and examines eight option strategies used by individual and institutional investors. Each strategy will be either a speculative or risk management strategy, and each will be based on exchange-traded options on the shares of a fictitious company, XYZ Inc. It is important to note that these strategies and the majority of the results are equally applicable to options on any underlying asset. If you want to learn more about options, the Derivatives Fundamentals and Options Licensing Course (DFOL) offered by CSI explains the strategies commonly used in the market to speculate or hedge portfolios.

All of the strategies presented below assume that it is currently June and that XYZ Inc. stock is trading at $52.50 per share. The discussions that follow will make use of one of the four options listed in Table 10.4.

TABLE 10.4

FOUR OPTIONS ON XYZ INC. STOCK TRADING AT $52.50

Option Type

Expiration

Strike Price

Premium

Call

September

$50

$4.55

Call

December

$55

$2.00

Put

September

$50

$1.50

Put

December

$55

$4.85

To keep things simple, commissions, margin requirements and dividends are ignored in all of the examples in this chapter. BUYING CALL OPTIONS

The most popular reason for buying calls is to profit from an expected increase in the price of the underlying stock by investing only a fraction of the amount required to buy the stock. This speculative strategy relies on the fact that call option prices tend to rise as the price of the stock rises. The challenge with this strategy is to select the appropriate expiration date and strike price to generate the maximum profit given the expected increase in the price of the stock. There are two ways to realize profit on call options when the underlying increases in price: Investors can exercise the option and buy the stock at the lower exercise price or they can sell the option directly into the market at a profit. Calls are also bought to establish a maximum purchase price for the stock, or to limit the potential losses on a short position in the stock. In this sense, buying options act much like insurance, protecting the investor when the stock price moves higher. These strategies are considered risk management strategies.


10 •22


Strategy #1: Buying Calls to Speculate

Refer to Table 10.4 for figures presented in this strategy.

Suppose an investor buys 5 XYZ December 55 call options at the current price of $2. Let’s break this down into individual parts: 5

= The number of contracts (and each contract is worth 100 shares)

XYZ

= The underlying stock the call option is based on

December = The expiration month 55

= The strike price

$2

= The premium or cost to purchase the call option

The investor pays a premium of $1,000 ($2 × 100 shares × 5 contracts) to obtain the right to buy 500 shares of XYZ Inc. at $55 a share on or before the expiration date in December. Because the options are out-of-the-money (the strike price is greater than the stock price of $52.50), the $2 premium consists entirely of time value. The options have no intrinsic value. If the investor (we’ll call him the holder) is a speculator, the intent of the call purchase is to profit from the expectation of a higher XYZ stock price: •

The holder probably has no intention of actually owning 500 shares of XYZ.

•

Rather, the holder will want to sell the 5 XYZ December 55 calls before they expire, preferably at a higher price than what was paid for them.

•

The chances of this depend on many factors, most importantly the price of XYZ shares. If the price of XYZ shares rise, the price of the calls will likely rise, and the holder will be able to sell them at a profit.

•

Of course, the holder faces the risk that the stock price does not rise or, worse, it falls. If this happens, the price of the calls will likely fall as well, and the holder may be forced to sell them at a loss.

For example, if by September the price of XYZ stock is $60, the XYZ December 55 calls will be trading for at least their intrinsic value, which in this case is $5. Since there are still three months remaining before the options expire, the premium will also include some time value. Assuming the calls have $1.70 of time value, they will be trading at $6.70. Therefore, the investor could choose to sell the options at $6.70 and realize a profit of $4.70 a share, equal to the difference between the current premium ($6.70) minus the premium paid ($2), or $2,350 total ($4.70 × 100 shares × 5 contracts). If, however, XYZ shares are trading at $45 a share in September, the XYZ December 55 calls might be worth only $0.25. At this time, and indeed, at all other times before expiration, the investor will have to decide whether to sell the options or hold on in the hope that the stock price (and the options’ price) recovers. If the investor decides to sell at this time, a loss equal to $1.75 a share ($2 - $0.25), or $875 total ($1.75 × 100 shares × 5 contracts) will result.


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TEN • DERIVATIVES

The decision to sell prior to expiration is not an easy one. On the one hand, selling before expiration allows the holder to earn any time value that remains built into the option premium. On the other hand, the option holder gives up any chance of reaping any further increases in the option’s intrinsic value. The call holder’s outlook for the price of the stock obviously plays a crucial role in the decision. EXHIBIT

OPTIONS AND LEVERAGE

This example highlights one of the reasons why investors are attracted to the strategy of buying calls in anticipation of a higher stock price: leverage. In the realm of buying call options, leverage results in larger profits or losses, on a percentage basis, from buying calls instead of buying the stock directly. For instance, if the price of XYZ Inc. stock rose to $60 in September, and the call buyer sold the XYZ December 55 calls for a profit of $4.70, the call buyer’s rate of return, based on the initial cost of $2, is 235%. $4.70 = 235% $2 If the stock price declined to $45, however, and the call buyer sells the options for a loss of $1.75, the rate of return is -87.5%. – $1.75 = – 87.5% $2 To see how leverage increases both profits and losses on a percentage basis, compare these returns to the returns from simply buying the stock at $52.50. If the stock is sold at $60, for a profit of $7.50 a share, the return is “only” 14.3%. $7.50 = 14.3% $52.50 If the stock fell to $45, and the loss is $7.50 a share, the rate of return is -14.3%. – $7.50 = – 14.3% $52.50 Thus, while the call provided a greater rate of return when the stock price increased, it also provided a lower rate of return when the stock price fell. This is the risk faced by all investors who decide to use leverage when they buy call options.

Strategy #2: Buying Calls to Manage Risk


The other reason that investors buy call options is to manage risk. Suppose a fund manager intends to buy 50,000 shares of XYZ stock, but will not receive the funds until December.


10 •24


Buying 500 XYZ December 55 call options will protect the fund manager from any sharp increase in the price of XYZ above the $55 strike price, because they will establish a maximum price at which the shares can be purchased. For instance, if XYZ shares increase to $60 just prior to the expiration date in December: •

The options will be trading for their intrinsic value only, in this case $5 ($60 – $55).

•

Since the call buyer now has the money to buy the shares, the calls can be exercised, at which point the call buyer will purchase 50,000 shares of XYZ at the strike price of $55.

•

Since the options originally cost $2, the call buyer’s net purchase price is actually $57 a share.

If, however, XYZ shares are trading at $45 just prior to the expiration date, the call buyer will let the options expire and will buy the shares at the going price of $45 each. The investor’s effective cost is $47, which includes the $2 paid for the calls. PROTECTING A SHORT SALE

Suppose an investor sells short 500 shares of XYZ stock at its current price of $52.50, but wants to limit the loss in case the stock price rises. Buying 5 XYZ December 55 call options will protect the investor from any sharp increase in the price of XYZ above the $55 strike price, because the call establishes a maximum price at which the shares can be purchased back. For instance, if XYZ shares increase to $60 just prior to the expiration date in December, the options will be trading for their intrinsic value only, in this case $5 ($60 - $55). The investor exercises the calls and purchases 500 shares of XYZ at the strike price of $55. Since the options originally cost $2, the call buyer’s net purchase price is actually $57 a share. Since he sold the stock short at $52.50 and bought it back at $57, the loss is limited to $4.50 per share. If, however, XYZ shares are trading at $45 just prior to the expiration date, the investor will let the options expire and will buy the shares at the market price of $45 a share. The investor’s effective purchase price is $47, which includes the $2 paid for the calls. In this case, his profit is $5.50 on the short sale (sell at $52.50, buy back at $47 to close the position).

WRITING CALL OPTIONS

Investors write call options primarily for the income they provide. The income, in the form of the premium, is the writer’s to keep no matter what happens to the price of the underlying asset or what the buyer eventually does. Call-writing strategies are primarily speculative in nature, but they can be used to manage risk as well. Call option writers can be classified as either covered call writers or as naked call writers. Covered call writers own the underlying stock, and will use this position to meet their obligations if they are assigned. Naked call writers do not own the underlying stock. If a naked call writer is assigned, the underlying stock must first be purchased in the market before it can be sold to the call option buyer. Since call option buyers will only exercise if the price of the stock is above the strike price, assigned naked call writers must buy the stock at one price (the market price) and sell at a lower price (the strike price). Naked call writers hope, however, that this loss is less than the premium they originally received, so that the overall result for the strategy is a profit.


TEN • DERIVATIVES

10 •25

Strategy #1: Covered Call Writing


Suppose an investor purchased 1,000 shares of XYZ at $40 a share. She writes 10 XYZ September 50 call options at the current price of $4.55. The investor receives a premium of $4,550 ($4.55 × 100 shares × 10 contracts) to take on the obligation of selling 1,000 shares of XYZ Inc. at $50 a share on or before the expiration date in September. Because the options are in-themoney (the strike price is less than the stock price), the $4.55 premium consists of both intrinsic and time value. Intrinsic value is equal to $2.50 and time value is equal to $2.05. Since the investor owns shares of XYZ, the overall position is known as a covered call. (We’ll call this investor the covered call writer.) If at expiration in September, the price of XYZ stock is greater than $50 (i.e., the options are in-the-money): •

The covered call writer will be assigned and will have to sell the stock to the call buyer at $50 a share.

•

From the covered call writer’s perspective, however, the effective sale price is $54.55, because of the initial premium of $4.55.

•

Overall, the total profit on this position is $14.55 per share, because the investor bought XYZ at $40, sold it for $50 and made $4.55 from the premium.

If, however, the price of the stock at expiration in September is less than $50, the covered call writer will not be assigned and the options will expire worthless. Call buyers will not elect to buy the stock at $50 when it can be purchased for less in the market. The covered call writer will retain the shares and the initial premium. In this case, the premium reduces the covered call writer’s effective stock purchase price by $4.55 a share. That is, because the covered call writer bought the XYZ stock at $40, and the options expired worthless, the covered call writer’s effective purchase price is now $35.45 ($40 – $4.55). In this sense, writing the call slightly reduces the risk of owning the stock. Strategy # 2: Naked Call Writing


Suppose a different investor writes 10 XYZ September 50 call options at the current price of $4.55. If this investor did not already own the shares, the investor is considered a naked call writer (and that’s what we’ll call him or her). The best that the naked call writer can hope for is that the price of XYZ stock will be lower than $50 at expiration. If this happens, the calls will expire worthless and the naked call writer will earn a profit equal to $4.55 a share, the initial premium received. This is the most that the call writer can expect to earn from this strategy.


10 •26


If the price of the shares increases, the naked call writer will realize a loss if the stock price is higher than the strike price plus the premium received, in this case $54.55. If this happens, the naked call writer will be forced to buy the stock at the higher market price and then turn around and sell them to the call buyer at the $50 strike price. When the stock price is greater than $54.55, the cost of buying the stock is greater than the combined proceeds from selling the stock and the premium initially received. For example, if the price of the XYZ rose to $60 at expiration, the naked call writer will suffer a $10 loss on the purchase and sale of the shares (buy at $60, sell at $50). This loss is offset somewhat by the initial premium received of $4.55, so that the actual loss is $5.45 a share, or $5,450 in total ($5.45 × 100 shares × 10 contracts). BUYING PUT OPTIONS

A popular reason for buying puts is to profit from an expected decline in the price of the stock. This speculative strategy relies on the fact that put option prices tend to rise as the price of the stock falls. Just like buying calls, the selection of an expiration date and strike price is crucial to the success (or lack thereof ) of the strategy. Puts are also bought for risk management purposes. Because puts can be used to lock in a minimum selling price for a stock, they are very popular with investors who own stock. Buying puts can protect investors from a decline in the price of a stock below the strike price. Strategy #1: Buying Puts to Speculate


Suppose an investor buys 10 XYZ September 50 put options at the current price of $1.50. The put buyer pays a premium of $1,500 ($1.50 × 100 shares × 10 contracts) to obtain the right to sell 1,000 shares of XYZ Inc. at $50 a share on or before the expiration date in September. Because the options are out-of-the-money (the strike price is less than the stock price), the $1.50 premium consists entirely of time value. The option has no intrinsic value. The put buyer could have an opinion about the price of XYZ stock exactly opposite that of the call buyer. That is, the put buyer might believe that the price of XYZ stock will fall and that put options on XYZ can be bought and sold for a profit. The put buyer might have no intention of actually selling 1,000 shares of XYZ stock. In fact, the put buyer in this case probably doesn’t even own 1,000 XYZ shares to sell. He only wants to speculate that the price of XYZ shares will fall. If the stock price falls, the XYZ September 50 put options will likely rise in value. This will allow the put buyer to sell his options for a profit. Of course, if the stock price rises, the put options will most likely lose value and the put buyer may be forced to sell the options at a loss. For example: •

If XYZ stock is trading at $45 one month before the September expiration date, the XYZ September 50 puts will be trading for at least their intrinsic value, or $5.


TEN • DERIVATIVES

10 •27

•

Since there is still one month before the expiration date, the options will have some time value as well.

•

Assuming they have time value of $0.25, the options will be trading at $5.25.

•

Therefore, the put buyer could choose to sell the puts for $5.25 and realize a profit of $3.75 a share, which is equal to the difference between the current put price and the put buyer’s original purchase price of $1.50.

•

Based on 10 contracts, the put buyer’s total profit is $3,750 ($3.75 × 100 shares × 10 contracts).

If, however, XYZ were trading at $60 a share, the XYZ September 50 puts might be worth only $0.05. Because the options are so far out-of-the-money, and because there is only one month left until the options expire, the options will not have a lot of time value. The low option price tells us the market does not believe there is much of a chance for XYZ shares to fall below $50 anytime over the next month. The put buyer would have to decide whether to sell the options at this price, or hold on in hope that the price of XYZ does fall to below $50. If the stock does fall, the price of puts will rise. If the stock doesn’t fall below $50, the puts will be worthless when they expire. If the put buyer decides to sell the options at $0.05, a loss equal to $1.45 a share ($0.05 – $1.50) or $1,450 total ($1.45 × 100 shares × 10 contracts) would result. Strategy #2: Buying Puts to Manage Risk


Suppose a different investor buys 10 XYZ September 50 put options at the current price of $1.50, but in this case the put buyer actually owns 1,000 shares of XYZ. In this case, the put purchase will act as insurance against a drop in the price of the stock. Recall that put buyers have the right to sell the stock at the strike price. Therefore, buying a put in conjunction with owning the stock, a strategy known as a married put or a put hedge, gives the put buyer the right to sell the stock at the strike price. If the price of the stock is below the strike price of the put when the puts expire, the put buyer will most likely exercise the puts and sell the stock to the put writer. The strike price acts as a floor price for the sale of the stock. For example, if XYZ shares are trading at $45 just prior to the expiration date in September: •

The puts will be trading very close to their intrinsic value of $5, because the puts are in-themoney and there is very little time left until the expiration date.

•

The put buyer may choose to exercise the puts and sell the stock at the $50 strike price.

•

The put buyer has been protected from the drop in the stock price below $50.

•

The protection was not free, however, because the put buyer had to pay $1.50 for the puts.

•

The put buyer’s effective sale price is actually only $48.50 ($50 - $1.50), after deducting the cost of the puts. But this sale price is still better than the stock’s $45 market price.


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WRITING PUT OPTIONS

Investors write put options primarily for the income they provide. The income, in the form of the premium, is the writer’s to keep no matter what happens to the price of the underlying asset or what the buyer eventually does. Like their call-writing cousins, put-writing strategies are primarily speculative in nature, but they can be used to manage risk as well. Put option writers can be classified as either covered or naked. Covered put writing, however, is not nearly as common as covered call writing because, technically, a covered put write combines a short put with a short position in the stock. It’s a simple fact of the stock markets that there are many more long positions in stocks than there are short positions. A more common, “nearly” covered put writing strategy is known as a cash-secured put write. A cash-secured put write involves writing a put and setting aside an amount of cash equal to the strike price. If possible, the cash should be invested in a short-term, liquid money market security such as a Treasury bill so that it will earn some interest. If the cash-secured put writer is assigned, the cash (or proceeds from selling the T-bill) will be used to buy the stock from the exercising put buyer. Naked put writers have no position in the stock and have not specifically earmarked an amount of cash to buy the stock. That being said, naked put writers must be prepared to buy the stock, so they should always have the financial resources to do so. Naked put writers hope to profit from a stock price that stays the same or goes up. If this happens, the price of the puts will likely decline as well, and the chance of being assigned will also be less. The naked put writer may then choose to buy back the options at the lower price to realize a profit. If the stock price does not rise, the put writer may be assigned, and may suffer a loss. Depending on how low the stock price is and the amount of premium received, naked put writers may still profit even if they are assigned. Strategy # 1: Cash-Secured Put Writing


Suppose an investor writes 5 XYZ December 55 put options at the current price of $4.85. The put writer receives a premium of $2,425 ($4.85 × 100 shares × 5 contracts) to take on the obligation of buying 500 shares of XYZ Inc. at $55 a share on or before the expiration date in December. Because the options are in-the-money (the strike price is greater than the stock price), the $4.85 premium consists of both intrinsic value and time value. Intrinsic value is equal to $2.50 and time value is equal to $2.35. If the put writer had set aside an amount of cash equal to the purchase value of the stock, the strategy is known as a cash-secured put write. The put writer in this case would have to set aside $27,500 ($55 strike price × 100 shares × 5 contracts). Some investors actually use cash-secured put writes as a way to buy the stock at an effective price that is lower than the current market price. The effective price is equal to the strike price minus the premium received. For example, if at expiration in December the price of XYZ stock is less than $55: •

The put writer will be assigned and will have to buy 500 shares of XYZ at the strike price of $55 a share.


TEN • DERIVATIVES

10 •29

•

The effective purchase price is actually $50.15, because the put writer received a premium of $4.85 when the options were written.

•

This effective purchase price is less than the $52.50 price of the stock when the cash-secured put write was established.

If at expiration in December the price of XYZ stock is greater than $55, the cash-secured put writer will not be assigned because the options are out-of-the-money. The cash-secured put writer, however, gets to keep the premium of $4.85, and will have to decide whether to use the cash to buy the stock at the market price. Strategy #2: Naked Put Writing


Suppose a different investor writes 5 XYZ December 55 put options at the current price of $4.85. If the put writer does not set aside a specific amount of cash to cover the potential purchase of the stock, the put writer is considered a naked put writer. The naked put writer wants the price of XYZ to be higher than $55 at expiration. If this happens, the puts will expire worthless and the put writer will earn a profit equal to $4.85 a share, the initial premium received. If the price of XYZ stock falls, however, the naked put writer will most likely realize a loss, because put buyers will exercise their options to sell the stock at the higher strike price. (The naked put writer in this case will suffer a loss only if XYZ stock is trading for less than $50.15 at option expiration.) The naked put writer will have to buy stock at a price that is higher than the market price. If the put writer did not want to hold the shares in anticipation of a higher price, they could be sold. For example, if the price of XYZ fell to $45 at expiration, the naked put writer will suffer a $10 loss on the purchase and sale of the shares (buy at the strike price of $55, sell at the market price of $45). This loss is offset somewhat by the initial premium of $4.85, so that the actual loss is $5.15 a share, or $2,575 in total ($5.15 × 100 shares × 5 contracts).

Option Strategies for Corporations Unlike individual and institutional investors, corporations do not normally speculate with derivatives. They’re just not interested in risking their shareholders’ money betting on the price of an underlying asset. They are, however, interested in managing risk, and they often use options to do so. The risks that corporations most often manage are related to interest rates, exchange rates or commodity prices. For instance, corporations regularly take on debt to help finance their operations. Sometimes the interest rate on the debt is a floating rate that rises and falls with market interest rates. Just like the investor who buys a call to establish a maximum purchase price for a stock, corporations can buy a call to establish a maximum interest rate on floating-rate debt.


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HOW CORPORATIONS USE CALL AND PUT OPTIONS STRATEGIES (for information purposes only)

Call Option Strategies Suppose a Canadian company knows it will buy US$1 million worth of goods from a U.S. supplier in three months’ time. Based on an exchange rate of C$1.12 per U.S. dollar, the U.S. dollar purchase will cost the company C$1.12 million. The company can do two things to secure the US$1 million: buy it now and pay C$1.12 million, or wait three months and pay whatever the exchange rate is at that time. The company would prefer to do the latter and wait, but by doing this, it faces the risk that the value of the U.S. dollar will strengthen relative to the Canadian dollar. This would cause the Canadian dollar cost of the purchase to be higher than C$1.12 million. To protect itself against this risk, the corporation can buy a call option on the U.S. dollar. Suppose the corporation buys a three-month U.S. dollar call option with a strike price of C$1.15. This option is an OTC option and would most likely be written by the corporation’s bank. If at the end of three months the exchange turns out to be C$1.20, the corporation will exercise the call and buy the U.S. dollars from its bank for C$1.15 million. If, however, the U.S. dollar weakens so that in three months the exchange rate is C$1.10, the corporation will let the option expire and will buy the U.S. dollars at the lower exchange rate. The purchase of the call option has capped the exchange rate at C$1.15 plus the cost of the option. Put Option Strategies Suppose a Canadian oil company will have 1 million barrels of crude oil to sell in six months’ time. The current price of crude oil is US$70 a barrel, but the company is not sure what the price will be in six months. To lock in a minimum sale price, the company buys a put option on one million barrels of crude oil with a strike price of US$68 a barrel. This will protect the company from an oil price lower than US$68 a barrel. If in six months the price of crude oil is less than US$68, the company will exercise its put option and sell the oil to the put option writer at the strike price. If the price is greater than US$68, the company will let the option expire and will sell the oil at the going market price.

Complete the following Online Learning Activity What Is a Derivative? To fully understand derivatives, you must be able to describe options and the trading mechanics of options. In these activities, you will review your knowledge of derivatives. Complete the Key Terms activity. Complete the Trading Options activity. Complete the Trading Options Quiz activity.


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TEN • DERIVATIVES

WHAT ARE FORWARDS AND FUTURES? A forward is a contract between two parties: a buyer and a seller. The buyer of a forward agrees to buy the underlying asset from the seller on a future date at a price agreed upon today. Unlike for options, both parties are obligated to participate in the future trade. Forwards can trade on an exchange or over the counter. When a forward is traded on an exchange, it is known as a futures contract. Futures are usually classified into two groups depending on the type of underlying asset. Contracts that have a financial asset as the underlying asset are referred to as financial futures. Contracts that have a physical asset as the underlying asset are known as commodity futures. TABLE 10.5

MOST COMMON UNDERLYING ASSETS FOR FUTURES CONTRACTS

Financial Futures

Commodity Futures

Stocks

Gold

Bonds

Crude Oil

Currencies

Grains and Oilseeds

Interest rates

Dairy

Stock Indexes

Livestock Forest

When a forward is traded over the counter, it is generally referred to as a forward agreement. The predominant types of forward agreements are based on interest rates and currencies.

Key Terms and Definitions Futures are simply exchange-traded forward contracts, and as such they have many of the features inherent to all forward contracts. They are agreements between two parties to buy or sell an underlying asset at some future point in time at a predetermined price. The party that agrees to buy the underlying asset holds a long position in the futures contract. This party is also said to have bought the futures contract. The party that agrees to sell the underlying asset holds a short position in the futures contract, and is said to have sold the futures contract. The buyer of a futures contract does not pay anything to the seller when the two enter into the contract. Likewise, the seller does not deliver the underlying asset right away. The futures contract simply establishes the price at which a trade will take place in the future. As it turns out, most parties end up offsetting their positions prior to expiration, so that few deliveries actually take place. If a contract is not offset and is held to the expiration date, delivery will occur. Longs will have to accept delivery of the underlying asset and make payments to the shorts. Shorts have to make delivery of the underlying asset and accept payments from the longs.


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Like all exchange-traded derivatives, futures are standardized with respect to the amount of the asset underlying each contract, expiration dates and delivery locations. Standardization allows users to offset their contracts prior to expiration and provides the backing of a clearinghouse. 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 based on the performance of the underlying asset from the time the future was entered into until the time that it expires. These futures are known as cash-settled futures contracts. An equity index futures contract is an example of a futures contract that is cash settled. Those who are long a stock index futures contract are not obligated to accept delivery of the stocks that make up the index, nor are those who are short required to make delivery of the stocks. Instead, if the position is held to the expiration date, either the long or the short will make a cash payment to the other based on the difference between the price agreed to in the futures contract and the price of the underlying asset on the expiration date. •

If the price agreed to in the futures contract is greater than the price of the underlying asset at expiration, prices have fallen, and the long must pay the short.

•

If the price agreed to in the futures contract is less than the price of the underlying asset at expiration, prices have risen, and the short must pay the long.

As with all other futures contracts, cash-settled futures can be offset prior to expiration. MARGIN REQUIREMENTS AND MARKING-TO-MARKET

Buyers and sellers of futures contracts must deposit and maintain adequate margin in their futures accounts. Unlike margin on stock transactions (which are the counterpart to the maximum loan value that a dealer may extend to its clients), futures margins are meant to provide a level of assurance that the financial obligations of the contract will be met. In effect, futures margins represent a good-faith deposit or performance bond. There are two levels of margin used in futures trading: initial margin and maintenance margin. Initial or original margin is required when the contract is entered into. Maintenance margin is the minimum account balance that must be maintained while the contract is still open. Minimum initial and maintenance margin rates for a particular futures contract are set by the exchange on which it trades, although investment dealers may impose higher rates on their clients. Dealers, however, may not charge their clients less than the exchange minimums. One of the important features of futures trading is the daily settlement of gains and losses. This process is known as marking-to-market. At the end of each trading day, those who are long a contract make a payment to those who are short, or vice versa, depending on the change in the price of the contract from the previous day. If either party accumulates losses that cause their account balance to fall below the maintenance margin level, they must deposit additional margin into their futures account.


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TEN • DERIVATIVES

EXAMPLE

INITIAL AND MAINTENANCE MARGIN AND MARKING-TO-MARKET

Greg buys a futures contract and Leila sells the same futures contract on the same day. For the purpose of this example, let’s say the initial margin required in each account is $2,000 and the maintenance margin is $1,500. Both Greg and Leila put up the initial margin required in their accounts. The first day, the futures gain $200. At the end of this day, Greg’s account is credited $200 and Leila’s is debited $200. Greg’s account now shows $2,200 and Leila’s account shows $1,800. On the second day, the futures drop $300. At the end of the second day, Greg is debited $300 and Leila is credited $300. Greg’s account now shows a balance of $1,900 and Leila’s account shows a balance of $2,100. As you can see, Greg and Leila’s accounts are debited and credited each day by the amount of the gain or loss on the futures contract until they offset or close their positions. If the contract drops more than $500, let’s say $600, Greg’s account will be debited $600. His account now shows a balance of $1,400, which is below the maintenance margin. Greg’s dealer will send a margin call to Greg and Greg must deposit $600 so the account is back to the initial margin. This is how initial and maintenance margins and marking-to-market work.

Futures Exchanges ICE Futures Canada lists futures contracts on wheat, canola and western barley. The Montréal Exchange (ME) lists financial futures. The ME offers contracts on index futures, two-year and ten-year Government of Canada bonds, bankers’ acceptances, and the 30-day overnight repo rate.

Futures Strategies for Investors Futures are inherently simpler than options. Whereas with options there are four basic positions – long a call, short a call, long a put, short a put – there are only two basic positions with futures contracts – long and short. Options also have strike prices, so that an almost uncountable number of different strategies can be designed by combining options with different strike prices and expiration dates, as well as with a position in the underlying asset. The number of strategies that can be designed with futures is limited because there are only two basic positions for each expiration date. BUYING FUTURES

Investors buy futures either to profit from an expected increase in the price of the underlying asset, or to lock in a purchase price for the asset on some future date. The former application is speculation while the latter is risk management. Buying Futures to Speculate

An investor may buy a futures contract to profit from the expectation of rising prices. This investor probably has no intention of actually buying the underlying asset. Rather, the investor wants to sell the futures contract at a higher price than what was originally paid. The chances of this happening depend primarily on the change in the price of the underlying asset in the spot or cash market. If the spot price of the underlying asset rises, then the price of the futures contract will also rise. Of course, the investor faces the risk that the price of the underlying asset will fall. If this happens, the price of the futures contract will fall as well, and the investor may be forced to sell the contract at a loss.


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Buying Futures to Manage Risk

The purchase of a future contract to lock in a purchase price is considered a risk management decision. In this case, the investor does not offset the contract. At expiration, the investor takes delivery of the underlying asset for the amount agreed upon when the contract was originally bought. The purchase of the futures contracts locks the investor in to a pre-determined purchase price of the underlying asset regardless of what happens to the price of the underlying in the spot market. SELLING FUTURES

Investors sell futures either to profit from an expected decline in the price of the underlying asset or to lock in a sale price for the asset on some future date. Selling Futures to Speculate

An investor may sell futures simply to profit from an expectation of lower prices. The investor probably has no intention of actually selling the underlying asset. Rather, the investor wants to buy back the futures in the market at a lower price than what the contract was originally sold for. The chances of this happening depend primarily on the change in price of the underlying asset in the spot or cash market. If the price of the underlying asset falls in the cash market, then the price of the futures contract will also fall, and the investor realizes a profit in offsetting the futures contract at a lower price. Of course, the investor faces the risk that the underlying prices will rise. If this happens, the price of the futures contract will rise as well, and the investor may be forced to buy back the contracts at a loss. Selling Futures to Manage Risk

The sale of a futures contract to lock in a selling price is considered a risk management decision. In this case, the investor does not offset the contract. At expiration, the investor will be required to sell the underlying asset for the amount agreed to when the contract was originally sold. The sale of the futures contract locks the investor in to a pre-determined selling price regardless of what happens to the price of the underlying asset in the spot market. FUTURES STRATEGIES FOR CORPORATIONS

Corporations use futures to manage risk in the same way that investors do. When a company needs to lock in the purchase price of an asset, they may decide to buy futures on the asset. Similarly, when a company needs to lock in the sale price of an asset, they may decide to sell futures on the asset. Even though they take futures positions consistent with their risk management needs, companies usually offset their positions before expiration rather than actually making or taking delivery of the underlying asset. But the futures can still satisfy a company’s risk management needs by providing price protection.


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TEN • DERIVATIVES

EXHIBIT

EXAMPLE OF A FUTURES STRATEGY (for information purposes only)

In July, a brewery determines that it will need 100 tonnes of barley in November. Barley is trading in the spot market at $150 a tonne, while November barley futures are trading at $155 a tonne. The brewery’s regular barley supplier will not guarantee a fixed price for the November purchase, but instead will charge the spot price on the day the brewery places the order. In order to protect itself from a sharp increase in the price of barley, the brewery buys 5 November barley futures at the current price of $155. (Each barley futures contract has an underlying asset of 20 tonnes of barley.) In early November, barley is trading at $170 a tonne in the spot market. At the same time, November barley futures are trading at $171 a tonne. Rather than take delivery by holding its futures position until the expiration date, the brewery would like to buy the barley from its regular supplier. There are a number of reasons why the brewery might want to do this. • First, the brewery’s operations may be located far from the standardized delivery location for barley futures. If the brewery were to take delivery of the barley, it would incur the expense of shipping the barley from the delivery location to its own location. • Second, the exact quality of the barley that underlies the barley futures contract may not match the quality the brewery normally uses. The brewery’s regular supplier would presumably be able to deliver the required quality. • Third, the standardized delivery date of the barley futures contract may not coincide with the exact date the brewery requires the barley. Again, the regular supplier would likely be able to deliver on the date the brewery required. As a result, the brewery would likely want to deal with its regular supplier. To get out of its obligation to buy barley by way of the futures contracts, the brewery offsets its position by selling 5 November barley futures at the current price of $171 a tonne. Because the price rose and the brewery had a long position, it earns a profit of $16 a tonne on the futures transactions. At the same time, the brewery places an order to buy 100 tonnes of barley from its supplier. The supplier charges the brewery the current spot price of $170 a tonne. The brewery’s effective price, however, is lower than this because of the futures profit. The net effect is that the brewery ends up paying $154 a tonne, which is equal to the $170 purchase price minus the $16 futures profit. So, even though barley rose $20 from late July to early November, the price the brewery actually pays is only $4 higher than the price back in July. This is because the futures provided the brewery with price protection for the majority of the price increase. This process illustrates how companies use futures for price protection rather than an outlet to buy or sell the underlying asset.


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Complete the following Online Learning Activity Forwards and Futures Forward and futures contracts are designed to reduce risks related to the uncertainty of future market prices for both sellers and buyers of underlying assets. By entering these contracts, the end-users achieve greater certainty about their future underlying transaction, which may help them to have better control over their financial resources. In this activity you have the opportunity to review your knowledge of forwards and futures by identifying the differences and similarities between the two types of contract. Review the Forwards and Futures activity.

WHAT ARE RIGHTS AND WARRANTS? Like call options on stocks, rights and warrants are securities that give their owners the right, but not the obligation, to buy a specific amount of stock at a specified price on or before the expiration date. Unlike options, however, rights and warrants are usually issued by a company as a method of raising capital. Although they may dilute the positions of existing shareholders if they are exercised, they allow the company to raise capital quickly and cost-effectively. The other major difference between rights, warrants and call options is the time to expiration. Rights are usually very short term, with an expiration date often as little as four to six weeks after they are issued, while warrants tend to be issued with three to five years to expiration.

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. To raise capital by issuing additional common shares, a company may give shareholders rights that allow them to buy additional shares in direct proportion to the number of shares they already own. For example, shareholders may be given one right for each share they own, and the offer may be based on the right to buy one additional share for each ten shares held. In this case, the company wants to increase its outstanding shares by 10%, and each shareholder is given the opportunity to increase their own holdings by 10%. The exercise price of a right, known as the subscription or offering price, is the price shareholders pay to purchase additional shares of the company. The offering price is almost always lower than the market price of the shares at the time the rights are issued. This makes the rights valuable and gives shareholders an incentive to exercise them.


TEN • DERIVATIVES

10 •37

When a company decides to do a rights offering, they announce a record date to determine the list of shareholders who will receive the rights, much as they do when they issue a dividend. All common shareholders who are in the record books on the record date receive rights. For the two business days before the record date, the shares trade ex rights. This means that anyone buying shares on or after the ex rights date is not entitled to receive the rights from the company. Between the day of the announcement that rights will be issued and the ex rights date, the stock is said to be trading cum rights, meaning that anyone who buys the stock is entitled to receive the rights if they hold the stock until at least the record date. The usual method of making an offering is to issue one right for each outstanding common share. A certain number of these rights are required to buy one new share. In addition to having the correct number of rights required to purchase shares, the subscriber must pay the subscription price to the company to acquire these additional shares. No commission is levied when the rights holder exercises the rights and acquires shares. The rights are usually listed on the exchange that lists the underlying common stock. The price of the rights tends to rise and fall in the secondary market as the price of the common stock fluctuates, although not necessarily to the same degree. A rights holder may take any one of four courses of action: •

Exercise some or all of the rights and acquire the shares

•

Sell some or all of the rights

•

Buy additional rights to trade or exercise later

•

Do nothing and let the rights expire worthless

Doing nothing provides no benefit. Rights are not automatically exercised on behalf of their holders. The holder must select a course of action appropriate for his or her circumstances. INTRINSIC VALUE OF RIGHTS

Like options, rights may have intrinsic value. As mentioned previously, rights are normally issued with a subscription price lower than the market price of the stock. This means that they have intrinsic value at the time they are issued. After they are issued, they will have intrinsic value as long as the market price of the stock stays above the subscription price. Because rights have a short lifespan, they generally have very little time value. That being said, they usually have some time value. As with options, the trading price of a right is equal to the intrinsic value, if any, plus the time value. There are two formulas used to calculate the intrinsic value of a right: one is used during the ex-rights period and the other is used during the cum-rights period.


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THE INTRINSIC VALUE OF RIGHTS DURING THE EX-RIGHTS PERIOD

Two business days before the record date, the shares start trading ex rights and the rights begin to trade as a separate entity. The intrinsic value of a right during the ex-rights period is calculated using the following formula: Intrinsic Value of Rights during the Ex-Rights Period

SX 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 EXAMPLE

On June 1, ABC Co. declares a rights offering: To shareholders of record on Friday, June 10, will be granted one right for each common share held. Five rights are required to buy one new share at a subscription price of $23. The rights will expire at the close of business on July 6. On June 8, the first day of the ex-rights period, the rights begin to trade as a separate security. If on this day ABC shares open for trading at $25, the intrinsic value of each right is $0.40. Intrinsic Value of Rights

$25 $23 5 $2 5

$0.40

THE INTRINSIC VALUE OF RIGHTS DURING THE CUM-RIGHTS PERIOD

A different formula is needed to calculate the intrinsic value of a right during the cum-rights period because during this time the rights are embedded in the common stock. Since buyers of the stock during the cum-rights period are eligible to receive the rights, a portion of the common stock’s price represents the value of the rights as well as the value of the stock. The formula for the intrinsic value of the rights during the cum-rights period must take into account the fact that each ABC share includes one right. Therefore, the following formula must be used to determine the intrinsic value of rights during the cum-rights period: Intrinsic Value of Rights during the Cum-Rights Period

SX n 1

Adding the “+1” term to the denominator is all that’s needed to make the adjustment and account for the fact that the price of ABC now includes the intrinsic value of the rights. TRADING RIGHTS

If the common shares of the company issuing rights are listed on a stock exchange, the rights are listed on the exchange automatically. Trading in the rights takes place until they expire.


TEN • DERIVATIVES

10 •39

Canadian trading practice requires that a rights transaction be settled by the third business day after the transaction takes place. This is known as regular delivery and is identical to the settlement period for a stock. On the TSX Venture Exchange, rights are usually traded on a cash basis three days prior to and including the expiry date. Starting on the third business day prior to expiry, the buyer is required to pay cash and take delivery of the rights on the same day the transaction takes place. The TSX Venture Exchange terminates trading in the rights at the close of the market on the expiry date. The Toronto Stock Exchange has special settlement procedures for rights to facilitate settlement as the expiry date approaches. Trades three days before the expiry date settle one day before the expiry date. Trades two days and one day before the expiry date settle for cash the next day. Trades executed on the expiry date are settled in cash the same day. Because the settlement periods are shortened, the investor must deliver the rights certificate to the investment dealer’s offices in time to make the trades. Orders may not be accepted unless the certificates are held in the member firm’s account. The TSX terminates trading in the rights at noon on the expiry date.

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 – that is, written – by other investors. Warrants are often issued as part of a package that also contains a new debt or preferred share issue. The warrants help make these issues more attractive to buyers by giving them the opportunity to participate in any appreciation of the issuer’s common shares. In other words, they function as a sweetener. Once issued, warrants can be sold either immediately or after a certain holding period. The expiration date of warrants, which can extend to several years from the date of issue, is longer than that of a right. VALUING WARRANTS

Like options, warrants may have both intrinsic value and time value. Intrinsic value is the amount by which the market price of the underlying common stock exceeds the exercise price of the warrant. A warrant has no intrinsic value if the market price of the common stock is less than the exercise price. Time value is the amount by which the market price of the warrant exceeds the intrinsic value. For example, even though a warrant to buy one common share at $40 has no intrinsic value when the price of the common stock is $30, it could still have a market value of several dollars. Even with no intrinsic value, the market will attach a time value to the warrant. With a large amount of time remaining to expiration, there will be more time for the underlying common stock to increase in price. The market will speculate on this possibility and attach a value to it: hence the term “time value.” As the expiration date approaches, there is less time for the common stock to increase in value, so the time value also falls. When it expires, an unexercised warrant is worthless.


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WHY INVESTORS BUY WARRANTS

The main attraction of warrants is their leverage potential. The market price of a warrant is usually much lower than the price of the underlying security, and generally moves in the same direction at the same time as the price of the underlying. The capital appreciation of a warrant on a percentage basis can therefore greatly exceed that of the underlying security. EXAMPLE

Suppose investor A buys a warrant and investor B buys the underlying common stock. The warrant has the following information: • Market value of the warrant: $4 • Exercise price: $12 • Market price of the underlying common stock: $15 This warrant has an intrinsic value of $3 and a time value of $1. Intrinsic value of a warrant = Market price – exercise price = $15 - $12 Time value of a warrant

= Market value of the warrant – intrinsic value

If the common stock rises to, say, $23 a share before the warrants expire, the results are: • For the warrant buyer: a rise in price from $4 to $11 (the warrants would rise to at least their intrinsic value) generating a 175% return from the original market value. • For the common stock buyer, the profit would be $8 ($23 – $15), or 53%. Of course, the reverse is also true. Instead of rising from $15 to $23, let’s say the stock declines from $15 to $10. A decline in the price of the common stock from $15 to $10 would result in a 33% loss for the shareholder, whereas if the warrants fall from $4 to $0.25 (no intrinsic value but still a small amount of time value), the buyer will face a 94% loss.


TEN • DERIVATIVES

10 •41


2.

3.

Describe what a derivative is and explain the differences between over-the-counter and exchange-traded derivatives. •

A derivative is a financial contract that has a specific expiration date and includes rights and/or obligations for the buyer and the seller. The derivative includes a price or formula to determine the price of the asset being bought or sold in the future and whose value is derived from or dependent on the value of some other asset.

•

Derivatives that trade over-the-counter (OTC) can be customized to fit specific circumstances and are typically more complex than exchange-traded derivatives.

•

OTC derivatives may not be liquid, are generally conducted privately without public disclosure, have default risk, are lightly regulated, often result in delivery of the underlying asset or a cash payment, and are generally used only by corporate or institutional investors.

•

Exchange-traded derivatives are standardized contracts. They are liquid, traded publicly, have little or no default risk, are heavily regulated, rarely result in delivery of the underlying asset, and are used by a variety of investors.

Identify the types of underlying assets on which derivatives are based. •

Commodities that underlie derivative contracts include grains and oilseeds; livestock and meat; forest, fibre, and food; precious and industrial metals; and energy products.

•

Financials that underlie derivative contracts include equities and equity indexes, interest rates and interest-rate sensitive securities, and currencies.

Describe the participants in and uses of derivative trading. •

There are four main participants in derivatives: individual investors, institutional investors, businesses and corporations, and derivative dealers.

•

Investors, businesses and corporations use derivatives to speculate on the price or value of an underlying asset (speculators) or to protect the value of an anticipated or existing position in an underlying asset (hedgers).

•

Derivative dealers are the intermediaries in the markets, buying and selling to meet the demands of the end users.


10 •42


4.

Describe what options are and how they are traded, and evaluate call and put option strategies for individual and institutional investors and corporations. •

Options are contracts between a buyer and seller and can be exchange-traded or traded OTC.

•

The buyer of an option 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 on today. The seller of the option is obligated to complete the transaction if called on to do so.

•

An option that gives its owner the right to buy the underlying asset is known as a call option; the right to sell the underlying asset is known as a put option.

•

Option buyers must pay sellers a fee known as the option price or option premium. Once the premium has been paid, the option buyer has no further obligation to the writer, unless the buyer decides to exercise the option. The most that the buyer of an option can lose is the premium paid.

•

American-style options can be exercised at any time up to and including the expiration dates; European-style options can be exercised only on the expiration dates.

•

Exchange-traded options can be offset by entering an offsetting order on the exchange on which the option trades. OTC options can be offset or closed only by negotiation between buyer and seller.

•

A call option is in-the-money when the price of the underlying asset is higher than the strike price.

•

A put option is in-the-money when the price of the underlying asset is lower than the strike price.

•

The amount that an option is trading above its intrinsic value is the option’s time value.

•

An investor buys a call option to lock in a price for a future purchase or to speculate on a future rise in price.

•

An investor writes or sells a call option to generate income. Naked call writers do not own the stock, which can be risky; covered call writers own the stock.

•

An investor buys a put option to lock in a selling price for a current position or to speculate on a future decline in price.

•

An investor writes or sells a put option to generate income. A covered put writer typically has a short position in the underlying asset or is secured by a cash position; most put writers are naked, which can be risky.


TEN • DERIVATIVES

5.

6

10 •43

Describe what forwards are, distinguish futures contracts from forward agreements, and evaluate futures strategies for investors and corporations. •

Forwards are contracts between a buyer and a seller in which both parties obligate themselves to trade the underlying asset in the future at a price agreed on at the time of contract creation.

•

Futures contracts are standardized and regulated exchange-traded forward contracts that can be offset through the exchange prior to expiration.

•

Daily gains and losses on futures contracts are marked-to-market (calculated and settled) daily.

•

Investors buy futures either to profit from an expected increase in the price of the underlying asset or to lock in a purchase price for the asset on some future date.

•

Investors sell futures either to profit from an expected decline in the price of the underlying asset or to lock in a sale price for the asset on some future date.

Define and describe rights and warrants, explain why they are issued, and calculate the value of rights and warrants. •

A right is a free privilege granted to a shareholder by an issuing company to acquire additional shares in direct proportion to the number of shares already owned. The shares are acquired directly from the issuing company up to a set expiration date at a price (known as the subscription or offering price) that is usually lower than the market price of the shares at the time of the rights issue.

•

Corporations issue rights when market conditions are not conducive to an ordinary common share issue, a company wants to give existing shareholders the opportunity to acquire additional shares before anyone else, or a company wants to allow existing shareholders to maintain their proportionate interest in the company.

•

Rights begin to trade separately from the related stock on the ex-rights day.

•

The intrinsic value of a right during the ex-rights period is calculated as: Market price of the stock Subscription price Number of rights needed to buy one share

•

The intrinsic value of a right during the cum-rights period is calculated as: Market price of the stock Subscription price Number of rights needed to buy one share 1

•

A warrant is a security, often issued as part of a package that also contains a new debt or preferred share issue, that gives its holder the right to buy shares in a company from the issuer at a set price until expiration.

•

Warrants can be sold either immediately or after a certain holding period.


10 •44


•

Intrinsic value of a warrant is the amount, if any, that the market price of the underlying common stock exceeds the exercise price of the warrant.

•

Time value of a warrant is the amount that the market price of the warrant exceeds the intrinsic value.






SECTION

IV

The Corporation


Chapter

11

Financing and Listing Securities


11•1

11 Financing and Listing Securities

CHAPTER OUTLINE What are the Different Types of Business Structures? What are Incorporated Businesses? • Public and Private Corporations • The Structure of the Organization How do Governments and Corporations Finance Themselves? • Investment Dealer Finance Department • Canadian Government Issues • Provincial and Municipal Issues • Corporate Issues How does the Corporate Financing Process Work? • The Dealer’s Advisory Relationship with Corporations • The Method of Offering • The Prospectus • After-Market Stabilization What are the Other Methods of Distributing Securities to the Public? • Junior Company Distributions • Options of Treasury Shares and Escrowed Shares • Capital Pool Company Program • NEX

11•2


How does the Listing Process Work? • Advantages and Disadvantages of Listing • Withdrawing Trading Privileges Summary

LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Compare and contrast the three types of business structures and explain the process, outcomes, advantages and disadvantages of incorporation. 2. Describe the processes by which governments raise debt capital to finance their funding requirements. 3. Describe the processes by which corporations raise debt or equity capital to finance their funding requirements. 4. Summarize the steps in the corporate financing process, explain the different methods of offering securities to the public, summarize the prospectus system and evaluate after-market stabilization. 5. Identify other methods of distributing securities to the public through stock exchanges. 6. Discuss the advantages and disadvantages of listing shares for trading on an exchange and explain the circumstances and ways in which exchanges can withdraw trading privileges.


11•3

BRINGING SECURITIES TO MARKET So far in this course we have learned a great deal about the different types of financial securities and the roles played by financial intermediaries and the various financial markets. What we have yet to talk about is the way in which a company has its securities listed on a stock exchange so that investors can trade them. Stocks and bonds go through a very detailed process before they can be listed on a stock exchange. Not only are there regulatory requirements, but there is also significant financial expense. The process is established and rigorous and has been refined over the years so that investors are protected and the integrity of the capital markets is maintained. The media often discusses new and exciting initial public offerings (IPOs); however, before the new issue can get to that stage, the issuing company faces many challenges. Financial institutions have specific departments to handle securities offerings because the last thing a company wants to do is issue securities that investors are not interested in buying. This chapter begins with a look at the different ways that companies are structured and then reviews the financing process.

KEY TERMS

11•4

After-market stabilization

NEX

Authorized shares

No par value

Banking Group

Non-competitive tender

Blue sky

Outstanding shares

Bought deal

Over-allotment option

Broker of record

Override

Capital Pool Company (CPC)

Partnership

Capital stock

Preliminary prospectus

Competitive tender

Primary dealers

Continuous disclosure

Primary offering

Corporation

Private offering

Covenants

Prospectus

Delayed opening

Protective Provisions

Delisting

Proxy

Direct bond

Public float


Due diligence report

Red herring prospectus

Equity capital

Reporting issuer

Escrowed shares

Selling Group

Exchange offering prospectus

Shareholder

Final prospectus

Short form prospectus

Financing

Short position

Fiscal agency

Sole proprietorship

General partnership

Statement of material facts

Government securities distributor

Suspension of trading

Green shoe option

Syndicate

Greensheet

Transparency

Halt in trading

Tombstone advertisements

Information circular

Treasury shares

Initial Public Offering (IPO)

Trust Deed

Issued shares

Trust Deed Restrictions

Limited partnership

Trustee

Listing agreement

Underwriting

Material fact

Voting trust

Negotiated offering

Waiting period


11•5

11•6


WHAT ARE THE DIFFERENT TYPES OF BUSINESS STRUCTURES? There are three forms of business organization: sole proprietorships, partnerships and corporations. •

Sole proprietorship involves one person running his or her own business, and the individual is taxed on earnings at their personal income tax rate. While the individual profits if the venture is successful, he or she is also personally liable for all debts, losses and obligations arising from the business activity beyond the assets held in the business.

•

Partnership involves two or more persons contributing to the business, whether it be capital or expertise required to run the enterprise. This form of business organization is legislated under the Partnership Act. There are two forms of partnership agreements: general partnership and limited partnership.

•

–

General partnership: the general partners are involved in the day-to-day operations and are personally liable for all debts and obligations incurred in the course of business,

–

Limited partnership: a limited partner cannot participate in the daily business activity and liability is limited to the partner’s investment.

A corporation is an incorporated business that is a distinct legal entity separate from the people who own its shares. Corporations pay taxes and can sue or be sued in a court of law. Property acquired by the corporation does not belong to the shareholders of the corporation, but to the corporation itself. The shareholders have no liability for the debts of the corporation and there can be no additional levy on shareholders if the debts of a bankrupt corporation exceed the value of its realizable assets. In addition, corporations are able to raise funds by issuing equity or debt, and are thus more suitable for large business ventures than proprietorships or partnerships.

WHAT ARE INCORPORATED BUSINESSES? Although corporations form a small percentage of the total number of businesses, they attract a large proportion of the total capital invested. The basic procedure for incorporation is for one or more persons to file documents with the appropriate department of either the federal or a provincial government and pay the required fees. The government will issue a charter, the document under which the corporation comes into existence, in the form of letters patent, memorandum of association or articles of incorporation. A corporation’s name must include the words limited, corporation, or incorporated (or abbreviations thereof or French equivalents). Certain enterprises must be incorporated under a specific statute dealing only with that type of business. For example, chartered banks can only be incorporated under the federal Bank Act. There are a number of advantages and disadvantages to consider before incorporating a business. Table 11.1 summarizes some of the advantages and disadvantages of incorporation.


ELEVEN • FINANCING AND LISTING SECURITIES

TABLE 11.1

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ADVANTAGES AND DISADVANTAGES OF INCORPORATION

Advantages of Incorporation Limited Liability The principle that shareholders of a corporation risk only the amount of money of Shareholders they have invested in the corporation’s common shares is an outstanding advantage of the corporate form of organization. For example, a shareholder who has invested $1,000 in a corporation’s common shares is not liable for additional contributions even if the corporation were to go bankrupt and its obligations to creditors far exceeded the value of its realizable assets. Continuity of Existence

A sole proprietorship ends when the proprietor dies, and, subject to an agreement to the contrary, a partnership terminates upon the death or withdrawal of one partner. A corporation’s continued existence is not affected by the death of any or all of its shareholders. The existence of a corporation is terminated only by imposed acts such as bankruptcy of the corporation itself.

Transfer of Ownership

Shareholders of a public corporation can usually transfer their shares to other investors with relative ease. This liquidity is an attractive feature of share ownership. And, although the ownership of shares may change, the assets of the corporation continue to be owned by the corporate entity itself.

Ability to Finance

The raising of capital by a corporation, through the issue of different classes of shares and debt instruments is much easier than for sole proprietorships or partnerships. The limited liability feature permits investors to contribute capital with a chance of return and without further liability.

Growth

The corporate form is well suited to handle easily the large amounts of capital needed to operate large and growing businesses.

Legal Entity

A corporation is an entity separate from its owners and can sue or be sued.

Professional Management

Although the shareholders are the ultimate owners of the corporation, they play a very small part in the management of the corporation. They elect, through their voting rights, a board of directors who manage the affairs of the corporation. If the directors do not manage the corporation to their satisfaction, the shareholders may elect different directors.

Disadvantages of Incorporation Loss of Flexibility

A corporation is subject to many rules imposed by various statutes, and the trend is towards an increase in the degree of regulation. Changes in the charter and by-laws of the corporation can be complicated and sometimes require formal approval of the government of the incorporating jurisdiction as well as of the directors and shareholders.


11•8


TABLE 11.1

ADVANTAGES AND DISADVANTAGES OF INCORPORATION – Cont’d

Disadvantages of Incorporation Taxation

The possibility of double taxation arises when the after-tax profits of a corporation are distributed in the form of dividends to shareholders, who themselves pay tax on their dividend income.

Expense

After the initial cost of incorporation, there are annual costs additional to those incurred in proprietorships or partnerships. Annual returns, audits, preparation of federal and provincial corporate tax returns, the holding of shareholders’ meetings and, for many corporations, the requirements of securities laws can result in substantial additional administrative costs.

Capital Withdrawal

The statutory procedures for the redemption of shares and purchase of shares by the corporation, when permitted by the applicable statute, must be very carefully followed. Practically, a small investor in a public corporation can withdraw his or her capital only by selling the shares on the market.

Once a decision has been made to incorporate, the jurisdiction of incorporation must be selected. In most cases the choice will be whether to incorporate under the laws of the province where the corporation’s chief place of business will be located or to incorporate federally under the Canada Business Corporations Act (CBCA). A provincially incorporated corporation can carry on business in the province of incorporation, but may need a further licence or registration to carry on business in other provinces. A federally incorporated corporation is subject to the laws of general application in a province and may have to register there, but no provincial law may discriminate against a federal corporation so as to deprive it of the powers conferred on it by the federal government.

Complete the following Online Learning Activity Advantages and Disadvantages of Incorporating Use this study aid to review the first section of Chapter 11 and the related learning objective that requires you to compare and contrast the three types of business structures and explain the process, outcomes, and advantages and disadvantages of incorporation. Download the Advantages and Disadvantages of Partnership/ Corporate Business Structure study aid.



11• 9

Public and Private Corporations Historically, corporations have been divided into two types: •

Private corporations, which have in their charters a restriction on the right of shareholders to transfer shares, a limitation on the number of shareholders to not more than 50, and a prohibition on inviting members of the public to subscribe for their securities

•

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

THE BY-LAWS

A corporation is regulated by: •

The federal or provincial act under which its charter is issued

•

Its own charter

•

Its by-laws

A general by-law is prepared at the time of incorporation and contains rules that govern the conduct of the corporation. By-laws are passed by the directors and approved by the shareholders. Provisions in the by-laws usually deal with items such as: •

Shareholders’ and Directors’ meetings

•

Qualification, election and removal of directors

•

Appointment, duties and remuneration of officers

•

Declaration and payment of dividends

•

Date of fiscal year end

•

Signing authority for documents

VOTING AND CONTROL

Through the right to vote at the annual meeting and at special or general meetings, shareholders exercise their rights as owners to control the destiny of the corporation. They elect the directors who guide and control the business operations of the corporation through its officers. Many matters of an unusual, non-recurring nature, such as the sale, merger or liquidation of the business and the amendment of the charter, must receive shareholder approval before action is taken. To vote, an individual must have shares registered in his or her own name or be in possession of a completed proxy form. Usually each common shareholder has one vote for each share owned. •

If there were nine directors being elected, each shareholder may cast a ballot for each of the nine persons to be elected, with a vote equal to the number of shares the shareholder owns.

•

Under this system, one or more shareholders controlling more than half of the total number of voting shares can determine every question and elect all the directors.


11•10


•

The result is control by those holding a majority of the voting shares and not necessarily by the majority in number of shareholders.

•

If the voting shares are widely held (i.e., held by many shareholders), a corporation may be controlled by a shareholder or a group of shareholders owning substantially less than 50% of the voting shares.

SHAREHOLDERS’ MEETINGS

All shareholders must be given the opportunity to receive materials relating to meetings of shareholders, including proxies and audited (or unaudited) annual financial statements, and to attend and to vote at the meetings. Shares may not be voted by intermediaries (including investment dealers) unless instructions have been given by the shareholder to do so. In the case of a regular meeting, the list of eligible shareholders is prepared as of a certain date prior to the meeting and shareholders are notified of the meeting within a specified time period. At the annual meeting, they elect the directors, appoint independent auditors (or accountants), receive the financial statements and the auditor’s (or accountant’s) report for the preceding year and consider other matters regarding the company’s affairs. Special meetings may be called for any matter that requires attention prior to the next annual meeting. VOTING BY PROXY

A proxy is a power of attorney given by a shareholder that gives a designated person the authority to vote the shareholder’s stock at a shareholders’ meeting. Under the federal act and many provincial acts, the proxy holder need not be a shareholder of the company. Proxies are always revocable. Sending proxies to company shareholders is compulsory. A proxy form and an information circular must accompany the notice of a shareholders’ meeting which is sent to all shareholders. The information circular sent with the notice of the annual meeting must contain details about proposed directors, directors’ and officers’ remuneration, interest of directors and officers in material transactions, the appointment of auditors and particulars of other matters to be acted upon at the meeting.

At the annual shareholders’ meeting of a public corporation, enough shareholders have usually signed proxy forms appointing the management nominees as their proxy that the management is able to carry any resolution it wishes. Most resolutions are passed as a matter of course with or without significant prior discussion. Even in these circumstances, where individual shareholders have no real chance to defeat a management proposal, the meeting can be a valuable opportunity for shareholders to question management and to make their views known. In many public corporations, the management group itself does not own a large percentage of the issued shares and may be dependent upon the support of the shareholders at large. In such circumstances, there is always the possibility of a contest for control of the corporation, with both the management group and the challengers actively seeking proxy support from the shareholders at large before the meeting. Although such “proxy fights” are rare, they can lead to the removal of the existing management if enough shareholders lend support to the challengers.


11•11


VOTING TRUSTS

A corporation that is undergoing a restructuring due to financial difficulties may be placed under the control of a few individuals through a voting trust. The voting trust is usually put into effect for specific periods of time, or until certain results have been achieved. It is used because financiers may be willing to inject new capital only if they can be assured of control to protect their investment until there is a recovery in the fortunes of the corporation. To transfer voting control, shareholders are asked to deposit their shares with a trustee, usually a trust company, under the terms of a voting trust agreement. The trustee issues a voting trust certificate, which returns to the shareholder the same rights possessed by the original shares, with the exception of the voting privileges which remain with the trustee.

The Structure of the Organization Organizational Chart 11.1 illustrates the way corporations are structured. CHART 11.1

SIMPLIFIED ORGANIZATION CHART OF A HYPOTHETICAL CORPORATION

Shareholders

Board of Directors *

Chairman of the Board

President

Executive Vice-President

Vice-President Finance

Vice-President Manufacturing

Vice-President Marketing

Vice-President Secretary and General Counsel

Vice-President Human Resources

Vice-President Research

* Many Boards of Directors elect Executive Committees, Finance Committees and Audit Committees.


Vice-President Public Affairs

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Table 11.2 lists the main responsibilities of the highest members of a corporation’s structure. TABLE 11.2

Directors

MAIN RESPONSIBILITIES OF THE HIGHEST MEMBERS OF A CORPORATION’S STRUCTURE

Must be of the age of majority, of sound mind and not an undischarged bankrupt. Responsibilities: • Set company policies by passing resolutions; • They are normally responsible for the appointment and supervision of officers and signing authorities for banking, the approval of budgets, financing and plans for expansion; the decision to issue shares; and the declaration of dividends and other dispositions of profits; • They are personally liable for illegal acts of the corporation done with their knowledge and consent; • They are personally responsible for employees wages, declared dividends and government remittances; • They must act honestly, in good faith and in the best interests of the corporation.

Officers

Appointed by the company directors Responsibilities: • They are corporate employees responsible for the day-to-day operation of the business

Chairman of the Board

Elected by the board of directors Responsibilities: • May have all or any of the duties of the president or any other officer of the corporation • May be the chief executive officer • Presides over meetings of the board and generally exerts great influence on the management of the affairs of the corporation • May be combined with the job of president

President

Appointed by and responsible to the board of directors Responsibilities: • Exercises authority through the other officers and through the heads of departments or divisions • If the job of president is not combined with that of the chairman, the president may act as chairman in the latter’s absence

VicePresidents

Appointed by and responsible to the president Responsibilities: • Head specific areas of the corporation’s operations such as sales or finance



11•13

HOW DO GOVERNMENTS AND CORPORATIONS FINANCE THEMSELVES? Governments and large corporations often need to raise funds to finance large projects. Governments may need money to finance bridges, highways or deficits while corporations may want to finance new plants or business acquisitions. The process by which an issuer (government or company) raises debt or equity capital either publicly or privately is called financing, or underwriting. •

For governments, this financing is often accomplished through an auction process and occasionally through a fiscal agency.

•

For companies, financing takes the form of a private offering, an initial public offering or IPO, or a secondary offering.

Public financings are undertaken by public companies that trade on the exchanges and the overthe-counter markets. Private financings are discussed only briefly in this chapter.

Investment Dealer Finance Department The finance department of an investment dealer helps corporations and governments achieve their funding targets by acting as an intermediary between investors and the issuers of the debt and equity securities. There are usually two distinct groups in the finance department of an investment dealer: Government Finance and Corporate Finance. GOVERNMENT FINANCE

The government finance department specializes in selling debt instruments to institutions and other interested parties, and advises both clients and the issuing governments on debt issues. The persons charged with the responsibility of government finance need to be in touch with the market at all times to ensure awareness of market conditions and prices. Their advice to issuing governments includes: •

The size (or dollar value), coupon (interest rate offered) and currency of denomination of the issue

•

The timing of the issue

•

Whether the issue should be domestic or foreign

•

What effect the issue may have on the market

•

Whether the issue should be a new maturity, or whether a previous issue should be reopened

CORPORATE FINANCE

Corporate financing is a careful balancing act in which the dealer must balance the needs of the corporate client that requires funding with the requirements of the investing public who provide the money necessary for corporate purposes. The dealer must also balance current market conditions in both the debt and equity markets with the limitations of the company’s statement


11•14


of financial position (formerly the balance sheet) and future prospects. This requires skill in market timing, technical knowledge with regard to legal and financial matters, and a thorough understanding of financial analysis and promotion. Some of the decisions involved with a new issue include: •

What types of securities are to be issued

•

Whether the issue should be a private or public offering

•

What the issue price will be

•

What the coupon rate or valuation multiple (such as the price-earnings ratio) will be

•

What the underwriting fee charged to the corporation will be

•

When the issue will come to market

•

What proportion of the issue will be bought by institutional and by retail investors

Canadian Government Issues The Canadian Government brings new issues of fixed-coupon marketable bonds and treasury bills to market on a regularly scheduled basis by using the competitive tender system. The securities are issued by way of an auction, whereby the amount won at the auction is based on the bids submitted. Only those institutions recognized as government securities distributors are permitted to submit bids to the Bank of Canada. These institutions include the Schedule I and Schedule II banks, investment dealers, and foreign dealers active in the distribution of government securities. Government securities distributors that maintain a certain threshold of activity are known as primary dealers. Bids can also be submitted on a non-competitive tender basis, whereby the bid is accepted in full by the Bank of Canada and bonds are awarded at the auction average. The process generally works as described below. •

Bids are submitted to the Bank of Canada, usually electronically, by 12:30 p.m. on the date of the auction.

•

Competitive tenders may consist of up to seven bids stated in multiples of $1,000 and subject to a minimum size per individual bid of $100,000. Bids do not state a price for the bond, but instead, the yield on the bond that each bidder hopes to earn.

•

Primary dealers have bidding limits on the auctioned amount that cannot exceed 40% of the total amount of the bonds being offered. Bidders may not act in collusion with another bidder to acquire more bonds than the auction limit.

•

Each government securities distributor may also submit one non-competitive tender, in addition to any competitive bids. The ceiling on non-competitive bids for each participant is $3 million. Non-competitive tenders are allotted by the Bank of Canada at the average price of the accepted competitive tenders. A non-competitive tender is in multiples of $1,000, subject to a minimum of $1,000.


11•15


The submitted bids are accepted in rising order of yield until the full amount of the auction has been allocated. The total amount of the bids, as well as the high, low and average bid, are published. The day of the tender, the Bank of Canada sends out complete information on the results of the tender. Based on this information, each participant can determine the number and cost of the bonds and/or bills specifically awarded. EXHIBIT 11.1

EXAMPLE OF A GOVERNMENT OF CANADA 10-YEAR BOND ISSUE

Consider an auction of $2.5 billion Government of Canada ten-year bonds, for which ten government securities distributors submit bids in the following manner: Bidder

Competitive Bid Yield*

Size

1

5.041%

$500 million

2

5.043%

$500 million

3

5.043%

$500 million

4

5.044%

$500 million

5

5.047%

$500 million

6

5.048%

$500 million

7

5.048%

$500 million

–

$25 million

Non-Competitive Tenders

*Bond yields are discussed in detail in Chapter 7.

In this situation, bonds would be allocated to the first five competitive bidders only. • The first four bidders would each receive $500 million of bonds which represents their total bid amounts. • The fifth bidder would receive $475 million of bonds which is equal to its bid amount of $500 million minus the $25 million amount of non-competitive bids. Each of the five successful competitive bidders pays a price based on its competitive bid yield. The non-competitive bidders would receive $25 million of bonds, paying a price based on the average yield of the bonds awarded (i.e., based on the average yield of the five accepted bids, or 5.0436%). No bonds would be allocated to bidders 6 and 7, their bids being too high.

To maintain regularity and openness, or clarity (called transparency), in its debt operations, the Canadian Government now holds regularly scheduled quarterly auctions of benchmark two-, five- and ten-year bonds, and semi-annual auctions for the benchmark 30-year bond. Denominations available are $1,000, $5,000, $100,000 and $1 million.

Provincial and Municipal Issues New issues of provincial direct bonds and guaranteed bonds offered in Canada are usually sold at a negotiated price through a fiscal agent. Under this method, a provincial government appoints a group of investment dealers and banks, called a syndicate, to underwrite issues as well as advise


11•16


and manage the process of issuing securities. The syndicate usually includes many major dealers, whose combined financial responsibility and distribution powers are more than adequate to underwrite and sell the large issues required by these parties. The terms direct and guaranteed refer to the structure of the debt issued by the government. •

A direct obligation is one that is issued in the government’s name, e.g., Province of Manitoba bonds.

•

A guaranteed debt is an obligation that is issued in the name of a crown corporation, but is guaranteed by the provincial government as to payment. An example of a guaranteed obligation would be a bond issued by Ontario Electric Financial Corporation but guaranteed by the Province of Ontario.

Municipal bond and debenture issues are more likely to be placed in institutional portfolios and pension accounts. Municipal bonds and debentures require in-depth knowledge of the tax-generating potential of the local municipal area as well as the industrial base and other demographic information.

Corporate Issues Corporations seek new financing for a variety of reasons, including the need to increase working capital, repay debts, purchase fixed assets or other companies, or repurchase the firm’s own shares. Very few companies generate enough cash internally to satisfy all their cash needs. Companies often need to borrow to fund activities such as additional research, expansion and growth. Even a profitable company must seek external funds to expand and compete in an increasingly competitive global marketplace. This new funding is provided by the market, if the company can prove that its plans are viable, and that such an investment sufficiently compensates the investor for the risk borne from making the investment. Some of the decisions involved with a new issue include: •

What types of securities are to be issued and when the issue will come to market

•

What the issue price, coupon rate, underwriting fee will be

•

What proportion of the issue will be bought by institutional and by retail investors

Canadian financings usually occur through a negotiated offering. Under a negotiated offering, a firm’s management negotiates with a dealer on the type of security, price, interest or valuation multiple, special features and protective provisions needed to market a new issue successfully. EQUITY FINANCING

The money to start a corporation is often raised by issuing common shares for cash to persons who thus become the initial shareholders of the corporation. The common shares usually carry the right to vote at shareholders’ meetings. In many cases, charters also authorize another class of shares, sometimes called preferred or special shares, which may be non-voting but have a special status compared to the common shares in terms of dividends, distribution of assets in liquidation, etc. In larger corporations, there may be several classes of preferred shares with different features.



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Both common shares and preferred shares form the company’s share capital. SHARE CAPITAL

Authorized shares refer to the maximum number of common (or preferred) shares that the corporation may issue under the terms of its charter. Usually more shares are authorized than issued to shareholders so that the corporation may raise additional funds in the future by issuing more shares. A corporation may amend its charter to increase or decrease the number of authorized shares. In recent years, corporations’ acts have made it possible to provide for an unlimited number of shares which may be issued for an unlimited amount of money. Example: The charter of ABC Inc. indicates that it has 1,000,000 commons shares authorized. The company’s statement of changes in equity would show the following: Common Shares – Authorized 1,000,000 shares of no par value

Issued shares refer to that part of the authorized shares that have been issued by the corporation. A corporation is not required to issue all of its authorized shares. In a related way, outstanding shares refer to that part of the issued shares which remain outstanding and owned by the shareholders of the company. Issued and outstanding shares are often used interchangeably. The capital stock section of the statement of changes in equity (formerly the balance sheet) shows the number of shares a company currently has issued and outstanding. From time to time, a corporation may redeem or purchase some or all of various classes of its issued shares, which in normal circumstances would then reduce the number of shares outstanding. If no redemptions or repurchases of shares are made by the corporation, the total number of shares issued will be the same as the total number outstanding. Example: ABC Inc. has 850,000 common shares issued and outstanding. The company’s statement of changes in equity would show the following: Common Shares – Authorized 1,000,000 shares of no par value – Issued and outstanding 850,000 shares

The total of a company’s outstanding shares is used to determine its market capitalization, which is the total dollar value of the company based on the current market price of its issued and outstanding shares. For ABC Inc., if the shares are currently trading at a price of $10 a share, its market capitalization is $8,500,000. Public float refers to that part of the issued shares that are outstanding and available for trading by the public and not held by company officers, directors or institutions that hold a controlling interest in the company. Public float is different from outstanding shares as it excludes those shares owned in large blocks by institutions (e.g., mutual funds or pension funds). Investors should be interested in the size of a company’s public float. The smaller the float, the more volatile the price of the stock will be because large buy or sell orders on the stock can influence its price dramatically. A larger float means that the stock’s price would be less volatile. Example: ABC Inc. has 200,000 common shares held by the company’s officers and directors and by large institutions. Its public float is then 650,000 shares (850,000 issued and outstanding shares less the 200,000 non-public shares).


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DEBT FINANCING AND OTHER ALTERNATIVES

A corporation with a large need for new capital may also undertake debt financing. Unlike equity financing, funds raised by issuing debt securities really represent a loan from investors and must be repaid. The two main types of securities used in long-term debt financing are mortgage bonds and debentures. Other financing methods include bank loans, medium-term notes, callable bonds and convertible bonds. Mortgage bonds are backed by a specific pledge of assets such as land or properties, similar to the way that a mortgage loan on a house is secured by the house itself to protect the lender. Debentures are backed only by the general credit of the corporation. The corporation’s ability to repay its obligations is considered sufficient without a specific pledge of its assets. In practice, a corporation also has many other financing alternatives including bank loans, money market borrowing, commercial paper, bankers’ acceptances, leasing, government grants and export financing assistance.

Complete the following Online Learning Activity Debt and Equity Financing Assess your knowledge of the differences between debt and equity financing. Complete the Features of Debt and Equity Financing activity.

HOW DOES THE CORPORATE FINANCING PROCESS WORK? When deciding on who will be the corporation’s inaugural lead dealer or its new lead dealer, a corporate issuer considers the dealer’s reputation for providing various services. These include advisory services on timing, amount and pricing of an issue, issue distribution, after-issue market support, and after-issue market informational support. Corporate issuers attempt to engage a lead dealer with a better reputation, since this usually results in both better market acceptance of the issue and a cheaper financing for the issuing corporation. When negotiations for a new issue of securities begin between the dealer and corporate issuer, the dealer normally prepares a thorough study of the corporation and the industry within which the corporation operates. This includes the position of the corporation within that industry, the financial record and financial structure of the corporation, its future prospects, and all risk factors associated with the industry and company. This report is sometimes referred to as the due diligence report. Often the assistance of outside consultants or experts in the appropriate field, such as engineering, geology, management or chartered accountancy, is required. After the study is conducted, the dealer decides whether it wants to continue to negotiate to be the lead in the proposed offering.


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The Dealer’s Advisory Relationship with Corporations Whether the dealer subsequently acts as principal or agent, the issuing corporation relies on the dealer’s advice and guidance in security design, including establishing the amount of the issue, its attributes and the final issue price. Corporations that frequently raise capital develop a close advisory relationship with the lead dealer, similar to the professional relationship between a lawyer and client. Once the relationship is solidified, the dealer may become the broker of record and may have the right of first refusal on new financings planned by the corporation. ADVICE ON THE SECURITY TO BE ISSUED

The lead dealer’s corporate finance team plays an important role in designing the new issue and advising the corporation on the best approach in the market. The corporation wants to ensure both that the new securities are consistent with its capitalization (i.e., the way the firm is financed with debt and equity) and that the restrictive covenants or provisions included in these new securities do not limit the corporation’s future decision-making flexibility. Based on the dealer’s assessment of current market conditions, investor preferences, the impact of various financing options on the corporation’s existing capitalization, future earnings stability and prospects, the dealer recommends an appropriate financing vehicle. When considering the merits of recommending a debt issue instead of an equity issue, the dealer considers the advantages and disadvantages of each type of financing. Table 11.3 summarizes some of the advantages and disadvantages in issuing different debt and equity securities. TABLE 11.3

ISSUING SECURITIES

Type of Security

Advantages

Disadvantages

Bonds

Lower interest rate than a comparable debenture.

Less flexible because of pledge of assets to trustee.

Marketable to institutions that require debt issues secured by assets.

Difficult in mergers and amalgamations because of pledges against specific assets.

Flexible: there are no specific pledges or liens.

Possibly a higher coupon than a comparable bond because of lack of pledge on specific assets.

Debentures

Reduction in cost at issue because there is no registration of assets.


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TABLE 11.3

ISSUING SECURITIES – Cont’d

Type of Security

Advantages

Disadvantages

Preferred Shares

Because preferreds are technically equity, the company can increase debt outstanding and still maintain a stable debt-equity ratio if the issue of preferreds is successful.

Cost of issuing preferred shares is expensive as the dividends are paid with after-tax income. This can increase risk and cost to the corporation.

Omission of a dividend payment does not trigger default as nonpayment of interest on the bond or debenture would.

Occasionally, non-payment of dividends on preferred issues can trigger the implementation of voting privileges for preferred shareholders.

Greater flexibility in financing because of lack of pledge of assets. Limited lifespan through redemption of shares through open market, lottery or purchase fund. Common Shares

No obligation to pay dividends. No repayment of capital required. Larger equity base can support more debt. Market value of the company can be established for estate purposes, mergers or takeovers.

A purchase fund could be drain on company assets during recessionary times.

Dilution of equity for existing shareholders on issuance of additional shares. Dividends if paid are more expensive than interest because they are paid with after-tax dollars. The underwriting discount is usually greater than that which would have been charged on debt issue.

ADVICE ON PROTECTIVE PROVISIONS

The dealer also offers advice about the security’s specific attributes, which may include for bonds the rate of interest, redemption and refunding provisions, and protective clauses called Protective Provisions, Trust Deed Restrictions or Covenants. These clauses appear in a legal document called a Trust Deed. They are called a Deed of Trust and Mortgage in the case of a mortgage bond secured by assets, or a Trust Indenture in the case of a corporate debenture. These clauses are essentially safeguards placed in the issue’s contract with the purchaser to guard against any further weakening in the position of the security holder if the issuer’s financial position weakens. Protective provisions may make an issue more appealing to an investor. A company in weak financial condition may need to include more, or more stringent, restrictive protective provisions in order to float a new issue than a company with greater financial strength.



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The Method of Offering The dealer helps decide how the issue is to be distributed or sold, either as a private placement or as a public offering. THE PRIVATE PLACEMENT

In a private placement, one or a few large institutional investors, such as banks, mutual fund companies, insurance companies and pension funds, are solicited and the entire issue is sold to one or more of them. Given that private placements are generally offered to sophisticated investors and institutional clients, the requirements for detailed disclosure and public notice are typically waived, thus no formal prospectus need be prepared. This dramatically reduces the cost of distribution for the issuing company. In many cases, private placements are announced after they have occurred, usually via advertisements in the financial press. PUBLIC OFFERINGS

Where the decision is to offer securities to the public in Canada, the corporation and the dealer come to a preliminary agreement only on whether the dealer is to act as agent or is to underwrite the securities as a principal. Agreement on the dealer’s commission (when acting as agent) or on the spread between the possible offering price and the dealer’s cost price (when acting as principal) is arranged at an early stage in the negotiations. The final offering price and certain other details are usually finalized just before the public offering date. The pricing of the issue and the actual volume of securities issued are dependent upon the market environment at the issue date. Prior to issue, steps are taken to comply with the provisions of the provincial securities acts that regulate the manner in which securities may be sold. Whenever a new issue of securities is offered to the public in the province, a prospectus must be prepared in accordance with the requirements of the particular provincial act, and must be accepted for filing by the provincial securities commission. The prospectus must be approved separately in each Canadian province and territory where the offering will be sold. A primary offering of securities refers to a new issue of securities by an issuer and generally takes place in the IPO market. The IPO requires a great deal of finesse by the underwriter, especially in terms of the pricing and marketing of the issue. The company seeking financing is relying on the expertise and advice of the investment dealer in providing funding. How the issue is handled can affect the financial well-being of the company for years to come. A secondary offering refers to the public sale of a company’s previously issued securities made after its IPO. As with an IPO, a secondary offering (or distribution) is usually handled by an investment dealer or syndicate. The dealer purchases the shares from the company at an agreed-upon price and then resells them at a higher price to institutions and the public, making a profit on the spread. In a related tactic, a company may find it advantageous to repurchase some of its outstanding shares currently trading in the market. These repurchased shares are called treasury shares. Treasury shares do not have voting rights or dividend entitlements; however, the company does have the option of reselling them back to the market at a later date through a secondary offering (or treasury offering). Accordingly, a secondary common share offering increases the number of shares outstanding.


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The Prospectus A prospectus provides a detailed description of the securities offered and of the issuing corporation, including its history, operations, management, risk and audited financial statements. The basic principle governing prospectus requirements is “full, true and plain disclosure of all material facts relating to the securities offered” A material fact is any information that significantly affects, or would reasonably be expected to have a significant effect on, the market price of the securities being offered. In no way does the prospectus imply that any government body has approved the issue as being a suitable or attractive investment. The prospectus is designed to enable prospective investors to make intelligent investment decisions. The acts of most provinces require that a prospectus be mailed or delivered to all purchasers of the securities being offered through public offerings. This mailing or delivery must be made to the purchaser or the purchaser’s agent by not later than midnight on the second business day after the trade. Examples of some of the more important items required for a prospectus company include: •

Details of the offering (e.g., offering price to the public, plan of distribution, characteristics of the security)

•

What the company plans to do with the proceeds from the issue

•

Information on the business and affairs of the issuer (e.g., history, operation details, directors and their history, legal proceedings)

•

Factors affecting an investment decision (e.g., risk factors, income tax considerations)

•

Information on promoters, principal security holders, and interest of management in material transactions

•

Financial information, including the company’s share and loan capital structure, operating results, debt, etc.

The issuing company may decide to list its shares in the unlisted market. In this case, a prospectus or a similar disclosure document would still be required for filing with the provincial administrators. THE PRELIMINARY AND FINAL PROSPECTUS

Most provinces require that issuers file both a preliminary prospectus and a final prospectus. When the issuer and the underwriters have agreed to the basic terms and methods of issuing the new securities, they submit the preliminary prospectus to the respective provincial securities commissions for review. The applicable securities commission will then issue a receipt and the issuing company will have 90 days to prepare, submit and receive approval for the final prospectus. This period of 90 days is referred to as the waiting period. Since the preliminary prospectus is not in its final form, it is required to display in red ink on its front cover a statement, in approved form, stating that it is preliminary. It should say something to the effect that the preliminary prospectus has been filed but is not final, is subject to completion or amendment, and that commitments for the purchase or sale of the securities cannot be made until a receipt for the final prospectus has been issued. This prominent warning led to the term red herring prospectus. © CSI GLOBAL EDUCATION INC. (2013)


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A preliminary prospectus serves two key purposes. It is a disclosure document required under provincial securities laws. Secondly, underwriters use the preliminary prospectus to solicit expressions of interest from potential buyers of the security. The dealers may also prepare an information circular, for in-house use only, called a greensheet. For sales representatives, the greensheet highlights the salient features of the new issue, both pro and con, in order to successfully solicit interest to the general public. The preliminary prospectus often does not include information that is quite important to potential investors. The price and size of an issue are usually not stated in the preliminary prospectus because that information is not finalized until after the issue has been marketed to the investment community. The interval between issuing the preliminary and final prospectuses is a mandatory period during which only limited communication with potential investors is permitted. The sales staff is allowed to identify the security, its features and price (if determined), and is obligated to record names and addresses of individuals and corporations who have requested and received a preliminary prospectus. If any amendments to the preliminary prospectus are to be made, a copy of the amended prospectus must be forwarded to all prospective purchasers that had received the original copy. Most other activities in furtherance of an issue (e.g., entering into agreements of purchase and sale of the new securities) are strictly prohibited. Additionally, information not contained in the preliminary prospectus, such as market commentary, research and investment reports, projections and other matters relating to the issuer in question, may not be distributed to interested investors during this time. Once all of the issues in the preliminary prospectus have been resolved, a receipt is issued by the securities commission and a copy of the final prospectus must be delivered to all security purchasers on record. A final prospectus must contain sufficient details on the securities being offered for sale, so as to provide full, true and plain disclosure of all material facts about the securities proposed to be distributed. The final prospectus must contain all the information that may have been omitted in the preliminary prospectus, such as the offering price to the public, the proceeds to the issuer (and/or selling security holders), the underwriting discount, and any other required information that may have been omitted in the preliminary prospectus. The final prospectus must include the consent of experts such as appraisers, engineers, auditors and lawyers whose reports or opinions are referred to in the prospectus, the certificates and undertakings relating to financing and distribution arrangements, and other documents evidencing compliance with regulatory requirements. The regulators review the documents carefully and may require changes before final approval. Once approval of the final prospectus is granted, the issue is then said to be blue skyed and may be distributed to the investing public. THE SHORT FORM PROSPECTUS SYSTEM

Certain issuers may have quicker access to capital markets without the necessity of preparing a full preliminary and final prospectus prior to a distribution. The short form prospectus system may be used only by certain senior reporting issuers who have made public distributions and who are subject to continuous disclosure requirements of annual financial and other required information. © CSI GLOBAL EDUCATION INC. (2013)

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The short form prospectus works on the theory that much of the information that would be included in a full prospectus is already available and widely known because of this continuous disclosure. The system shortens the time period and streamlines the procedures by which qualified issuers can access Canadian securities markets through prospectus offerings. Under the system, an issuer is permitted to use a short form prospectus if it: • • • • • •

files electronically using SEDAR (System for Electronic Document Analysis and Retrieval) is a reporting issuer in at least one Canadian jurisdiction is up to date in its filings in every Canadian jurisdiction in which it is a reporting issuer has filed current annual financial statements and a current annual information form (AIF) in at least one Canadian jurisdiction in which it is a reporting issuer is not an issuer whose operations have ceased or whose principal asset is cash, cash equivalents or exchange listing (i.e., capital pool companies) has equity securities listed and posted for trading or quoted on a “short form eligible exchange” (i.e., TSX, TSX V, and CNSX)

Under certain circumstances, a long form prospectus will still be required. A short form prospectus does not include a large portion of the information found in a full prospectus. It focuses on matters relating primarily to the securities being distributed, such as price, distribution spread, use of proceeds and the securities’ attributes. The short form prospectus incorporates by reference certain information contained in the most recent AIF and continuous disclosure documents of the issuer, and also describes how members of the public may obtain copies of such documents. CONVENTIONAL UNDERWRITING AND BOUGHT DEAL

In contrast to the conventional short form prospectus system or other offering in which an underwriter agrees to make its best efforts to sell securities of an issuer to the public, a bought deal underwriter commits to buy a specified number of securities at a set price. The underwriter will then resell those securities to the public. In a conventional underwriting, if the securities do not sell, the issuer will not receive the proceeds of the sale of the securities. In a bought deal, the underwriter pays the full proceeds to the issuer regardless of whether the underwriter has been able to resell the securities to the public. In bought deals, an investment dealer negotiates with the issuer directly and bids for a specific new issue of securities. Under a bought deal, the dealer assumes the risk of the position, that is, acts as principal. The details of price and the type of issue are decided either simultaneously with filing the short form prospectus or shortly thereafter. Under a bought deal arrangement, the spread between the dealer’s cost and the final selling price may be as low as one per cent of the issue price, well below traditional financing spreads. Once final regulatory approval is received, the bought issue is sold by the investment dealer, either as a private placement to a select group of investors or as a public issue under a short form prospectus. Distribution probably is not as wide, since only one, or possibly a few, dealers are involved with the bought deal as opposed to the many dealers involved in other types of public offerings.

The following is a step-by-step description of the financing process in a simplified form. Chart 11.2 illustrates this process. © CSI GLOBAL EDUCATION INC. (2013)

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CHART 11.2

THE FINANCING PROCESS

Issuing Company sells $100 million of bonds at 98¼

Financing Group (Dealers A and B) which sells $100 million of fonds at 98½

Banking Group (Dealers A, B and C to T) which allocates

$60 million, i.e. 60% of participation at 98½ to Banking Group Members (Dealers A to T) for distribution at 100 to clients

$30 million at 100 to exempt list

$10 million at various prices

Selling Group at 99¼

Casual Dealers at 99½

Special Group variable

Step 1

The Issuing Company sells a $100 million bond issue at a discounted price of 98¼ to the Financing Group (also known as managing underwriters and syndicate managers or lead underwriters) consisting of Dealer A and Dealer B for public resale at the par value price of 100. In this case, the bond issue is sold for a total cost of $98.25 million to the Financing Group, while the sale to the public is made at $100 million. Dealers A and B have been in continuous contact with the Issuing Company, providing recommendations on type, size and timing of the issue, any covenants, protective clauses, as well as currency of payment, pricing, etc. They also arranged for the preparation of the prospectus and the trust deed, the clearing with securities commissions, and the provision of selling documents, etc. The Financing Group accepts the liability of the issue on behalf of Banking Group members, which include themselves. In addition to Dealers A and B, the Banking Group consists of Dealers C to T, all of whom have previously agreed to participate on set terms and to accept a liability up to their individual participation. For example: •

Dealers A and B might typically have participation (hence ultimate liability) ranging from perhaps $7 million to $25 million for an issue size of $100 million.


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•

Dealers C to T agree in advance to their individual participations (i.e., potential liabilities) in the Banking Group. Dealers C to T undertake to comply with terms and conditions concerning underwriting and distribution set out in the Banking Group agreement. Dealers A and B offer various amounts to Banking Group Members C to T based on estimated distribution ability, geographical locations, etc. However, the Issuing Company may request or require that special consideration be given to certain dealers. For example, on its global bond issues, the federal government may request that a certain minimum percentage be reserved for Canadian dealers.

Step 2

The Financing Group sells the $100 million bond issue to the Banking Group (Dealers A to T) at 98½. In practice, a “draw down” price somewhat higher than 98½ is established. The differential provides a fund which is applied against expenses incurred by the Financing Group on behalf of the Banking Group in connection with preparing and clearing the prospectus, legal fees, accountant fees, IIROC levy, etc. Any residue in the fund is ultimately distributed to Banking Group members proportionately. The Financing Group (Dealers A and B) also obtains an override, which is an additional payment over and above their original entitlement on the entire issue in payment for their services as financial advisors and syndicate managers or leads. Each Banking Group member (Dealers A to T) has a preset maximum liability. Dealers A to T are the dealers whose names appear in so-called tombstone advertisements which appear in the financial press as a matter of record once the deal has been completed. Step 3

The initial designation of bonds set by the Financing Group may be altered as the sale of the issue progresses. •

$60 million of the issue may be allotted to the Banking Group (Dealers A to T) for distribution to their clients at a price of 100 or par. This means that each dealer has 60% of its participation to sell although the liability of each dealer is still 100% of the agreed-upon participation.

•

$30 million may be designated for sale to the exempt list at 100. This list usually includes only large professional buyers, mostly financial institutions, who are exempt from prospectus requirements. They may receive a selling document instead of the prospectus, which would include the salient features of the issue. Each of these buyers is offered bonds by the Financing Group (Dealers A and B) on behalf of the entire Banking Group. Resultant sales are applied to reduce each Banking Group member’s liability proportionately. If exempt list sales are less than $30 million, the remainder may be returned proportionately to the Banking Group (Dealers A to T) or, if considered desirable, allocated to other dealers.



•

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$10 million may be provided to (i) the Selling Group, (ii) Casual Dealers, or (iii) Special Group. Bonds allotted to these three groups proportionately reduce each Banking Group (Dealers A to T) member’s liability. However, any shortfall is returned to the Banking Group. i)

The Selling Group consists of other dealers, normally members of IIROC, who are not members of the Banking Group (Dealers A to T). They are invited in writing by the Financing Group to buy bonds at 991/4 to offer at 100 to their clients (excluding the exempt list). The Selling Group orders are subject to allotment and each member of the Selling Group has liability for the orders placed with the Financing Group.

ii) Casual Dealers are non-members of the Banking or Selling Groups. They may be brokers, broker dealers, foreign dealers, banks, etc. They are not offered bonds directly or indirectly, but may receive orders for bonds from clients and apply to the Financing Group for an allocation. They may, at the discretion of the Financing Group, be allotted bonds at, say, 991/2 for resale at 100. Since they have firm orders, they incur no liability. iii) Special Group orders occur under various circumstances. For example, the Issuing Company may demand special consideration for a dealer or its banker, or its parent’s banker if it is a subsidiary of a foreign parent. The terms and conditions of the allotment are not standardized.

After-Market Stabilization Once an issue is brought to market, one of the duties of the lead dealer may involve providing after-market stabilization of that security’s offering. Under this arrangement, the dealer is required to support the offer price of the stock once it begins trading in the secondary market (also called the after-market). Typically, the issuing company and the dealer will negotiate the terms of any after-market stabilization as part of the underwriting contract. The dealer’s role is stated on the front page of the prospectus, and additional information must be provided inside the prospectus. Three types of after-market stabilization activities are possible. The most common type of after-market stabilization activity is the over-allotment option. The over-allotment option permits underwriters (or the dealer syndicate) to initially sell securities in excess of the original amount offered by the issuer for sale to the public. In this way, the underwriter may sell up to 15% more shares than those offered, setting up a short position in the stock prior to the close of the offering. Once the offering begins to trade in the after-market, two possible scenarios could develop: the share price falls below the IPO offer price, or the share price rises above the offer price on strong demand for the issue. •

If the share price falls below the IPO offer price, the underwriter buys share from the market to close out its short position. In this case, the price of the stock is somewhat supported by the demand of the underwriter. Since the underwriter closes out its short position directly from the market, the over-allotment option is not exercised.


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•

If the share price rises above the offer price, the underwriter cannot close out its position by buying the stock on the market without experiencing a loss. In this case, the underwriter exercises its over-allotment option and buys additional shares directly from the company, at the offering price to close out its short position. EXHIBIT

OVER-ALLOTMENT EXAMPLE

ABC Co. goes public with an IPO of 10 million shares at $10 a share. The offering includes an over-allotment option (also referred to as a green shoe option) whereby 10 million shares are issued but 11 million shares are actually sold by the dealer to the public. This creates a short position of 1 million shares for the dealer once the offering begins to trade. If the price of the ABC shares drops below the $10 IPO offer price, the dealer will cover the short position by buying shares offered for sale by public investors in the after-market. The buying activity on the part of the dealer is intended to support the price of the issue through open market purchases and the dealer does not exercise its over-allotment option. If the price of the ABC shares rises above the $10 offer price, the dealer can exercise the over-allotment option and close out the short position by buying shares from ABC at the original IPO price.

The second most common after-market stabilization activity is called a “penalty bid”. The lead underwriter will penalize members of the selling group if their customers “flip” (sell) shares in weak issues in the after-market during the distribution or shortly after the offer closes. The penalty may include paying back commissions to the underwriter or the underwriter may reduce the number of shares the IA receives in future initial public offerings. The least common stabilization activity is one where the dealer posts a stabilizing bid to purchase shares at a price not exceeding the offer price if the distribution of shares is not complete. These activities help to stabilize the after-market price of the recently issued security by maintaining demand while the dealer attempts to complete the distribution of securities.

Complete the following Online Learning Activity Ask the Expert Two of the learning objectives for this module require you to: 1. Compare and contrast the three types of business structures and explain the process, outcomes, and advantages and disadvantages of incorporation. 2. Summarize the steps in the corporate financing process, explain the different methods of offering securities to the public, summarize the prospectus system, and evaluate after-market stabilization. In this activity, you are an investment expert with a weekly column in the local newspaper. Readers send in their investment questions, and you select several letters to answer in your column. Read the letters and write your responses. Compare your answers to those of our expert advisor to assess whether you have successfully accomplished the learning objectives. Complete the Ask the Expert activity.



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WHAT ARE THE OTHER METHODS OF DISTRIBUTING SECURITIES TO THE PUBLIC? A different form of prospectus may be used when shares are distributed through the facilities of Canadian stock exchanges. The exchange, rather than the Administrator, reviews the prospectus and approves or disapproves it. Companies already listed may use a less detailed exchange offering prospectus or a statement of material facts with the applicable exchanges and securities administrators. Currently, only the TSX Venture Exchange maintains an Exchange Offering Prospectus (EOP) system.

Junior Company Distributions When a listed junior company decides it must raise new capital through a distribution of treasury shares to the public, it must find a dealer member to act either as an underwriter for the offering or as the issuing company’s agent with respect to the offering. Historically, listed junior mining and oil companies are frequent users of such distributions, raising millions of dollars. Such companies usually have no record of earnings and few assets that would qualify as collateral for conventional credit sources (i.e., bank loans, mortgage or funded debt, government assistance). The funds these companies need is known as risk capital because it is usually earmarked for exploration and development with a high risk of failure.

Options of Treasury Shares and Escrowed Shares As an incentive to an underwriter to provide risk capital as a principal rather than merely acting as agent for an offering, junior companies often grant the underwriter specified treasury share options. This technique involves the use of escrowed shares which serve as payment for properties, goods or services. Escrowed shares are shares held by an independent trustee in trust for its owner that cannot be sold or transferred unless special approval is given. Shares can be released from escrow only with the permission of the appropriate authorities, such as a stock exchange(s) or the securities administrators. Escrowing shares ties the value of the shares held by these shareholders to what happens to the property used to obtain these shares. In addition, it prevents their owners from selling their shares before a proper market can develop. This ensures some stability in the secondary market performance of the new issue after the completed offering. Escrowed shares maintain full voting and dividend privileges for these (primarily, non-dividend-paying) companies.

Capital Pool Company Program For small, emerging private companies, the costs associated with going public through a traditional IPO is not always financially viable. Accordingly, the TSX Venture Exchange, home to many emerging Canadian businesses, developed the Capital Pool Company (CPC) program as a vehicle to provide businesses with an opportunity to obtain financing earlier in their development than might be possible with a regular IPO.


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The CPC program permits an IPO to be conducted and a TSX Venture Exchange listing to be achieved by a newly created company which, other than cash, has no assets and has no business or operations. The new company’s goal is to buy an existing business or assets called “Significant Assets” through a “Qualifying Transaction” (QT). The CPC program involves a two-stage process. The first stage involves the filing and clearing of a CPC prospectus, the completion of the IPO and the listing of the CPC’s common shares on the Venture Exchange. The second stage involves: • • •

the identification of a business or asset that can be acquired as a Qualifying Transaction (QT) the preparation and filing with the Venture Exchange of a comprehensive CPC information circular containing prospectus-level disclosure of the QT the holding of a shareholders’ meeting to get approval to close the QT

Under the CPC program, the issuer must raise between $200,000 and $1,900,000 in an initial public offering. The IPO offering price can range from $0.15 to $0.30 per share.

NEX NEX is a separate board of the TSX Venture Exchange that provides a trading forum for companies that have fallen below the Venture Exchange’s listing standards. Companies that have low levels of business activity or who do not carry on active business will trade on the NEX board. NEX provides a trading forum for: •

Issuers that have been listed on the TSX Venture Exchange but no longer meet the TSX V Maintenance Requirements (these companies are currently known as Inactive Issuers)

•

CPCs that have failed to complete a QT in accordance with the requirements of the exchange

•

TSX issuers that no longer meet continued listing requirements and would have been eligible for listing on TSX Venture as Inactive Issuers under existing policies

HOW DOES THE LISTING PROCESS WORK? Companies wishing to be listed on a recognized exchange must apply and be accepted for trading. The application is a lengthy questionnaire designed to obtain detailed information about the company and its operations. When the listing application is completed and supporting documents are assembled, the company signs a formal Listing Agreement. The agreement details the specific regulations and reporting requirements that the company must follow to keep its listing in good standing.


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By signing a Listing Agreement, a company agrees to comply with specific regulations, some of which pertain to: •

The submission of annual and interim financial reports and other corporate reports to the exchange(s)

•

Prompt notification to the exchange(s) about dividends or other distributions; proposed employee stock options; sale or issue of treasury shares

•

Notification to the exchange(s) of other proposed material changes in the business or affairs of a listed company

After approval is given, a specific date is set for applicable securities to be called for trading on an exchange. There are formal announcements to members and public announcements in the financial press.

Advantages and Disadvantages of Listing When applying for a listing, a public company considers the advantages and disadvantages both to the company itself and to its shareholders of doing so. Some of the advantages and disadvantages of listing are listed in table 11.4: TABLE 11.4

Advantages of Listing

Disadvantages of Listing

Prestige and goodwill

Company prestige is enhanced due to increased public visibility. Shareholder goodwill is increased as buying and selling become easier and visibility of market performance is enhanced.

Additional controls on management

After listing, restrictions with respect to such matters as stock options (those issued for internal use only), reporting of dividends, issue of shares for assets, etc., are put in place.

Established and visible market value

The market value of a listed company is readily visible. Financial analyst following is likely to be higher with listing. In turn, this can attract new shareholders, enhancing overall marketability in the secondary market and increase the market for new issues by the company.

Need to keep market participants informed

A listed company’s management must devote considerable time to meeting with security analysts and institutional investors and meeting with the press to explain company developments.

Excellent market visibility

The daily financial press carries full details of listed trading on a daily and weekly basis.

Market indifference

Low trading volume and poor market performance of a listed company are a matter of public record.


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TABLE 11.4 – Cont’d

Advantages of Listing

Disadvantages of Listing

More information available

Because of strict exchange disclosure regulations, investors have access to more information on a regular basis.

Additional disclosure

Listing imposes additional disclosure requirements on the company that consume management time. Specifically, management is required to make continuous and prompt disclosure of material changes related to the company.

Facilitate valuation for tax purposes

The valuation of securities for estate tax purposes and estate tax planning is easier.

Additional costs to the company

Various fees, including a listing fee and subsequent annual sustaining fee, must be paid to the exchange(s) when a class of shares is listed.

Complete the following Online Learning Activity Listing Shares for Trading Chapter 11 discusses other methods of distributing securities and how shares are listed on an exchange. This activity provides a review of these sections of the chapter. Complete the Listing Shares for Trading multiple-choice questions.

Withdrawing Trading Privileges As a protection to investors, the exchanges are empowered to withdraw a listed security’s trading and/or listing privileges temporarily or permanently. Serious action such as delisting occurs infrequently. Other actions occur more frequently and may be implemented by either the exchanges or at the request of companies with regard to their own securities.



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TEMPORARY INTERRUPTION OF TRADING

There are three types of temporary withdrawals of trading privileges which exchanges can invoke.

Delayed Opening

Shortly before the opening of trading, an exchange can order trading in a security to be delayed. The need for this action might arise if a heavy influx of buy and/or sell orders for a particular security materialized. The delay gives exchange traders time to sort out the orders and match up buys with sells to allow fair and orderly trading when the delay order is removed. A delayed opening in one security does not affect trading in other listed securities.

Halt In Trading

A temporary halt in the trading of a security can be ordered or arranged at any time to allow significant news to be reported and widely disseminated (e.g., a pending merger or a substantial change in dividends or earnings).

Suspension In Trading

Trading privileges can be suspended for more than one trading session. Such suspensions are imposed if the company’s financial condition does not meet the exchange’s requirements for continued trading, if a company fails to comply with the terms of its listing agreement or for some other good cause. If the company rectifies the problem to the exchange’s satisfaction within the time required by the exchange, trading in the suspended security will resume. During the suspension, members are usually allowed to execute orders for the suspended security in the unlisted market except for those securities suspended from trading on TSX Venture Exchange.

CANCELLING A LISTING (DELISTING)

A listed security can be delisted by the exchanges (or at the request of the company itself ) which would be a permanent cancellation of listing privileges. Reasons for delisting could include: •

The delisted security no longer exists, having been called for redemption (e.g. a preferred share) or substituted for another security as a result of a merger

•

The company is without assets or bankrupt

•

The public distribution of the security has dwindled to an unacceptably low level

•

The company has failed to comply with the terms of its listing agreement


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2.

Compare and contrast the three types of business structures and explain the process, outcomes, advantages, and disadvantages of incorporation. •

The earnings from a sole proprietorship are taxed at the owner’s personal income tax rate, profits accrue to the owner, and losses or debts are the owner’s personal liabilities.

•

A partnership (two or more persons contributing to the business) is legislated under the Partnership Act and is either a general or a limited partnership.

•

General partners are involved in day-to-day operations and are personally liable for debts and obligations. Limited partners are not involved in the day-to-day business and are liable only up to the amount of their investment.

•

A corporation is owned by shareholders, is considered to be a unique entity under the law, pays taxes, and can sue or be sued. Property of the corporation belongs to the corporation, not to the shareholders. Shareholders have no liability for debts or other obligations of the corporation. The corporation can raise funds by issuing debt or equity.

•

Corporations are created through incorporation, which requires filing of jurisdiction dependent documents with the relevant provincial or federal authorities.

•

Corporations are generally either public or private, and are regulated by corporate bylaws, a corporate charter, and relevant federal or provincial legislative acts.

•

Shareholders generally have a right to vote or to assign a proxy at annual or general meetings.

•

Advantages of incorporation include limited liability of shareholders, continuity of interest, ability to transfer ownership of shares, certain tax benefits, feasibility of capital growth, status as a separate legal entity and professional management.

•

Disadvantages of incorporation include loss of flexibility, double taxation, additional expenses, and restrictions on withdrawal of capital.

Describe the processes by which governments raise debt capital to finance their funding requirements. •

Federal government financing is usually accomplished through an auction and sometimes through a fiscal agency.

•

Auction bids can be submitted on a competitive or non-competitive tender (the bid is accepted in full and bonds are awarded at the auction average).

•

Competitive bids are filled from highest price to lowest price, until all bonds not allocated to the amount of the non-competitive tender are distributed.



•

3.

4.

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New issues of provincial direct and guaranteed bonds offered in Canada are usually sold at a negotiated price through a fiscal agent.

Describe the processes by which corporations raise debt or equity capital to finance their funding requirements. •

Corporations issue shares (common and/or preferred) to raise capital, which creates the company’s capital stock.

•

The term issued shares refers to all shares issued; authorized shares are the maximum number of shares the company can issue according to its corporate charter; outstanding shares are the issued shares that have not been redeemed or repurchased by the company.

•

Corporations may also raise capital by issuing debt securities (e.g., bonds, debentures, medium-term notes, callable bonds, convertible bonds) or by borrowing from lending institutions (e.g., bank loan).

Summarize the steps in the corporate financing process, explain the different methods of offering securities to the public, summarize the prospectus system and evaluate after-market stabilization. •

A corporate issuer chooses a dealer to act as principal or agent in a new security issue.

•

The dealer prepares analyses of market conditions and other factors and suggests the terms and type of the issue, including debt or equity. Securities are then issued as a public offering or private placement (one or more large institutional investors buy the entire issue).

•

The prospectus is the primary information document for a new securities issue and is based on the premise of full, true and plain disclosure of all material facts relating to securities being offered.

•

Most provinces require that issuers file both a preliminary prospectus and a final prospectus.

•

The preliminary prospectus is a disclosure document required under provincial securities laws; it is also used to determine the level of interest of potential buyers of the security.

•

Companies that have previously made public distributions and that are subject to continuous disclosure requirements can use a short form prospectus.

•

After the securities have been issued, the lead dealer may be required to provide aftermarket stabilization in any of three ways: overselling to establish a short position that will be covered later in the open market if the price falls below the issue price, penalizing members of the selling group that sell securities shortly after issue, or creating an open bid to buy securities at the offer price.


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5.

Identify other methods of distributing securities to the public through stock exchanges. Discuss the advantages and disadvantages of listing shares for trading on an exchange and explain the circumstances and ways in which exchanges can withdraw trading privileges. •

Other methods of distributing securities to the public include distributions through the exchanges, junior company distributions, treasury share options, release of escrowed shares, the Capital Pool Company (CPC) program, and NEX (a separate trading board of the TSX Venture Exchange).

•

Companies must apply and be approved by the exchange(s) prior to listing.

•

Advantages of listing shares for trading on an exchange include prestige and goodwill, establishment of market value, increased market visibility, wider distribution of company information, easier valuation for tax purposes and increased investor following.

•

Disadvantages of listing shares for trading on an exchange include additional controls on management, additional costs, visibility of any market indifference, requirement for additional disclosure, and the requirement to provide information to a range of individuals and organizations on a regular basis.

•

Exchanges have the power to withdraw a listed security’s trading and/or listing privileges temporarily or permanently if necessary to protect investors.






Chapter

12

Corporations and their Financial Statements


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12 Corporations and their Financial Statements

CHAPTER OUTLINE What is the Statement of Financial Position? • Classification of Assets • Classification of Equity • Classification of Liabilities What is the Statement of Comprehensive Income? • Structure of the Statement of Comprehensive Income What is the Statement of Changes In Equity? What is the Statement of Cash Flows? • Operating Activities • Financing Activities (items 38 to 41) • Investing Activities (items 42 to 44) • The Change in Cash Flow (items 45 to 46) What is included in the Annual Report? • Notes to the Financial Statements • The Auditor’s Report Summary Appendix A – Sample Financial Statements

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LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Describe the format and the items of the statement of financial position and explain how the items are classified. 2. Describe the structure of the statement of comprehensive income. 3. Describe the purpose of the statement of changes in equity and describe its link with the statement of changes in financial position and the statement of comprehensive income. 4. Describe the components of the statement of cash flows and classify an accounting activity or item as a cash flow from operating, financing or investing activities. 5. Explain the importance of the notes to the financial statements and the auditor’s report.

UNDERSTANDING THE FINANCIAL STATEMENTS Financial information that is accurate and relevant is the driving force behind good investment decisions. A company’s financial statements are one of the best ways it can communicate the successes (and challenges) it has experienced to the investing public. Financial statements are like a scorecard of a company’s operations; they show what the company owns and how it was financed, as well as how profitable it was (or the losses it incurred) over a given period, usually a year. The ability to understand and analyze these statements effectively, and compare them with other companies, is important for anyone who is considering investing in a company’s stocks or bonds, because the statements can reveal a great deal about a company’s financial health. The success or failure of investing in a company’s securities depends on how the company will fare in the future. Future prospects are difficult to forecast with a high degree of accuracy, but the past often provides a clue. Thus, if an investor has some knowledge of a company’s present financial position and information about its past financial record, she is more likely to select securities that will stand the test of time. The investor will, of course, need to combine this information with an understanding of the industry in which the company operates, the economy in general, and the specific plans and prospects for the company in question to make a sound selection from investment alternatives. Whether you are an investor, advisor or analyst, you need to approach a company’s financial statements like an investigator. Becoming familiar with the information presented in the financial statements is a first step toward making informed investment decisions.


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On January 1, 2011, Canada moved from GAAP to International Financial Reporting Standards (IFRS), a globally accepted high-quality accounting standard already used by public companies in over 100 countries around the world. This change enhances transparency and increase comparability of Canadian publiclytraded companies with others using IFRS. IFRS is principle-based, with a focus on providing detailed disclosure, whereas GAAP accounting is a mix of rule and principle based accounting. Rules-based accounting is more rigid, meaning specific procedures are observed when preparing financial statements. This makes for less ambiguity but also increases the complexity of the process. There is also more difficulty in making rules that fit every situation. In principle-based accounting, guidelines are more general because the goal is to have the completed financial statements achieve a set of good reporting objectives. An example of a good reporting objective is sufficient disclosure of data so that an investor can make an objective analysis. In comparison to GAAP, IFRS requires a more extensive and detailed disclosure by the company to explain why particular accounting treatments are utilized.

KEY TERMS Amortization

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Goodwill

Asset

Intangible asset

Book value

Investments in associates

Capitalizing

International Financial Reporting Standards (IFRS)

Inventories

Liabilities

Cost method

Retained earnings

Cost of sales

Share capital

Current asset

Share of profit of associates

Current liabilities

Straight-line method

Declining-balance method

Statement of cash flows

Deferred tax liabilities

Statement of changes in equity

Depletion

Statement of comprehensive income

Depreciation

Statement of financial position

Equity

Trade payables

FIFO (first-in-first-out)

Trade receivables


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TWELVE • CORPORATIONS AND THEIR FINANCIAL STATEMENTS

WHAT IS THE STATEMENT OF FINANCIAL POSITION? The statement of financial position (previously called the balance sheet) shows a company’s financial position at a specific date. In annual reports, that date is the last day of the company’s fiscal year. While many companies have a fiscal year end that corresponds with the calendar year end, i.e., December 31, this is not always the case. Example: Banks and trust companies traditionally end their fiscal year on October 31. In this instance, October 2011 would be the last month of the bank’s “fiscal 2011” while November 2011 would represent the first month of “fiscal 2012.”

The statement of financial position shows what the company owns and what is owing to it. These items are called assets. This statement also shows the equity of the company which represents the shareholders’ interest in the company and what the company owes (called liabilities). Equity represents the excess of the company’s assets over its liabilities. Accordingly, the company’s total assets are equal to the sum of equity plus the company’s liabilities. Assets = Equity + Liabilities

A statement of financial position is prepared and presented in more or less the same way for all Canadian publicly-traded companies. Using the Trans-Canada Retail Stores Ltd. financial statements shown in Appendix A of this chapter as an example, the relationship between items on the statement of financial position is shown in Table 12.1. TABLE 12.1

SIMPLIFIED STATEMENT OF FINANCIAL POSITION

Assets Total Assets Equity Total Equity Liabilities Total Liabilities Total Equity and Liabilities

$19,454,000 $19,454,000 $13,306,000 $13,306,000 $6,148,000 $6,148,000 $19,454,000

The above equation between statement of financial position items may alternatively be expressed as: Total Assets Less: Total Liabilities Equals: Total Equity


$19,454,000 6,148,000 $13,306,000

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Equity is also referred to as the book value of the company, and this represents the total value of the company’s assets that shareholders would theoretically receive if the company were liquidated. However, this item does not necessarily indicate the amount shareholders will receive for their ownership interest in the event of sale. The market value of the shareholders’ interest may be worth a lot more or less than the book value, largely depending upon the company’s earning power and prospects.

Classification of Assets Taking each class of asset one by one and in the order in which they are shown in the TransCanada Retail statement of financial position, we will see what they are and what they tell us about the company. NON-CURRENT ASSETS (ITEMS 1 TO 4)

Property, Plant and Equipment (Item 1)

Property, plant and equipment (PP&E) consist of land, buildings, machinery, tools and equipment of all kinds, trucks, furnishings and so on used in the day-to-day operations of a business. A company’s PP&E is valuable because it is used directly in producing the goods and services the company eventually sells. Unlike current assets (shown below), which are consumed or converted by successive steps into cash, the items that make up a company’s PP&E are not intended to be sold. PP&E are initially shown on the statement of financial position at original cost, including certain costs of acquisition (such as installation costs). Except for land, PP&E are depreciated (or reduced in value to reflect wear and tear) each year and the total accumulated depreciation is deducted from the original cost. Depreciation, Amortization and Depletion

With the exception of land, property plant and equipment wear out in time or otherwise lose their usefulness. Between the time when a given asset is acquired and when it is no longer economically useful, a decrease in its value takes place. This loss in value over a period of years is known as depreciation. In contrast, amortization is used to describe the writing off of intangible assets such as patents or trademarks. To spread the cost of PP&E over their years of useful service, companies record depreciation expenses in each year’s statement of comprehensive income (previously called the income or earnings statement). This is done on the grounds that PP&E are used in the process of producing goods or services and depreciation is, therefore, a cost of doing business, just like wages and other expenses. Depreciation applies to the ordinary wearing out of plant and equipment. The amount recorded as depreciation each year is based upon the original cost of each asset, its expected useful life and any residual value. Let’s have a look at two of the main depreciation methods. •

The method used most frequently in Canada by public companies is the straight-line method, whereby an equal amount is charged to each period.


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•

The declining-balance method is also frequently used. This method applies a fixed percentage, rather than a fixed dollar amount, to the outstanding balance to determine the expense to be charged in each period. This amount is deducted from the capital asset balance to determine the amount against which the percentage will be applied in the subsequent period – thus the term declining balance.

The example in Table 12.2 shows the calculation of depreciation by the straight-line and declining balance methods. TABLE 12.2

METHODS OF CALCULATING DEPRECIATION

Suppose a piece of equipment bought by XYZ Co. Ltd. at $100,000 is expected to have a useful life of eight years and a residual value of $10,000 at the end of the asset’s useful life. The annual depreciation for this asset utilizing the straight-line method is: $100, 000 $10, 000 $11, 250 8 and the depreciation rate is 12.5% (100% / 8) per year for each of the eight years of expected usefulness. Let’s assume XYZ uses a depreciation rate of 25% under the declining-balance method on each year’s remaining balance. Thus, in Year 1: $100,000 depreciated at 25% = $25,000. In Year 2: $75,000 ($100,000 – $25,000) depreciated at 25% = $18,750. By the end of eight years, using the declining balance method of calculating depreciation, there is an undepreciated balance of $10,011 as the following table shows: Depreciation: Straight-Line Versus Declining-Balance Cost of Asset: $100,000

Residual Value: $10,000

Straight-Line

Useful Life: 8 Years Declining-Balance

Depreciation Charge

Carrying Amount on Statement of Financial Position

Fiscal Year-End

Depreciation Charge

Carrying Amount on Statement of Financial Position

1st

$11,250

$88,750

$25,000

$75,000

nd

2

11,250

77,500

18,750

56,250

3rd

11,250

66,250

14,063

42,188

4th

11,250

55,000

10,547

31,641

5th

11,250

43,750

7,910

23,730

6th

11,250

32,500

5,933

17,798

th

7

11,250

21,250

4,449

13,348

8th

11,250

10,000

3,337

10,011


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Depreciation is intended to allocate the cost (minus residual value) of the company’s PP&E over their useful lives. It provides a realistic matching of earnings to expenses in a fiscal period to determine a company’s net or comprehensive income on an annual basis. IFRS requires that the depreciation method, estimated life and valuations be reviewed each year. Depletion is similar to depreciation and is usually used by mining, oil, natural gas, timber companies and other industries involved in resource extraction. The assets of these industries consist largely of natural wealth such as minerals in the ground or standing timber. As these assets are developed and sold, the company loses part of its assets with each sale. Such assets are known as wasting assets and depletion is the annual decrease in value the company records. Important points to keep in mind: •

Annual allowances for depreciation, amortization and depletion appear as non-cash expenses in the statement of comprehensive income.

•

Thus, it is quite possible for a company to add considerably to its cash resources for the year yet show little or no profit, if substantial depreciation, amortization and/or depletion charges were made.

•

These effects will be reflected in the statement of cash flows, where the cash from operations is reported.

Capitalization

Capitalizing refers to the recording of an expenditure as an asset rather than as an expense so that the expense can be spread over more than one accounting period. Example: If a company recorded the cost to purchase a piece of machinery as an expense on its statement of comprehensive income in the year incurred then the purchase of a $10 million piece of machinery would likely have a substantial impact on a company’s profit for the year.

When a company decides to capitalize an asset, profit in the year of acquisition is impacted in a much smaller way. The expense is instead recorded as an asset on the statement of financial position which is then depreciated over a certain number of periods. Under IFRS, fewer acquisition related costs can be capitalized and therefore, must be expensed in the year of acquisition. Goodwill and Other Intangible Assets (Item 2)

Goodwill is often defined as the probability that a regular customer will continue to return to do business. If people get into the habit of doing business with a firm because of its location or reputation for fair dealing and good products, they will probably continue that habit, at least to some extent, even though the firm changes hands. The buyer of a business is often willing to pay for its “good name” in addition to the value of its assets. Goodwill may also signify the amount that a purchaser of a company will pay for the good management of the company. It will appear on the purchasing company’s consolidated (or combined) statement of financial position as the excess of the amount paid for the shares over their net asset value. Intangible assets are non-monetary assets that do not have physical substance. They can be sold, licensed or transferred but usually decline greatly in value in the event of liquidation. Some common examples are patents, copyrights, franchises and trademarks. © CSI GLOBAL EDUCATION INC. (2013)


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In general, the values given to intangible assets on the statement of financial position should be viewed with caution. The value of such an asset is connected more to its contribution to earning power than to its saleability as an asset. For example, a trademark may mean much to a company from the point of view of brand recognition, yet it may be difficult to assess the trademark’s dollar value if it were to be sold. Investments in Associates (Item 3)

Investment in associates refers to the degree of ownership a company has in another company. As a general rule, significant influence is presumed to exist when a company owns 20% or more of the voting rights of the other company. CURRENT ASSETS (ITEMS 5 TO 9)

Current assets are cash and other assets that will be realized, consumed, or sold, in the normal course of business, normally within one year. Current assets are the most important group of assets because they largely determine a firm’s ability to pay its day-to-day operating expenses. There are four broad groups of current assets: •

Inventories – consists of the goods and supplies that a company keeps in stock. For example, a furniture manufacturer that sells chairs to Trans-Canada Retail would have inventories of raw materials (e.g., the fabric and wood used to build the chairs), work-inprogress (assembled chair frames) and finished goods (completed chairs ready for shipping). Inventories are changed by successive steps into cash as raw materials are processed into finished goods. Finished goods not sold for cash but on credit terms give rise to trade receivables. These receivables are eventually paid off in cash. This process goes on day after day, providing the funds to enable the company to pay for wages, raw materials, taxes and other expenses and ultimately to provide the profits out of which dividends may be paid to shareholders. Inventories are valued at original cost or net realizable value – whichever is lower. If the original cost is used, there are two commonly used methods of determining the cost of inventories: –

Weighted average of all items in inventory; or

–

FIFO (first-in-first-out) – items acquired earliest are assumed to be used or sold first.

Example: A computer company manufactured 1,000 hard drives last month at a cost of $125 each and an additional 1,000 units this month at a cost of $150 each. The higher costs are due to rising raw materials prices. The company sells 1,000 hard drives today. Under the FIFO method, the cost of the goods sold is $125 per hard drive because that was the cost of each of the first hard drives into inventory. The remaining hard drives would be valued at the more recent and higher cost of $150 each, which works out to an inventory value of $150,000 (1,000 hard drives × $150).


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As its name suggests, the weighted average method uses the average of the total cost of the goods purchased over the period on a per unit basis. • The total cost of the hard drives is $275,000 ([1,000 × $125] + [1,000 × $150]). • The average cost of the inventory is $137.50 ($275,000 ÷ 2,000 units). • The cost of the goods sold is $137.50 per hard drive and the inventory value on the statement of financial position would be reported as $137,500.

As the above example shows, if prices are changing, each of these methods produces a different inventory value on the statement of financial position and, consequently, a different profit based on the costs of the goods sold. As you will learn in the section on the statement of comprehensive income, a lower cost of goods sold produces a higher profit level for the company. •

Prepaid expenses – payment made by the company for services to be received in the near future. Since these prepaid expenses eliminate the need to pay cash for goods or services in the immediate future, they are the equivalent of cash. Rents, insurance premiums and taxes, for example, are sometimes paid in advance.

•

Trade receivables – money owing to the company for goods or services it has sold. Additionally, because some customers fail to pay their bills, an item called ‘allowance for doubtful accounts’ is often subtracted from receivables. This allowance is management’s estimate of the amount that will not be collected. The net amount of trade receivables (trade receivables minus the allowance for doubtful accounts) is shown on the statement of financial position.

•

Cash and cash equivalents – cash on hand or in the company’s bank account(s) or in shortterm, highly liquid investments that are readily convertible into known amounts of cash (while having minimal risk of a change in value).

Classification of Equity We now turn our attention to the various categories of equity found in the statement of financial position. EQUITY (ITEMS 11 TO 13)

The items in this section of the statement of financial position represent the amount that shareholders have at risk in the business. The money that is paid in by the shareholders is designated as share capital, and the profits that have been earned over a period of years and not paid out as dividends make up the retained earnings. The shareholders’ equity section is made up of the following items: Share Capital (Item 11)

This item is the amount received by the company for its shares at the time they were issued. Thus, the share capital shown on the statement of financial position is not related in any way to the current market price of the outstanding shares. Share capital would not change from year to year unless the company issued new shares or bought back outstanding ones. © CSI GLOBAL EDUCATION INC. (2013)


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Retained Earnings (Item 12)

Retained earnings is the portion of annual profit (earnings) retained by the company after payment of all expenses and the distribution of dividends. The earnings retained each year are reinvested in the business. The reinvestment of accumulated earnings may be held in cash or reinvested in inventories, property or any other of the company’s assets. If a company suffers a loss in any year, the loss is deducted from the retained earnings. In this event, each shareholder’s ownership interest in the company is reduced because there are less retained earnings. If more losses than earnings accumulate, the resulting figure is designated a deficit. Non-Controlling Interest (Item 13)

This item appears when a company uses consolidated financial statements. Consolidated means that the company combines all the assets, liabilities and operating accounts of the parent company with those of its subsidiaries into a single joint statement when a company owns more than 50% of a subsidiary. Even if the parent company owns less than 100% of a subsidiary’s stock, all of the assets and liabilities are combined in the consolidated financial statements. To compensate, that part of the subsidiary not owned by the parent company is shown in the consolidated statement of financial position as non-controlling interest. From the viewpoint of the consolidated statement, this non-controlling interest is considered to be the interest or ownership outsiders have in the subsidiary company. Under IFRS, noncontrolling interest is presented separately from the parent shareholders’ equity.

Classification of Liabilities We will now examine the various categories of liabilities. NON-CURRENT LIABILITIES (ITEMS 15 AND 16)

Long-Term Debt (Item 15)

As distinct from current debts (shown below), which have to be paid within a year, the long-term debt of a company is usually due in annual instalments over a period of years or in a lump sum in a future year. Any portion of long-term debt that is due within the current year is shown as a current item. The most common of these debts are mortgages, bonds and debentures. Frequently, capital assets like PP&E have been pledged as security for such borrowings. It is customary to describe these debt items in the notes to the financial statements. There must be sufficient detail to tell the reader what kind of security is provided on the loan, the interest rate carried, when the debt becomes repayable and what sinking fund provision, if any, is made for repayment. As discussed in chapter 6, a sinking fund is the amount set aside each year for repayment of the debt. Deferred Tax Liabilities (Item 16)

Deferred tax liabilities represents income tax payable in future periods. These liabilities commonly result from temporary differences between the book value of assets and liabilities as reported on the statement of financial position and the amount attributed to that asset or liability for income tax purposes. A company will take the difference between these two amounts and then multiply it by a future tax rate to arrive at the amount of future tax for the period. © CSI GLOBAL EDUCATION INC. (2013)

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CURRENT LIABILITIES (ITEMS 18 TO 21)

For the most part, current liabilities are debts incurred by a company in the ordinary course of its business that have to be paid within a short time – defined as the company’s normal operating cycle. This period is usually one year. The Trans-Canada Retail statement of financial position shows four common types of current liabilities: •

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

•

Taxes payable to the government in the near term.

•

Trade payables for unpaid bills for raw materials, supplies and the like.

•

Short-term borrowings from financial institutions.

It is important to distinguish between debts (i.e., where the company has borrowed money through methods such as short-term borrowings or bonds) and other types of liabilities such as trade payables or taxes owed. This is an important point to remember when calculating debt ratios (covered in Chapter 14) for companies. Only debts incurred by borrowing are included in ratios involving debt.

WHAT IS THE STATEMENT OF COMPREHENSIVE INCOME? This statement shows how much revenue a company received during the year from the sale of its products or services and the expenses the company incurred (the statement was previously called the income or earnings statement). The difference between the two is the company’s profit or loss for the year out of which dividends may be paid to the shareholders. The statement of comprehensive income reveals the following information about a company: •

Where the income comes from and how it is spent; and

•

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

It should be emphasized that, in analyzing the financial condition of a company, its earning power and cash flow are of primary interest. The proof of a company’s financial strength and its security lies in its ability to generate earnings and cash flow through those earnings. Evidence of this is provided by both the statement of comprehensive income and the statement of cash flows.

Structure of the Statement of Comprehensive Income The statement of comprehensive income begins with revenue. Generally, a company has two main sources of income. First, there is income from selling its main products or services. For example, if the company is a public utility, it derives income from the sale of gas or electricity. This income is termed revenue. The second source of income is not directly related to a company’s normal operating activities and is referred to as other income. This income includes dividends and interest from investments, rents, and sometimes profits from the sale of PP&E.



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Why is it important differentiate between these two sources of income? If revenue and other income are combined in one figure, it is impossible to gain a true picture of the company’s real earning power. Example: A company might in one year realize a substantial profit from the sale of securities or some other asset. A profit of this kind is not likely to be repeated the next year. Yet if it were combined with revenue, it would be impossible to obtain an accurate indication of the company’s true earning power based upon its main operations.

For this reason, good accounting practice requires that revenue and other income be shown separately in the statement of comprehensive income, especially if other income is substantial. The first section of the statement of comprehensive income may be divided into three parts: •

Revenue

•

Cost of Sales

•

Gross profit

REVENUE AND COST OF SALES (ITEMS 24 AND 25)

Revenue is a key figure in the statement of comprehensive income. It is the figure needed to calculate various ratios useful in determining the basic soundness of a company’s financial position. For example, revenue must be known to calculate net and gross profit margins. These ratios are used by credit managers, bankers and security analysts in making a detailed investigation of a company’s financial affairs. From the revenue figure, various expenses are deducted. The expenses arise in producing the income received from the sale of the company’s products or services. The first such deduction, in the case of a manufacturing or merchandising concern, is termed cost of sales. This item includes costs of labour, raw materials, fuel and power, supplies and services and other kinds of expenses which go directly into the cost of manufacturing or, in the case of a merchandising concern, the cost of goods purchased for resale. Although statements of comprehensive income provide the same financial information, there are two different formats that a company could use to disclose expenses. •

One format is to disclose expenses by nature of their use – for example, depreciation, raw materials, employee benefits.

•

A second format is to disclose expenses by function – for example, cost of sales, administrative, and distribution.

GROSS PROFIT AND OTHER INCOME (ITEMS 26 AND 27)

After deducting the cost of sales from the amount of revenue we have the company’s gross profit figure for the period. This figure is significant because it measures the margin of profit or spread between the cost of goods produced for sale and revenue.


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When the percentage of gross profit to revenue is calculated and compared with those of other companies engaged in the same line of business, it provides an indication of whether the company’s merchandising operations are more or less successful in producing profits than its competitors. Between different companies in the same business, differences in the margin of gross profit generally reflect differences in managerial ability. Once gross profit is determined, other income (item 27) is added. GENERAL EXPENSES (ITEMS 28 TO 31)

Next, a number of other expense items are then deducted. The first is distribution costs (item 28). This item includes such expenses as salaries and/or commissions to sales personnel and advertising. The next item, administrative expenses (item 29), includes office salaries, accounting staff salaries and office supplies. Other expenses (item 30) include expenses that are not directly related to the company’s normal operating activities. For example, if the company has rental income (described above as part of other income) then the company may incur expenses associated with the rentals. Finance costs (item 31) result from debtholders receiving interest payments on their securities or loans to the company. The distribution of income to creditors is usually made in the form of fixed interest charges to banks and other debtholders who have lent money to the company. These interest charges are paid out of income before taxes and are fixed in the sense that the amount of interest that has to be paid on borrowed money is definite. Example: If the company has $1,000,000 worth of bonds outstanding in the hands of investors, and these bonds bear interest at the rate of 9% per annum, there is exactly $90,000 interest to be paid each year.

Interest charges are also fixed in the sense that they must be paid. Non-payment would result in default and give creditors the right to place the company in receivership. In the event of bankruptcy, the assets may be offered for sale and the proceeds used to pay off the claims of the creditors. Consequently, if receivership is to be avoided, the fixed interest charges incurred by the company must be paid before any of the income may be distributed to the shareholders. SHARE OF PROFIT OF ASSOCIATES (ITEM 32)

Share of profit of associates occurs when a company invests in another company and where significant influence exists without control (traditionally when 20% or more of the voting shares are owned) and where each company has its own financial statements. The equity accounting method is used capture the income received from this investment. Example: Trans-Canada Retail Stores Ltd. owns 25% of Alberta Retail Stores Ltd., and Alberta Retail Stores earned $20,000 (after tax) in a particular fiscal year. Trans-Canada Retail Stores, in its statement of comprehensive income, reports $5,000 (25% × $20,000) of this as share of profit of associates.

One other method, called the cost method, is primarily used for ownership holdings that do not result in significant influence (traditionally ownership of less than 20%) and where investments in other companies are reported in the form of investments on the financial statements.



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Certain profit calculations must be adjusted for share of profit of associates because, while the company reports this income, it does not actually receive it in cash. Thus, share of profit of associates is a non-cash source of funds, just as depreciation, amortization and depletion are non-cash uses of funds. Company profit needs to be reduced by the amount of share of profit of associates when calculating ratios when a true picture of the company’s cash profit is required (see also item 32 on the consolidated statement of cash flows). If an entity subject to significant influence experiences a loss, the company will report its share of the loss on its statement of comprehensive income. This entry, called Share of loss of associates, would reduce profit on the company’s statement of comprehensive income. But, as with share of profit of associates, a share of loss of associates is also a non-cash item. The amount of the share of loss of associates would therefore have to be added back to the company’s profit when calculating ratios when a true picture of the company’s cash profit is required.

INCOME TAX EXPENSE (ITEM 33)

Income tax expense includes both current tax and deferred tax for the time period. The notes to the company’s financial statements would provide additional information on this topic. PROFIT (ITEM 34)

The next step in the statement of comprehensive income is the calculation of profit (or loss), the amount of profit from the year’s operations that may be available for distribution to shareholders. OTHER COMPREHENSIVE INCOME – For information purposes only:

An additional section found in a company’s statement of comprehensive income details other comprehensive income. Items found in other comprehensive income might include: • Actuarial gains and losses on defined benefit plans • Gains and losses from currency translations relating to the financial statements of a foreign operation

The total comprehensive income (item 35) consists of the profit (or loss) plus the other comprehensive income. At this point total comprehensive income is transferred to the statement of changes in equity.

WHAT IS THE STATEMENT OF CHANGES IN EQUITY? The total comprehensive income in a company’s most recent year is determined in the statement of comprehensive income and then transferred to the statement of changes in equity. This statement is used to record changes to each component of equity (for example, share capital, retained earnings) in addition to the change in non-controlling interest (the link here is with item 13 on the statement of financial position). © CSI GLOBAL EDUCATION INC. (2013)

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RETAINED EARNINGS

Retained earnings are profits earned over the years that have not been paid out to shareholders as dividends. These retained profits accrue to the shareholders, but the directors have decided for the present time to reinvest them in the business. Retained earnings provides a record of the total comprehensive income kept in the business year after year. A portion of the total comprehensive income for the current year is added to, or in the event of a loss is subtracted from, the balance of retained earnings shown in the statement of financial position from the previous year. Dividends declared during the year are subtracted from retained earnings in the statement of changes in equity. A new final retained earnings figure is determined and carried to the statement of financial position where it appears in the equity section (item 12). Why this is important: The statement of changes in equity provides a link between the statement of comprehensive income and the statement of financial position.

In addition, the consolidated statement of changes in equity will provide a disclosure of the profit or loss to the non-controlling interests and to the parent company (in our example, the parent company is Trans-Canada Retail).

TOTAL COMPREHENSIVE INCOME ATTRIBUTABLE TO THE OWNERS AND TO NON-CONTROLLING INTERESTS

The total comprehensive income attributable to the owners of the company represents the total comprehensive income of the company minus the total comprehensive income attributable to the non-controlling interests. The statement also shows the amount of total comprehensive income attributable to noncontrolling interests. Example: A company owns 80% of the shares of a subsidiary, and the subsidiary had total comprehensive income of $1,000,000 last year. The subsidiary’s total comprehensive income of $1,000,000 will be included in the total comprehensive income of the parent company. $200,000 will show on the statement of comprehensive income as total comprehensive income attributable to noncontrolling interests to represent the 20% of the subsidiary that is not owned by the parent company.

WHAT IS THE STATEMENT OF CASH FLOWS? While the statement of financial position shows a company’s financial position at a specific point in time and the statement of comprehensive income summarizes the company’s operating activities for the year, neither statement shows how the company’s financial position changed from one period to the next. The statement of cash flows fills this gap between the statement of financial position and the statement of comprehensive income by providing information about how the company generated and spent its cash during the year.



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The statement of cash flows assists users of financial statements in evaluating the liquidity and solvency of a company. In assessing the quality of a company, the user needs to determine if the company will be able to: • Pay its creditors, especially in business downturns • Fund its needs internally if necessary • Reinvest and continue to pay dividends to shareholders A review of the statement of cash flows over a number of years may illustrate trends that might otherwise go unnoticed. The statement of cash flows often provides a clearer picture of the viability of a company than does the statement of comprehensive income, as the statement of cash flows measures actual cash generated from the business. For purposes of the statement of cash flows, cash and cash equivalents, as mentioned previously, include cash on hand or in the company’s bank account(s) or in short-term, highly liquid investments that are readily convertible into known amounts of cash (while having minimal risk of a change in value). This financial statement details the changes in cash and cash equivalents, and the reasons for them. A statement of cash flows shows the company’s cash flows for the period under the following three headings: • Operating Activities • Financing Activities • Investing Activities

Operating Activities The statement of cash flows begins by looking at those accounts that directly reflect the business activities of the company – those activities requiring an inflow of cash or outflow of cash, which generate sales and expenses during the year. It begins with profit (item 34). Added back to profit are all items not involving cash such as depreciation and amortization. Share of profit of associates (item 32) is subtracted as it is not an actual cash transaction for the company. The “change in net working capital items” (item 37) represents changes in the various asset and liabilities accounts that appear on the statement of financial position. The dollar amounts of these accounts in the current year are compared to the dollar amounts of the accounts in the previous year. The change in each account is recorded in the statement of cash flows. Net working capital items include accounts such as: • Trade receivables • Inventories • Trade payables • Interest payable • Taxes payable Example: The trade receivables account records invoices that have been sent to customers, but have not yet been paid. The company includes the sale in revenue but has not yet received the money. When the invoice is paid, the receivables account declines as the cash account increases.


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Why are changes in these accounts considered important? Consider the following: •

If trade receivables increase substantially in the current year, the company’s sales revenue will be much higher than the amount of cash collected over the period.

•

This may require further investigation on the part of the analyst. It could be an indication that the company has a poorly managed receivables department or that it is extending credit to customers that are unable to pay.

•

More importantly, a company needs a regular stream of cash flowing into the business to maintain its operations. If credit sales go uncollected for an extended period of time, it might be difficult for the company to pay its bills or meet interest charges.

•

While the company may look good on paper because its revenues are up, as demonstrated by the statement of comprehensive income, the company may shortly be in serious financial difficulty if it cannot generate enough cash to pay its creditors.

Financing Activities (items 38 to 41) Cash flows from financing activities involve transactions used to finance the company. •

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.

This section is of particular interest to the shareholders of the company as it highlights changes to a company’s capital structure – the overall use of debt and equity financing. A substantial increase in debt, or issuance of new shares, may negatively affect the shareholders’ equity in the company. Note that dividends paid to shareholders could be placed in either the operating activities section or financing activities section. We have chosen to place them in the financing activities section.

Investing Activities (items 42 to 44) Investing activities highlight what the company did with any money not used in the direct operation of the company. It includes any investments that the company made in itself, such as the purchase of new capital assets (item 42) or disposal of such assets (item 43). As well, in this section you will find any dividends actually received from associates (item 44). Note that dividends from associates could be placed in either the operating activities section or investing activities section. We have chosen to place them in the investing activities section.

The Change in Cash Flow (items 45 to 46) The final section of the statement of cash flows sums up the cash flows from operating, investing and financing activities to arrive at the increase (decrease) in cash (item 45) for the current fiscal year. Since the statement of cash flows looks at the actual change in the cash position for the year, the final balance in cash and cash equivalents (item 46) is comprised of cash and cash equivalents (item 8) found in the year-end statement of financial position for Trans-Canada Retail.



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Ideally the company should always have a positive net cash flow. If it does not, it is important to find out why. IFRS requires additional disclosures not normally seen with Canadian GAAP, such as: whether the financial statements represent a single entity, or grouping of entities, the measurement basis (historical cost or fair value). These disclosures assist the reader to understand the financial statement presentation rationale.

WHAT IS INCLUDED IN THE ANNUAL REPORT?

Notes to the Financial Statements There is a considerable amount of detailed information which, in the shareholders’ interest, needs to be disclosed. If shown directly in the financial statements themselves, it would result in their becoming so cluttered as to be unreadable. This information is usually shown in a series of notes to the financial statements. It is essential for an investor to have an understanding of the notes as they provide important details about the company’s financial condition. Items in a company’s notes include the company’s statement of compliance with IFRS, the accounting policies used, descriptions of fixed assets, share capital and long-term debt, and commitments and contingencies. It is also here that a potential investor should look to ascertain whether the company uses derivatives for hedging or other purposes.

The Auditor’s Report Canadian corporate law requires that every limited company appoint an auditor to represent shareholders and report to them annually on the company’s financial statements, expressing an opinion in writing as to their fairness. The only exception is for privately held corporations where all shareholders have agreed that an audit is not necessary. The auditor is appointed at the company’s annual meeting by a resolution of the shareholders and may be dismissed by them. In Canada the auditor’s report conventionally has four sections: •

The introductory section identifies the financial statements covered by the auditor’s report.

•

The second section outlines the financial statement responsibilities of management.

•

The third section outlines the auditor’s responsibilities and states how the audit was conducted. The purpose of the third section is for the auditor to inform the reader that the audit was planned and conducted in accordance with international auditing standards and that the auditor has made judgments in applying these standards. It explains to the reader the nature and extent of an audit.

•

The fourth section gives the auditor’s opinion on the financial statements of the company being audited. This paragraph provides a statement on the fairness of the company’s financial statements presented in accordance with International Financial Reporting Standards.


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Complete the following Online Learning Activity Financial Statements Review This module described the financial statements of corporations and the types of financial data that each of these statements contain. Complete for following activity to review the key features of the Financial Statements. Review the key features of the different statements with the Financial Statements Review w activity.

Complete the following Online Learning Activity NFR Inc. Do you know what information belongs on which financial statement and can you correctly classify the items? In this case study activity you’ll review the background of NFR Inc., a fictitious Canadian company that operates in the retail segment. You’ll then have the opportunity to practice categorizing and calculating specific financial statement items and you’ll decide on which financial statement the item belongs. This will help you interpret a corporation’s financial statements and understand the company’s current financial position. Complete the NFR Inc. activity.



12•21


Describe the format of and the items on the statement of financial position and explain how the items are classified. •

A statement of financial position presents a snapshot of a company’s operations at a specific date. The statement shows the book value of its assets, liabilities and equity.

•

Assets are what the company owns, including buildings, machinery, and inventory. Liabilities are the company’s obligations, including what it owes to creditors, suppliers, workers and the government. Equity is the claim on the company’s assets by its owners, the equity shareholders.

•

Assets and liabilities are classified as current when their use is expected to occur normally within a year; they are classified as non-current when they have a more permanent status. For example, inventory would be a current asset, while land and buildings would be non-current assets; debt due in the upcoming 12 months would be a current liability, while debt due several years in the future would be a non-current liability.

•

The basic accounting relationship shows how the statement of financial position balances: Assets = Equity + Liabilities.

2.

Describe the structure of the statement of comprehensive income. •

3.

A statement of comprehensive income shows a company’s profitability: the revenue received from selling its products, the expenses incurred to generate the revenue, and the profit for the company.

Describe the purpose of the statement of changes in equity and describe its link with the statement of financial position and statement of comprehensive income. •

A statement of changes in equity records the profits kept in the business and provides a direct link with the statement of comprehensive income and statement of financial position.

•

The statement of changes in equity is used to record changes to each component of equity (for example, share capital, retained earnings and non-controlling interest).

•

A portion of the total comprehensive income for the current year is added to, or in the event of a loss is subtracted from, the balance of retained earnings shown in the statement from the previous year.


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4.

5.

Describe the components of the statement of cash flows and classify an accounting activity or item as a cash flow from operating, financing or investing activities. •

The statement of cash flows provides a look at how a company generated and spent its cash during the period and reports the net change in the cash account over the period.

•

Operating activities directly reflect the business activities of the company: those that require an inflow or outflow of cash to generate sales and expenses during the year. Financing activities involve transactions used to finance the company and include the issue of new shares, new debt or the payment of dividends. Investing activities highlight what the company did with any money not used in its direct operations.

Explain the importance of the notes to the financial statements and the auditor’s report. •

Notes to the financial statements provide important details about the company’s financial condition not reported in the actual financial statements, for example, explanations of accounting policies or the descriptions of fixed assets.

•

The auditor’s report presents an independent opinion on the financial statements of the company being audited. The report is important because it ensures that the company’s financial statements are fair and have been prepared in accordance with International Financial Reporting Standards.






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APPENDIX A – SAMPLE FINANCIAL STATEMENTS The financial statements on the following pages should be referred to when reviewing this chapter. To make them easier to understand, these financial statements differ from real financial statements in the following ways: 1.

Comparative (previous year’s) figures are not shown.

2.

Notes to Financial Statements are not included.

3.

The consecutive numbers on the left-hand side of the statements, which are used in explaining ratio calculations, do not appear in real reports.

Note: It is assumed that Trans-Canada Retail Stores Ltd. is a non-food retail chain.

Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF FINANCIAL POSITION as at December 31, 20XX ASSETS 1. 2.

Property, plant and equipment ................................................................................................. Goodwill .........................................................................................................................................

$

6,149,000 150,000

3.

Investments in associates ...........................................................................................................

4.

TOTAL NON-CURRENT ASSETS.........................................................................................

7,216,000

5. 6. 7. 8. 9. 10.

Inventories ..................................................................................................................................... Prepaid expenses.......................................................................................................................... Trade receivables ......................................................................................................................... Cash and cash equivalents ......................................................................................................... TOTAL CURRENT ASSETS...................................................................................................... TOTAL ASSETS ............................................................................................................................

9,035,000 59,000 975,000 2,169,000 12,238,000 19,454,000

917,000

$

EQUITY AND LIABILITIES 11. Share capital .................................................................................................................................. 12. Retained earnings ......................................................................................................................... 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23.

Non-controlling interest ............................................................................................................ TOTAL EQUITY .......................................................................................................................... Long-term debt............................................................................................................................. Deferred tax liabilities ................................................................................................................ TOTAL NON-CURRENT LIABILITIES ................................................................................. Current portion of long-term debt ........................................................................................ Taxes payable ................................................................................................................................ Trade payables .............................................................................................................................. Short-term borrowings .............................................................................................................. TOTAL CURRENT LIABILITIES .............................................................................................. TOTAL EQUITY AND LIABILITIES .......................................................................................

Approved on behalf of the Board: [Signature], Director [Signature], Director


$

$

$

$ $

2,314,000 10,835,000 13,149,000 157,000 13,306,000 1,350,000 485,000 1,835,000 120,000 398,000 2,165,000 1,630,000 4,313,000 19,454,000

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Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME For the year ended December 31, 20XX OPERATING SECTION 24. Revenue ..........................................................................................................................................

$

43,800,000

25. Cost of sales ..................................................................................................................................

(28,250,000)

26. Gross Profit ...................................................................................................................................

15,550,000

27. Other income ...............................................................................................................................

130,000

28. Distribution costs ........................................................................................................................

(7,984,800)

29. Administration expenses ...........................................................................................................

(4,657,800)

30. Other expenses ............................................................................................................................

(665,400)

31. Finance costs .................................................................................................................................

(289,000)

32. Share of profit of associates ......................................................................................................

5,000

33. Income tax expense ....................................................................................................................

(880,000)

34. Profit ................................................................................................................................................

1,208,000

Other comprehensive income..................................................................................................

0

35. Total comprehensive income ....................................................................................................

$

1,208,000

Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF CHANGES IN EQUITY For the year ended December 31, 20XX

Balance at January 1, 20XX

Share Capital

Retained Earnings

1,564,000

10,026,500

Total

Noncontrolling interests

Total Equity

11,590,500

145,000

11,735,500

Changes in equity for 20XX Issue of share capital

750,000

Dividends

(387,500)

Total comprehensive income Balance at December 31, 20XX

2,314,000

750,000

750,000

(387,500)

(387,500)

1,196,000

1,196,000

12,000

1,208,000

10,835,000

13,149,000

157,000

13,306,000

Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF CASH FLOWS For the year ended December 31, 20XX OPERATING ACTIVITIES 34. Profit ................................................................................................................................................

$

1,208,000

$

496,000 (5,000) (401,000) 1,298,000

Add or (subtract) items not involving cash 36. Depreciation.................................................................................................................................. 32. Share of profit of associates ...................................................................................................... 37. Change in net working capital .................................................................................................. NET CASH FLOW PROVIDED BY OPERATING ACTIVITIES ..............................................


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Trans-Canada Retail Stores Ltd. CONSOLIDATED STATEMENT OF CASH FLOWS For the year ended December 31, 20XX FINANCING ACTIVITIES 38. Proceeds from issue of share capital.................................................................................... 39. Repayment of long-term debt ................................................................................................ 40. Proceeds from new long-term debt ..................................................................................... 41. Dividends paid ............................................................................................................................ NET CASH PROVIDED BY FINANCING ACTIVITIES ............................................................

$

$

750,000 (400,000) 50,000 (387,500) 12,500

INVESTING ACTIVITIES 42. Acquisitions of capital assets 43. Proceeds from disposal of capital assets ............................................................................. 44. Dividends received from associates ..................................................................................... NET CASH FLOW USED IN INVESTING ACTIVITIES ............................................................ 45. INCREASE IN CASH AND CASH EQUIVALENTS ....................................................... 46. CASH AND CASH EQUIVALENTS – YEAR END ........................................................

$

$

(900,000) 75,000 2,000 (823,000) 487,500 2,169,000

AUDITORS’ REPORT

To the Shareholders of Trans-Canada Retail Stores Ltd. We have audited the statement of financial position of Trans-Canada Retail Stores Ltd. as at December 31, 20XX and the statement of comprehensive income, statement of changes in equity and statement of cash flows for the year then ended, and a summary of significant accounting policies and other explanatory information. Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with International Standards of Auditing. Those standards require that we comply with ethical requirements and plan and perform an audit to obtain reasonable assurance whether the consolidated financial statements are free of material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgement, including the assessment of the risk of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes assessing the appropriateness of accounting principles used and the reasonableness of accounting estimates made by management, as well as evaluating the overall financial statement presentation. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. In our opinion, these financial statements give a true and fair view of the financial position of the company as at December 31, 20XX and of their financial performance and cash flows for the year then ended in accordance with International Financial Reporting Standards. Toronto, Ontario February 8, 20XX Signature of Auditors


Summary for Volume 1

Congratulations on completing Volume 1 of the CSC! A significant accomplishment given the amount of material, practice questions, learning activities, note taking, etc. you have done to help understand the course materials. As we noted in the introduction to the course, the CSC gives you the building blocks that cover a wide range of topics. Volume 1 Focus Our main focus in Volume 1 was understanding the different financial markets and financial instruments that help to facilitate the transfer of capital from savers and users through the various financial intermediaries. A quick recap: • We learned about the various financial markets so that you understand where the different types of financial instruments trade. You should now have a solid idea of where stocks, bonds, and derivatives trade and also the difference between auction and dealer markets. • We learned about the many different types of financial instruments, their features, and benefits, and risks. In Volume 2, you will use this knowledge as it applies to more advanced financial products, such as mutual funds, exchange-traded funds, and other structured products. • We learned about the important role played by financial intermediaries. Without banks, investment dealers, credit unions, caisse populaires, etc., the transfer of capital from savers to users would not work as smoothly as it currently does.


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Before Moving On Now that you have completed Volume 1 of the course, are you able to answer the following? • What role does investment capital play in facilitating the transfer of capital? • How do auction and dealer markets differ? • What roles do IIROC, the CDIC, OSFI, and the SROs play in the industry? • When does a director’s circular need to be sent out to security holders during a takeover bid? • Which phase of the business cycle is characterized by an increase in business failures and falling employment? • What are some of the key determinants of the exchange rate? • How does the Bank of Canada implement its inflation control policy? • What is an SRA and when is it used? • What are the key features of callable, extendible and convertible bonds? • How do sinking funds and purchase funds differ? • How would you characterize a bond issued in the U.S. in U.S. dollars by a Swiss company? • If you are given the years to maturity, the current market interest rate, and the current price of a bond, can you calculate the bond’s yield to maturity? • If a bond has a present value of $952, what does that tell you about the bond? • What is the relationship between bond prices and interest rates? • Does a stock split affect the dollar value of a company’s equity? • What does a cumulative feature on a preferred share mean? • How does a margin account differ from a cash account? • What is the main risk of taking a short position on a stock? • When is a limit order executed? • Can you list three differences between exchange-traded and OTC derivatives? • When is a call option in-the-money? When is a put option out-of-the-money? • How does an investor carry out a covered call strategy? • How does a primary offering differ from a secondary offering? • Can you describe one feature of an over-allotment option? • What is the balancing equation for the statement of financial position? • What is the link between the statement of changes in equity and comprehensive income and financial position?

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This list is far from exhaustive—a random selection of topics and concepts. However, it should give you a good idea of where your strengths and weaknesses are and may alert you to additional review before attempting the exam and moving onto Volume 2. We also encourage a thorough review of the glossary for the key terms you have come across in this first volume when preparing for the exam.


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Glossary

The following is a glossary of investment terms that will help you study for the CSC examination and increase your overall knowledge of the investment industry. Some of the terms also have a general meaning, but only their specialized investment industry meaning is given here. Words in bold face type within definitions have their own glossary definitions. Note that this list is not complete: it should be used in conjunction with your own definitions of terms compiled during your studies and with the Index.


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G•3

GLOSSARY

Accredited Investor An individual or institutional investor who meets certain minimum requirement relating to income, net worth, or investment knowledge. Also referred to as a sophisticated investor. Accrued Interest Interest accumulated on a bond or debenture since the last interest payment date. Adjusted Cost Base The deemed cost of an asset representing the sum of the amount originally paid plus any additional costs, such as brokerage fees and commissions. Advance-Decline Line A tool used in technical analysis to measure the breadth of the market. The analyst takes difference between the number of stocks that increased in value each day less the number that have decreased. After Acquired Clause A protective clause found in a bond’s indenture or contract that binds the bond issuer to pledging all subsequently purchased assets as part of the collateral for a bond issue. After Market Stabilization A type of arrangement where the dealer supports the offer price of a newly issued stock once it begins trading in the secondary market. Agency Traders Manage trades for institutional clients. They do not trade the dealer member’s capital, and they trade only when acting on behalf of clients. Agency traders do not merely take orders; they must manage institutional orders with minimal market impact and act as the client’s eyes and ears for relevant market intelligence. Agent An investment dealer operates as an agent when it acts on behalf of a buyer or a seller of a security and does not itself own title to the securities at any time during the transactions. See also Principal. All or None Order (AON) An order that must be executed in its entirety – partial fills will not be accepted. Allocation The administrative procedure by which income generated by the segregated fund’s


investment portfolio is flowed through to the individual contract holders of the fund. Alpha A statistical measure of the value a fund manager adds to the performance of the fund managed. If alpha is positive, the manager has added value to the portfolio. If the alpha is negative, the manager has underperformed the market. Alternative Trading Systems (ATS) Privately-owned computerized networks that match orders for securities outside of recognized exchange facilities. Also referred to as Proprietary Electronic Trading Systems (PETS). American-Style Option An option that can be exercised at any time during the option’s lifetime. See also European-Style Option. Amortization Gradually writing off the value of an intangible asset over a period of time. Commonly applied to items such as goodwill, improvements to leased premises, or expenses of a new stock or bond issue. See also Depreciation. Annual Information Form (AIF) A document in which an issuer is required to disclose information about presently known trends, commitments, events or uncertainties that are reasonably expected to have a material impact on the issuer’s business, financial condition or results of operations. Although investors are typically not provided with the AIF, the prospectus must state that it is available on request.

either a lump sum or a stream of payments. See Deferred Annuity and Immediate Annuity. Any Part Order A type of order in which the client will accept all stock in odd, broken or standard trading units up to the full amount of the order. Arbitrage The simultaneous purchase of a security on one stock exchange and the sale of the same security on another exchange at prices which yield a profit to the arbitrageur. Arbitration A method of dispute resolution in which an independent arbitrator is chosen to assist aggrieved parties recover damages. Arrears Interest or dividends that were not paid when due but are still owed. For example, dividends owed but not paid to cumulative preferred shareholders accumulate in a separate account (arrears). When payments resume, dividends in arrears must be paid to the preferred shareholders before the common shareholders. Ask The lowest price a seller will accept for the financial instrument being quoted. See also Bid. Asset Everything a company or a person owns or has owed to it. A statement of financial position category.

Annual Report The formal financial statements and report on operations issued by a company to its shareholders after its fiscal year-end.

Asset Allocation Apportioning investment funds among different categories of assets, such as cash, fixed income securities and equities. The allocation of assets is built around an investor’s risk tolerance.

Annuitant Person on whose life the maturity and death benefit guarantees are based. It can be the contract holder or someone else designated by the contract holder. In registered plans, the annuitant and contract holder must be the same person.

Asset-backed commercial paper (ABCP) A type of security that has a maturity date of less than one year, typically in the range of 90 to 180 days, with a legal and design structure of an asset-backed security.

Annuity A contract usually sold by life insurance companies that guarantees an income to the beneficiary or annuitant at some time in the future. The income stream can be very flexible. The original purchase price may be

Asset Mix The percentage distribution of assets in a portfolio among the three major asset classes: cash and equivalents, fixed income and equities.

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CANADIAN SECURITIES COURSE

Assuris A not for profit company whose member firms are issuers of life-insurance contracts and whose mandate is to provide protection to contract holders against the insolvency of a member company, At-the-Money An option with a strike price equal to (or almost equal to) the market price of the underlying security. See also Out-of-themoney and In-the-money. Attribution Rules A Canada Revenue Agency rule stating that an investor cannot avoid paying taxes at their marginal rate by transferring assets to other family members who have lower personal tax rates. Auction Market Market in which securities are bought and sold by brokers acting as agents for their clients, in contrast to a dealer market where trades are conducted over-the-counter. For example, the Toronto Stock Exchange is an auction market. Audit A professional review and examination of a company’s financial statements required under corporate law for the purpose of ensuring that the statements are fair, consistent and conform with International Financial Reporting Standards (IFRS). Authorized Shares The maximum number of common (or preferred) shares that a corporation may issue under the terms of its charter. Autorité des marchés financiers (Financial Services Authority) (AMF) The body that administers the regulatory framework surrounding Québec’s financial sector: securities sector, the distribution of financial products and services sector, the financial institutions sector and the compensation sector. Averages A statistical tool used to measure the direction of the market. The most common average is the Dow Jones Industrial Average. Back-End Load A sales charge applied on the redemption of a mutual fund.


Balance of Payments Canada’s interactions with the rest of the world which are captured here in the current account and capital account. Bank of Canada Canada’s central bank which exercises its influence on the economy by raising and lowering short-term interest rates. Bank Rate The minimum rate at which the Bank of Canada makes short-term advances to the chartered banks, other members of the Canadian Payments Association and investment dealers who trade in the money market. Bankers’ Acceptance A commercial draft (i.e., a written instruction to make payment) drawn by a borrower for payment on a specified date. A BA is guaranteed at maturity by the borrower’s bank. As with T-bills, BAs are sold at a discount and mature at their face value, with the difference representing the return to the investor. BAs may be sold before maturity at prevailing market rates, generally offering a higher yield than Canada T-bills. Banking Group A group of investment firms, each of which individually assumes financial responsibility for part of an underwriting. Bankrupt The legal status of an individual or company that is unable to pay its creditors and whose assets are therefore administered for its creditors by a Trustee in Bankruptcy. Basis Point One-hundredth of a percentage point of bond yields. Thus, 1% represents 100 basis points. Bear One who expects that the market generally, or the market price of a particular security, will decline. See also Bull. Bear Market A sustained decline in equity prices. Bear markets are usually associated with a downturn (recession or contraction) in the business cycle. Bearer Security A security (stock or bond) which does not have the owner’s name recorded in the books of the issuing company nor on the security

itself and which is payable to the holder, i.e., the holder is the deemed owner of the security. See also Registered Security. Beneficial Owner The real (underlying) owner of an account, securities or other assets. An investor may own shares which are registered in the name of an investment dealer, trustee or bank to facilitate transfer or to preserve anonymity, but the investor would be the beneficial owner. Beneficiary The individual or individuals who have been designated to receive the death benefit. Beneficiaries may be either revocable or irrevocable. Best Efforts Underwriting The attempt by an investment dealer (underwriter) to sell an issue of securities, to the best of their abilities, but does not guarantee that any or all of the issue will be sold. The investment dealer is not held liable to fulfill the order or to sell all of the securities. The underwriter acts as an agent for the issuer in distributing the issue. Beta A measure of the sensitivity (i.e., volatility) of a stock or a mutual fund to movements in the overall stock market. The beta for the market is considered to be 1. A fund that mirrors the market, such as an index fund, would also have a beta of 1. Funds or stocks with a beta greater than 1 are more volatile than the market and are therefore riskier. A beta less than 1 is not as volatile and can be expected to rise and fall by less than the overall market. Bid The highest price a buyer is willing to pay for the financial instrument being quoted. See also Ask. Blue Chip An active, leading, nationally known common stock with a record of continuous dividend payments and other strong investment qualities. The implication is that the company is of “good” investment value. Blue Sky A slang term for laws that various Canadian provinces and American states have enacted to protect the public against securities frauds. The term blue skyed is used to indicate that a new issue has been cleared

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GLOSSARY

by a securities commission and may be distributed. Bond A certificate evidencing a debt on which the issuer promises to pay the holder a specified amount of interest based on the coupon rate, for a specified length of time, and to repay the loan on its maturity. Strictly speaking, assets are pledged as security for a bond issue, except in the case of government “bonds”, but the term is often loosely used to describe any funded debt issue. Bond Contract The actual legal agreement between the issuer and the bondholder. The contract outlines the terms and conditions – the coupon rate, timing of coupon payments, maturity date and any other terms. The bond contract is usually administered by a trust company on behalf of all the bondholders. Also called a Bond Indenture or Trust Deed. Bond Indenture See Bond Contract. Book Value The amount of net assets belonging to the owners of a business (or shareholders of a company) based on statement of financial position values. It represents the total value of the company’s assets that shareholders would theoretically receive if a company were liquidated. Also represents the original cost of the units allocated to a segregated fund contract. Bottom-Up Analysis An investment approach that seeks out undervalued companies. A fund manager may find companies whose low share prices are not justified. They would buy these securities and when the market finally realizes that they are undervalued, the share price rises giving the astute bottom up manager a profit. See also Top-Down Analysis. Bought Deal A new issue of stocks or bonds bought from the issuer by an investment dealer, frequently acting alone, for resale to its clients, usually by way of a private placement or short form prospectus. The dealer risks its own capital in the bought deal. In the event that the price has to be lowered to sell out the issue, the dealer absorbs the loss.


Bourse de Montréal A stock exchange (also referred to as the Montréal Exchange) that deals exclusively with non-agricultural options and futures in Canada, including all options that previously traded on the Toronto Stock Exchange and all futures products that previously traded on the Toronto Futures Exchange. Broker An investment dealer or a duly registered individual that is registered to trade in securities in the capacity of an agent or principal and is a member of a SelfRegulatory Organization. Broker of Record The broker named as the official advisor to a corporation on financial matters; has the right of first refusal on any new issues. Bucketing Confirming a transaction where no trade has been executed. Budget Deficit Occurs when total spending by the government for the year is higher than revenue collected. Budget Surplus Occurs when government revenue for the year exceeds expenditures. Bull One who expects that the market generally or the market price of a particular security will rise. See also Bear. Bull Market A general and prolonged rising trend in security prices. Bull markets are usually associated with an expansionary phase of the business cycle. As a memory aid, it is said that a bull walks with his head up while a bear walks with his head down. Business Cycle The recurrence of periods of expansion and recession in economic activity. Each cycle is expected to move through five phases – the trough, recovery, expansion, peak, contraction (recession). Given an understanding of the relationship between the business cycle and security prices an investor or fund manager would select an asset mix to maximize returns.

Business Risk The risk inherent in a company’s operations, reflected in the variability in earnings. A weakening in consumer interest or technological obsolescence usually causes the decline. Examples include manufacturers of vinyl records, eight track recording tapes and beta video machines. Buy-Back A company’s purchase of its common shares either by tender or in the open market for cancellation, subsequent resale or for dividend reinvestment plans. Buy-Ins The obligation to buy back the stock after selling it short if adequate margin cannot be maintained by the client and/or if the originally borrowed stock is called by its owner and no other stock can be borrowed to replace it. Call Feature A clause in a bond or preferred share agreement that allows the issuer the right to “call back” the securities prior to maturity. The company would usually do this if they could refinance the debt at a lower rate (similar to refinancing a mortgage at a lower rate). Calling back a security prior to maturity may involve the payment of a penalty known as a call premium. Call Option The right to buy a specific number of shares at a specified price (the strike price) by a fixed date. The buyer pays a premium to the seller of the call option contract. An investor would buy a call option if the underlying stock’s price is expected to rise. See also Put Option. Call Price The price at which a bond or preferred share with a call feature is redeemed by the issuer. This is the amount the holder of the security would receive if the security was redeemed prior to maturity. The call price is equal to par (or a stated value for preferred shares) plus any call premium. See also Redemption Price. Call Protection Period For callable bonds, the period before the first possible call date. Callable May be redeemed (called in) upon due notice by the security’s issuer.

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Canada Deposit Insurance Corporation (CDIC) A federal Crown Corporation providing deposit insurance against loss (up to $100,000 per depositor) when a member institution fails. Canada Education Savings Grant (CESG) An incentive program for those investing in a Registered Education Savings Plan (RESP) whereby the federal government will make a matching grant of a maximum of $500 to $600 per year of the first $2,500 contributed each year to the RESP of a child under age 18. Canada Pension Plan (CPP) A mandatory contributory pension plan designed to provide monthly retirement, disability and survivor benefits for all Canadians. Employers and employees make equal contributions. Québec has its own parallel pension plan Québec Pension Plan (QPP). Canada Premium Bonds (CPBs) A relatively new type of savings product that offers a higher interest rate compared to the Canada Savings Bond and is redeemable once a year on the anniversary of the issue date or during the 30 days thereafter without penalty. Canada Savings Bonds (CSBs) A type of savings product that pays a competitive rate of interest and that is guaranteed for one or more years. They may be cashed at any time and, after the first three months, pay interest up to the end of the month prior to being cashed. Canada Yield Call A callable bond with a call price based on the greater of (a) par or (b) the price based on the yield of an equivalent-term Government of Canada bond plus a specified yield spread. Also known as a Doomsday call. See also Call Price and Callable Bond. Canadian Derivatives Clearing Corporation (CDCC) The CDCC is a service organization that clears, issues, settles, and guarantees options, futures, and futures options traded on the Bourse de Montréal (the Bourse).

Canadian Investor Protection Fund (CIPF) A fund that protects eligible customers in the event of the insolvency of an IIROC dealer member. It is sponsored solely by IIROC and funded by quarterly assessments on dealer members. Canadian Life and Health Insurance Association Inc. (CLHIA) The national trade group of the life insurance industry, which is actively involved in overseeing applications and setting industry standards. Canadian National Stock Exchange (CNSX) Launched in 2003 as an alternative marketplace for trading equity securities and emerging companies. Canadian Originated Preferred Securities (COPrS) Introduced to the Canadian market in March 1999, as long-term junior subordinated debt instruments. This type of security offers features that resemble both long-term corporate bonds and preferred shares. Canadian Payments Association (CPA) Established in the 1980 revision of the Bank Act, this association operates a highly automated national clearing system for interbank payments. Members include chartered banks, trust and loan companies and some credit unions and caisses. Canadian Securities Administrators (CSA) The CSA is a forum for the 13 securities regulators of Canada’s provinces and territories to co-ordinate and harmonize the regulation of the Canadian capital markets. Canadian Unlisted Board (CUB) An Internet web-based system for investment dealers to report completed trades in unlisted and unquoted equity securities in Ontario. CanDeal Provides institutional investors with electronic access to federal bond bid and offer prices and yields from its six bank-owned dealers. CanPx A joint venture of several IIROC member firms and operates as an electronic trading system for fixed income securities providing


investors with real-time bid and offer prices and hourly trade data. Capital

Has two distinct but related meanings. To an economist, it means machinery, factories and inventory required to produce other products. To an investor, it may mean the total of financial assets invested in securities, a home and other fixed assets, plus cash. Capital and Financial Account Account which reflects the transactions occurring between Canada and foreign countries with respect to the acquisition of assets, such as land or currency. Along with the current account a component of the balance of payments. Capital Gain Selling a security for more than its purchase price. For non-registered securities, 50% of the gain would be added to income and taxed at the investor’s marginal rate. Capital Loss Selling a security for less than its purchase price. Capital losses can only be applied against capital gains. Surplus losses can be carried forward indefinitely and used against future capital gains. Only 50% of the loss can be used to offset any taxable capital loss. Capital Market Financial markets where debt and equity securities trade. Capital markets include organized exchanges as well as private placement sources of debt and equity. Capital Stock All shares representing ownership of a company, including preferred as well as common. Also referred to as equity capital. Capitalization or Capital Structure Total dollar amount of all debt, preferred and common stock, and retained earnings of a company. Can also be expressed in percentage terms. Capitalizing Recording an expenditure initially as an asset on the statement of financial position rather than as an expense on the statement of comprehensive income, and then writing it off or amortizing it (as an expense on the statement of comprehensive income) over a period of years. Examples include interest, and research and development.

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GLOSSARY

Carry Forward The amount of RRSP contributions that can be carried forward from previous years. For example, if a client was entitled to place $13,500 in an RRSP and only contributed $10,000, the difference of $3,500 would be the unused contribution room and can be carried forward indefinitely. Cash Account A type of brokerage account where the investor is expected to have either cash in the account to cover their purchases or where an investor will deliver the required amount of cash before the settlement date of the purchase. Cash Flow A company’s profit for a stated period plus any deductions that are not paid out in actual cash, such as depreciation. For an investor, any source of income from an investment including dividends, interest income, rental income, etc. Cash-Secured Put Write Involves writing a put option and setting aside an amount of cash equal to the strike price. If the cash-secured put writer is assigned, the cash is used to buy the stock from the exercising put buyer. Cash Value The current market value of a segregated fund contract, less any applicable deferred sales charges or other withdrawal fees CBID An electronic trading system for fixedincome securities operating in both retail and institutional markets. CDS Clearing and Depository Services Inc. (CDS) CDS provides customers with physical and electronic facilities to deposit and withdraw depository-eligible securities and manage their related ledger positions (securities accounts). CDS also provides electronic clearing services both domestically and internationally, allowing customers to report, confirm and settle securities trade transactions. Central Bank A body established by a national Government to regulate currency and monetary policy on a national/ international level. In Canada, it is the Bank of Canada; in the United States, the Federal Reserve Board; in the U.K., the Bank of England.


Chart Analysis The use of charts and patterns to forecast buy and sell decisions. See also Technical Analysis. Chinese Walls Policies implemented to separate and isolate persons within a firm who make investment decisions from persons within a firm who are privy to undisclosed material information which may influence those decisions. For example, there should be separate fax machines for research departments and sales departments. Class A and B Stock Shares that have different classes sometimes have different rights. Some may have superior claims over other classes or may have different voting rights. Class A stock is often similar to a participating preferred share with a prior claim over Class B for a stated amount of dividends or assets or both, but without voting rights; the Class B may have voting rights but no priority as to dividends or assets. Note that these distinctions do not always apply. Clearing Corporations A not-for-profit service organization owned by the exchanges and their members for the clearance, settlement and issuance of options and futures. A clearing corporation provides a guarantee for all options and futures contracts it clears, by becoming the buyer to every seller and the seller to every buyer. Closed-End Fund Shares in closed-end investment companies are readily transferable in the open market and are bought and sold like other shares. Capitalization is fixed. See also Investment Company. Closet Indexing A portfolio strategy whereby the fund manager does not replicate the market exactly but sticks fairly close to the market weightings by industry sector, country or region or by the average market capitalization. Coincident Indicators Statistical data that, on average, change at approximately the same time and in the same direction as the economy as a whole. Collateral Trust Bond A bond secured by stocks or bonds of companies controlled by the issuing company, or other securities, which are deposited with a trustee.

Commercial Paper An unsecured promissory note issued by a corporation or an asset-backed security backed by a pool of underlying financial assets. Issue terms range from less than three months to one year. Most corporate paper trades in $1,000 multiples, with a minimum initial investment of $25,000. Commercial paper may be bought and sold in a secondary market before maturity at prevailing market rates. Commission The fee charged by a stockbroker for buying or selling securities as agent on behalf of a client. Commodity A product used for commerce that is traded on an organized exchange. A commodity could be an agricultural product such as canola or wheat, or a natural resource such as oil or gold. A commodity can be the basis for a futures contract. Common Stock Securities representing ownership in a company. They carry voting privileges and are entitled to the receipt of dividends, if declared. Also called common shares. Competitive Tender A distribution method used in particular by the Bank of Canada in distributing new issues of government marketable bonds. Bids are requested from primary distributors and the higher bids are awarded the securities for distribution. See also Non-Competitive Tender. Compound Interest Interest earned on an investment at periodic intervals and added to the amount of the investment; future interest payments are then calculated and paid at the original rate but on the increased total of the investment. In simple terms, interest paid on interest. Confirmation A printed acknowledgement giving details of a purchase or sale of a security which is normally mailed to a client by the broker or investment dealer within 24 hours of an order being executed. Also called a contract. Consolidated Financial Statements A combination of the financial statements of a parent company and its subsidiaries, presenting the financial position of the group as a whole.

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Consolidation See Reverse Split. Consumer Price Index (CPI) Price index which measures the cost of living by measuring the prices of a given basket of goods. The CPI is often used as an indicator of inflation. Continuation Pattern A chart formation indicating that the current trend will continue. Continuous Disclosure In Ontario, a reporting issuer must issue a press release as soon as a material change occurs in its affairs and, in any event, within ten days. See also Timely Disclosure. Contract Holder The owner of a segregated fund contract. Contraction Represents a downturn in the economy and can lead to a recession if prolonged. Contributions in Kind Transferring securities into an RRSP. The general rules are that when an asset is transferred there is a deemed disposition. Any capital gain would be reported and taxes paid. Any capital losses that result cannot be claimed. Conversion Price The dollar value at which a convertible bond or security can be converted into common stock. Conversion Privilege The right to exchange a bond for common shares on specifically determined terms. Convertible A bond, debenture or preferred share which may be exchanged by the owner, usually for the common stock of the same company, in accordance with the terms of the conversion privilege. A company can force conversion by calling in such shares for redemption if the redemption price is below the market price. Convertible Arbitrage A strategy that looks for mispricing between a convertible security and the underlying stock. A typical convertible arbitrage position is to be long the convertible bond and short the common stock of the same company.


Convexity A measure of the rate of change in duration over changes in yields. Typically, a bond will rise in price more if the yield change is negative than it will fall in price if the yield change is positive. Corporate Note An unsecured promise made by the borrower to pay interest and repay the principal at a specific date. Corporation or Company A form of business organization created under provincial or federal statutes which has a legal identity separate from its owners. The corporation’s owners (shareholders) have no personal liability for its debts. See also Limited Liability. Correction A price reversal that typically occurs when a security has been overbought or oversold in the market. Correlation A measure of the relationship between two or more securities. If two securities mirror each other’s movements perfectly, they are said to have a positive one (+1) correlation. Combining securities with high positive correlations does not reduce the risk of a portfolio. Combining securities that move in the exact opposite direction from each other are said to have perfect negative one (-1) correlation. Combining two securities with perfect negative correlation reduces risk. Very few, if any, securities have a perfect negative correlation. However, risk in a portfolio can be reduced if the combined securities have low positive correlations. Cost Accounting Method Used when a company owns less than 20% of a subsidiary.

Coupon Rate The rate of interest that appears on the certificate of a bond. Multiplying the coupon rate times the principal tells the holder the dollar amount of interest to be paid by the issuer until maturity. For example, a bond with a principal of $1,000 and a coupon of 10% would pay $100 in interest each year. Coupon rates remain fixed throughout the term of the bond. See also Yield. Covenant A pledge in a bond indenture indicating the fulfilment of a promise or agreement by the company issuing the debt. An example of a covenant may include the promise not to issue any more debt. Cover Buying a security previously sold short. See also Short Sale. Covered Writer The writer of an option who also holds a position that is equivalent to, but on the opposite side of the market from the short option position. In some circumstances, the equivalent position may be in cash, a convertible security or the underlying security itself. See also Naked Writer. CUB Canadian Unlisted Board – a web-based trade reporting system for unlisted securities. Cum Dividend With dividend. If you buy shares quoted cum dividend, i.e., before the ex dividend date, you will receive an upcoming already-declared dividend. If shares are quoted ex-dividend (without dividend) you are not entitled to the declared dividend.

Cost of Sales A statement of comprehensive income account representing the cost of buying raw materials that go directly into producing finished goods.

Cum Rights With rights. Buyers of shares quoted cum rights, i.e., before the ex-rights date, are entitled to forthcoming already-declared rights. If shares are quoted ex rights (without rights) the buyer is not entitled to receive the declared rights.

Cost-Push Inflation A type of inflation that develops due to an increase in the costs of production. For example, an increase in the price of oil may contribute to higher input costs for a company and could lead to higher inflation.

Cumulative Preferred A preferred stock having a provision that if one or more of its dividends are not paid, the unpaid dividends accumulate in arrears and must be paid before any dividends may be paid on the company’s common shares.

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GLOSSARY

Current Account Account that reflects all payments between Canadians and foreigners for goods, services, interest and dividends. Along with the capital and financial account it is a component of the balance of payments. Current Assets Cash and assets which in the normal course of business would be converted into cash, usually within a year, e.g. accounts receivable, inventories. A statement of financial position category. Current Liabilities Money owed and due to be paid within a year, e.g. accounts payable. A statement of financial position category. Current Ratio A liquidity ratio that shows a company’s ability to pay its current obligations from current assets. A current ratio of 2:1 is the generally accepted standard. See also Quick Ratio. Current Yield The annual income from an investment expressed as a percentage of the investment’s current value. On stock, calculated by dividing yearly dividend by market price; on bonds, by dividing the coupon by market price. See also Yield. Custodian A firm that holds the securities belonging to a mutual fund or a segregated fund for safekeeping. The custodian can be either the insurance company itself, or a qualified outside firm based in Canada. Cyclical Stock A stock in an industry that is particularly sensitive to swings in economic conditions. Cyclical Stocks tend to rise quickly when the economy does well and fall quickly when the economy contracts. In this way, cyclicals move in conjunction with the business cycle. For example, during periods of expansion auto stocks do well as individuals replace their older vehicles. During recessions, auto sales and auto company share values decline. Cyclical Unemployment The amount of unemployment that rises when the economy softens, firms’ demand for labour moderates, and some firms lay off workers in response to lower sales. It drops when the economy strengthens again.


Day Order A buy or sell order that automatically expires if it is not executed on the day it is entered. All orders are day orders unless otherwise specified. Dealer Market A market in which securities are bought and sold over-the-counter in which dealers acts as principals when buying and selling securities for clients. Also referred to as the unlisted market. Dealer Member A stock brokerage firm or investment dealer which is a member of a stock exchange or the Investment Industry Regulatory Organization of Canada. Dealer’s Spread The difference between the bid and ask prices on a security. Death Benefit The amount that a segregated fund policy pays to the beneficiary or the estate when the market value of the segregated fund is lower than the guaranteed amount on the death of the annuitant. Debenture A certificate of indebtedness of a government or company backed only by the general credit of the issuer and unsecured by mortgage or lien on any specific asset. In other words, no specific assets have been pledged as collateral. Debt Money borrowed from lenders for a variety of purposes. The borrower typically pays interest for the use of the money and is obligated to repay it at a set date. Debt/Equity Ratio A ratio that shows whether a company’s borrowing is excessive. The higher the ratio, the higher the financial risk. Declining Industry An industry moving from the maturity stage. It tends to grow at rates slower than the overall economy, or the growth rate actually begins to decline. Deemed Disposition Under certain circumstances, taxation rules state that a transfer of property has occurred, even without a purchase or sale, e.g., there is a deemed disposition on death or emigration from Canada.

Default A bond is in default when the borrower has failed to live up to its obligations under the trust deed with regard to interest, sinking fund payments or has failed to redeem the bonds at maturity. Default Risk The risk that a debt security issuer will be unable to pay interest on the prescribed date or the principal at maturity. Default risk applies to debt securities not equities since equity dividend payments are not contractual. Defensive Stock A stock of a company with a record of stable earnings and continuous dividend payments and which has demonstrated relative stability in poor economic conditions. For example, utility stock values do not usually change from periods of expansion to periods of recession since most individuals use a constant amount of electricity. Deferred Annuity This type of contract, usually sold by life insurance companies, pays a regular stream of income to the beneficiary or annuitant at some agreed-upon start date in the future. The original payment is usually a stream of payments made over time, ending prior to the beginning of the annuity payments. See also Annuity. Deferred Preferred Shares A type of preferred share that pays no dividend until a future maturity date. Deferred Sales Charge The fee charged by a mutual fund or insurance company for redeeming units. It is otherwise known as a redemption fee or back-end load. These fees decline over time and are eventually reduced to zero if the fund is held long enough. Deferred Tax Liabilities The income tax payable in future periods. These liabilities commonly result from temporary differences between the book value of assets and liabilities as reported on the statement of financial position and the amount attributed to that asset or liability for income tax purposes. Defined Benefit Plan A type of registered pension plan in which the annual payout is based on a formula. The plan pays a specific dollar amount at retirement using a predetermined formula.

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Defined Contribution Plan A type of registered pension plan where the amount contributed is known but the dollar amount of the pension to be received is unknown. Also known as a money purchase plan. Delayed Floater A type of variable rate preferred share that entitles the holder to a fixed dividend for a predetermined period of time after which the dividend becomes variable. Also known as a fixed-reset or fixed floater. Delayed Opening Postponement in the opening of trading of a security the result of a heavy influx of buy and/or sell orders. Delisting Removal of a security’s listing on a stock exchange. Demand Pull Inflation A type of inflation that develops when continued consumer demand pushes prices higher. Depletion Refers to consumption of natural resources that are part of a company’s assets. Producing oil, mining and gas companies deal in products that cannot be replenished and as such are known as wasting assets. The recording of depletion is a bookkeeping entry similar to depreciation and does not involve the expenditure of cash. Depreciation Systematic charges against earnings to write off the cost of an asset over its estimated useful life because of wear and tear through use, action of the elements, or obsolescence. It is a bookkeeping entry and does not involve the expenditure of cash. Derivative A type of financial instrument whose value is based on the performance of an underlying financial asset, commodity, or other investment. Derivatives are available on interest rates, currency, stock indexes. For example, a call option on IBM is a derivative because the value of the call varies in relation to the performance of IBM stock. See also Options. Direct Bonds This term is used to describe bonds issued by governments that are firsthand obligations of the government itself. See also Guaranteed Bonds.


Directional Hedge Funds A type of hedge fund that places a bet on the anticipated movements in the market prices of equities, fixed-income securities, foreign currencies and commodities.

Diversification Spreading investment risk by buying different types of securities in different companies in different kinds of businesses and/or locations.

Director Person elected by voting common shareholders at the annual meeting to direct company policies.

Dividend An amount distributed out of a company’s profits to its shareholders in proportion to the number of shares they hold. Over the years a preferred dividend will remain at a fixed annual amount. The amount of common dividends may fluctuate with the company’s profits. A company is under no legal obligation to pay preferred or common dividends.

Directors’ Circular Information sent to shareholders by the directors of a company that are the target of a takeover bid. A recommendation to accept or reject the bid, and reasons for this recommendation, must be included. Disclosure One of the principles of securities regulation in Canada. This principle entails full, true and plain disclosure of all material facts necessary to make reasoned investment decisions. Discount The amount by which a preferred stock or bond sells below its par value. Discount Brokers Brokerage house that buys and sells securities for clients at a greater commission discount than full-service firms. Discount Rate In computing the value of a bond, the discount rate is the interest rate used in calculating the present value of future cash flows. Discouraged Workers Individuals that are available and willing to work but cannot find jobs and have not made specific efforts to find a job within the previous month. Discretionary Account A securities account where the client has given specific written authorization to a partner, director or qualified portfolio manager to select securities and execute trades for him. See also Managed Account and Wrap Account. Disinflation A decline in the rate at which prices rise – i.e., a decrease in the rate of inflation. Prices are still rising, but at a slower rate. Disposable Income Personal income minus income taxes and any other transfers to government.

Dividend Discount Model The relationship between a stock’s current price and the present value of all future dividend payments. It is used to determine the price at which a stock should be selling based on projected future dividend payments. Dividend Payout Ratio A ratio that measures the amount or percentage of the company’s profit that are paid out to shareholders in the form of dividends. Dividend Reinvestment Plan The automatic reinvestment of shareholder dividends in more shares of the company’s stock. Dividend Tax Credit A procedure to encourage Canadians to invest in preferred and common shares of taxable, dividend-paying Canadian corporations. The taxpayer pays tax based on grossing up (i.e., adding 4 5% to the amount of dividends actually received) and obtains a credit against federal and provincial tax based on the grossed up amount in the amount of 19%. Dividend Yield A value ratio that shows the annual dividend rate expressed as a percentage of the current market price of a stock. Dividend yield represents the investor’s percentage return on investment at its prevailing market price. Dollar Cost Averaging Investing a fixed amount of dollars in a specific security at regular set intervals over a period of time, thereby reducing the average cost paid per unit.

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GLOSSARY

Domestic Bonds Bonds issued in the currency and country of the issuer. For example, a Canadian dollar-denominated bond, issued by a Canadian company, in the Canadian market would be considered a domestic bond. Dow Jones Industrial Average (DJIA) A price-weighted average that uses 30 actively traded blue chip companies as a measure of the direction of the New York Stock Exchange. Drawdown A cash management open-market operation pursued by the Bank of Canada to influence interest rates. A drawdown refers to the transfer of deposits to the Bank of Canada from the direct clearers, effectively draining the supply of available cash balances. See also Redeposit. Due Diligence Report When negotiations for a new issue of securities begin between a dealer and corporate issuer, the dealer normally prepares a due diligence report examining the financial structure of the company. Duration A measure of bond price volatility. The approximate percentage change in the price or value of a bond or bond portfolio for a 1% point change in interest rates. The higher the duration of a bond the greater its risk. Dynamic Asset Allocation An asset allocation strategy that refers to the systematic rebalancing, either by time period or weight, of the securities in the portfolio, so that they match the long-term benchmark asset mix among the various asset classes. Earned Income Income that is designated by Canada Revenue Agency for RRSP calculations. Most types of revenues are included with the exception of any form of investment income and pension income. Earnings Per Share (EPS) A value ratio that shows the portion of net income for a period attributable to a single common share of a company. For example, a company with $100 million in earnings and with 100 million common shareholders would report an EPS of $1 per share.


Economic Indicators Statistics or data series that are used to analyze business conditions and current economic activity. See also leading, lagging, and coincident indicators.

Equity Accounting Method An accounting method used to determine income derived from a company’s investment in another company over which it exerts significant influence.

Economies of Scale An economic principle whereby the per unit cost of producing each unit of output falls as the volume of production increases. Typically, a company that achieves economies of scale lowers the average cost per unit through increased production since fixed costs are shared over an increased number of goods.

Escrowed Shares Outstanding shares of a company which, while entitled to vote and receive dividends, may not be bought or sold unless special approval is obtained. Mining and oil companies commonly use this technique when treasury shares are issued for new properties. Shares can be released from escrow (i.e., freed to be bought and sold) only with the permission of applicable authorities such as a stock exchange and/or securities commission.

Efficient Market Hypothesis The theory that a stock’s price reflects all available information and reflects its true value. Election Period When an investor purchases an extendible or retractable bond, they have a time period in which to notify the company if they want to exercise the option. Elliot Wave Theory A theory used in technical analysis based on the rhythms found in nature. The theory states that there are repetitive, predictable sequences of numbers and cycles found in nature similar to patterns of stock movements. Emerging Industries Brand new industries in the early stages of growth. Often considered as speculative because they are introducing new products that may or may not be accepted and may face strong competition from other new entrants. Equilibrium Price The price at which the quantity demanded equals the quantity supplied. Equipment Trust Certificate A type of debt security that was historically used to finance “rolling stock” or railway boxcars. The cars were the collateral behind the issue and when the issue was paid down the cars reverted to the issuer. In recent times, equipment trusts are used as a method of financing containers for the offshore industry. A security, more common in the U.S. than in Canada. Equity Ownership interest in a corporation’s stock that represents a claim on its revenue and assets. See also Stock.

Eurobonds Bonds that are issued and sold outside a domestic market and typically denominated in a currency other than that of the domestic market. For example, a bond denominated in Canadian dollars and issued in Germany would be classified as a Eurobond. European-Style Option An option that can only be exercised on a specified date – normally the business day prior to expiration. Event-Driven Hedge Funds A type of hedge fund that seeks to profit from unique events such as mergers, acquisitions, stock splits or buybacks. Ex-Ante A projection of expected returns – what investors expect to realize as a return. Exchange Fund Account A special federal government account operated by the Bank of Canada to hold and conduct transactions in Canada’s foreign exchange reserves on instructions from the Minister of Finance. Exchange Rate The price at which one currency exchanges for another. Exchange-Traded Funds (ETFs) Open-ended mutual fund trusts that hold the same stocks in the same proportion as those included in a specific stock index. Shares of an exchange-traded fund trade on major stock exchanges. Like index mutual funds, ETFs are designed to mimic the performance of a specified index by investing in the constituent companies

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included in that index. Like the stocks in which they invest, shares can be traded throughout the trading day. Ex-Dividend A term that denotes that when a person purchases a common or preferred share, they are not entitled to the dividend payment. Shares go ex-dividend two business days prior to the shareholder record date. See also Cum Dividend. Exempt List Large professional buyers of securities, mostly financial institutions, that are offered a portion of a new issue by one member of the banking group on behalf of the whole syndicate. The term exempt indicates that this group of investors is exempt from receiving a prospectus on a new issue as they are considered to be sophisticated and knowledgeable. Exercise The process of invoking the rights of the option or warrant contract. It is the holder of the option who exercises his or her rights. See also Assignment. Exercise Price The price at which a derivative can be exchanged for a share of the underlying security (also known as subscription price). For an option, it is the price at which the underlying security can be purchased, in the case of a call, or sold, in the case of a put, by the option holder. Synonymous with strike price. Expansion A phase of the business cycle characterized by increasing corporate profits and hence increasing share prices, an increase in the demand for capital for business expansion, and hence an increase in interest rates. Expectations Theory A theory stating that the yield curve is shaped by a market consensus about future interest rates. Expiration Date The date on which certain rights or option contracts cease to exist. For equity options, this date is usually the Saturday following the third Friday of the month listed in the contract. This term can also be used to describe the day on which warrants and rights cease to exist.


Ex-Post The rate of return that was actually received. This historic data is used to measure actual performance.

Financial Risk The additional risk placed on the common shareholders from a company’s decision to use debt to finance its operations.

Ex-Rights A term that denotes that the purchaser of a common share would not be entitled to a rights offering. Common shares go ex-rights two business days prior to the shareholder of record date.

Financing The purchase for resale of a security issue by one or more investment dealers. The formal agreement between the investment dealer and the corporation issuing the securities is called the underwriting agreement. A term synonymous with underwriting.

Extendible Bond or Debenture A bond or debenture with terms granting the holder the option to extend the maturity date by a specified number of years. Extension Date For extendible bonds the maturity date of the bond can be extended so that the bond changes from a short-term bond to a longterm bond. Face Value The value of a bond or debenture that appears on the face of the certificate. Face value is ordinarily the amount the issuer will pay at maturity. Face value is no indication of market value. Fee-Based Accounts A type of account that bundles various services into a fee based on the client’s assets under management, for example, 1% to 3% of client assets. Fiduciary Responsibility The responsibility of an investment advisor, mutual fund salesperson or financial planner to always put the client’s interests first. The fiduciary is in a position of trust and must act accordingly. Final Good A finished product, one that is purchased by the ultimate end user. Final Prospectus The prospectus which supersedes the preliminary prospectus and is accepted for filing by applicable provincial securities commissions. The final prospectus shows all required information pertinent to the new issue and a copy must be given to each first-time buyer of the new issue. Financial Intermediary An institution such as a bank, life insurance company, credit union or mutual fund which receives cash, which it invests, from suppliers of capital.

First-In-First-Out (FIFO) Inventory items acquired earliest are sold first. First Mortgage Bonds The senior securities of a company as they constitute a first charge on the company’s assets, earnings and undertakings before unsecured current liabilities are paid. Fiscal Agent An investment dealer appointed by a company or government to advise it in financial matters and to manage the underwriting of its securities. Fiscal Policy The policy pursued by the federal government to influence economic growth through the use of taxation and government spending to smooth out the fluctuations of the business cycle. Fiscal Year A company’s accounting year. Due to the nature of particular businesses, some companies do not use the calendar year for their bookkeeping. A typical example is the department store that finds December 31 too early a date to close its books after the Christmas rush and so ends its fiscal year on January 31. Fixed Asset A tangible long-term asset such as land, building or machinery, held for use rather than for processing or resale. A statement of financial position category. Fixed Exchange Rate Regime A country whose central bank maintains the domestic currency at a fixed level against another currency or a composite of other currencies. Fixed-Floater Preferred See Delayed Floater.

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GLOSSARY

Fixed-Income Securities Securities that generate a predictable stream of interest or dividend income, such as bonds, debentures and preferred shares Fixed-Reset Preferred See Delayed Floater. Flat Means that the quoted market price of a bond or debenture is its total cost (as opposed to an accrued interest transaction). Bonds and debentures in default of interest trade flat. Floating Exchange Rate A country whose central bank allows market forces alone to determine the value of its currency, but will intervene if it thinks the move in the exchange rate is excessive or disorderly. Floating Rate A term used to describe the interest payments negotiated in a particular contract. In this case, a floating rate is one that is based on an administered rate, such as the Prime Rate. For example, the rate for a particular note may be 2% over Prime. See also Fixed Rate. Floating-Rate Debentures A type of debenture that offers protection to investors during periods of very volatile interest rates. For example, when interest rates are rising, the interest paid on floating rate debentures is adjusted upwards every six months. Floor Trader Employee of a member of a stock exchange, who executes buy and sell orders on the floor (trading area) of the exchange for the firm and its clients. Forced Conversion When a company’s stock rises in value above the conversion price a company may force the convertible security holder to exchange the security for stock by calling back the security. Faced with receiving a lower call price (par plus a call premium) or higher valued shares the investor is forced to convert into common shares. Foreign Bonds If a Canadian company issues debt securities in another country, denominated in that foreign country’s currency, the bond is known as a foreign bond. A bond issued in


the U.S. payable in U.S. dollars is known as a foreign bond or a “Yankee Bond.” See also Eurobond. Foreign Exchange Rate Risk The risk associated with an investment in a foreign security or any investment that pays in a denomination other than Canadian dollars, the investor is subject to the risk that the foreign currency may depreciate in value. Foreign Pay A Canadian debt security issued in Canada but pays interest and principle in a foreign currency is known as a foreign pay bond. This type of security allows Canadians to take advantage of possible shifts in currency values. Forward A forward contract is similar to a futures contract but trades on an OTC basis. The seller agrees to deliver a specified commodity or financial instrument at a specified price sometime in the future. The terms of a forward contract are not standardized but are negotiated at the time of the trade. There may be no secondary market. Frictional Unemployment Unemployment that results from normal labour turnover, from people entering and leaving the workforce and from the ongoing creation and destruction of jobs. Front-End Load A sales charge applied to the purchase price of a mutual fund when the fund is originally purchased. Front Running Making a practice, directly or indirectly, of taking the opposite side of the market to clients, or effecting a trade for the advisor’s own account prior to effecting a trade for a client. Full Employment The level of unemployment due solely to both frictional and structural factors, or when cyclical unemployment is zero. Fully Diluted Earnings Per Share Earnings per common share calculated on the assumption that all convertible securities are converted into common shares and all outstanding rights, warrants, options and contingent issues are exercised.

Fundamental Analysis Security analysis based on fundamental facts about a company as revealed through its financial statements and an analysis of economic conditions that affect the company’s business. See also Technical Analysis. Funded Debt All outstanding bonds, debentures, notes and similar debt instruments of a company not due for at least one year. Futures A contract in which the seller agrees to deliver a specified commodity or financial instrument at a specified price sometime in the future. A futures contract is traded on a recognized exchange. Unlike a forward contract, the terms of the futures contract are standardized by the exchange and there is a secondary market. See also Forwards. Good Delivery Form When a security is sold it must be delivered to the broker properly endorsed, not mutilated and with (if any) coupons attached. To avoid these difficulties and as a general practice most securities are held in street form with the broker. Good Faith Deposit A deposit of money by the buyer or seller of a futures product which acts as a financial guarantee as to the fulfilment of the contractual obligations of the futures contract. Also called a performance bond or margin. Good Through Order An order to buy or sell that is good for a specified number of days and then is automatically cancelled if it has not been filled. Good Till Cancelled Order An order that is valid from the date entered until the close of business on the date specified in the order. If the order has not been filled by the close of the market on that date, it is cancelled. This type of order can be cancelled or changed at any time. Goodwill Generally understood to represent the value of a well-respected business – its name, customer relations, employee relations, among others. Considered an intangible asset on the statement of financial position.

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Government Securities Distributors Typically an investment dealer or bank that is authorized to bid at Government of Canada debt auctions. Greensheet Highlights for the firm’s sales representatives the salient features of a new issue, both pro and con in order to successfully solicit interest to the general public. Dealers prepare this information circular for in-house use only. Gross Domestic Product (GDP) The value of all goods and services produced in a country in a year. Gross Profit Margin A profitability ratio that shows the company’s rate of profit after allowing for cost of sales. Growth Stock Common stock of a company with excellent prospects for above-average growth; a company which over a period of time seems destined for above-average expansion. Guaranteed Amount The minimum amount payable under death benefits or maturity guarantees provided for under the terms of the segregate fund contract. Guaranteed Bonds Bonds issued by a crown corporation but guaranteed by the applicable government as to interest and principal payments. Guaranteed Income Supplement (GIS) A pension payable to OAS recipients with no other or limited income. Guaranteed Investment Certificate (GIC) A deposit instrument most commonly available from trust companies, requiring a minimum investment at a predetermined rate of interest for a stated term. Generally nonredeemable prior to maturity but there can be exceptions. Guaranteed Minimum Withdrawal Benefit Plans (GMWB) A GMWB plan is similar to a variable annuity. With a GMWB, the client purchases the plan, and the GMWB option gives the planholder the right to withdraw a certain fixed percentage (7% is typical) of the


initial deposit every year until the entire principal is returned, no matter how the fund performs. Halt in Trading A temporary halt in the trading of a security to allow significant news to be reported and widely disseminated. Usually the result of a pending merger or a substantial change in dividends or earnings. Hedge Funds Lightly regulated pools of capital in which the hedge fund manager invests a significant amount of his or her own capital into the fund and whose offering memorandum allows for the fund to execute aggressive strategies that are unavailable to mutual funds such as short selling. Hedging A protective manoeuvre; a transaction intended to reduce the risk of loss from price fluctuations. High Water Mark Used in the context of how a hedge fund manager is compensated. The high water mark sets the bar above which the fund manager is paid a portion of the profits earned for the fund. Holding Period Return A transactional rate of return measure that takes into account all cash flows and increases or decreases in a security’s value for any time frame. Time frames can be greater or less than a year. Hypothecate To pledge securities as collateral for a loan. Referred to as collateral assignment or hypotec in Québec for segregated funds. ICE Futures Canada (formerly the Winnipeg Commodity Exchange) An exchange that trades agricultural futures and options exclusively. Income Splitting A tax planning strategy whereby the higher-earning spouse transfers income to the lower-earning spouse to reduce taxable income. Income Tax Act (ITA) The legislation dictating the process and collection of federal tax in Canada, administered by Canada Revenue Agency.

Income Trusts A type of investment trust that holds investments in the operating assets of a company. Income from these operating assets flows through to the trust, which in turn passes on the income to the trust unitholders. Index A measure of the market as measured by a basket of securities. An example would be the S&P/TSX Composite Index or the S&P 500. Fund managers and investors use a stock index to measure the overall direction and performance of the market. Index-Linked GICs A hybrid investment product that combines the safety of a deposit instrument with some of the growth potential of an equity investment. They have grown in popularity, particularly among conservative investors who are concerned with safety of capital but want yields greater than the interest on standard interest bearing GICs or other term deposits. Indexing A portfolio management style that involves buying and holding a portfolio of securities that matches, closely or exactly, the composition of a benchmark index. Individual variable insurance contract (IVIC) The term used in the IVIC Guidelines to describe a segregated fund contract. Inflation A generalized, sustained trend of rising prices. Inflation Rate The rate of change in prices. See also Consumer Price Index. Inflation Rate Risk The risk that the value of financial assets and the purchasing power of income will decline due to the impact of inflation on the real returns produced by those financial assets. Information Circular Document sent to shareholders with a proxy, providing details of matters to come before a shareholders’ meeting.

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GLOSSARY

Initial Public Offering (IPO) A new issue of securities offered to the public for investment for the very first time. IPOs must adhere to strict government regulations as to how the investments are sold to the public.

Interest Coverage Ratio A debt ratio that tests the ability of a company to pay the interest charges on its debt and indicates how many times these charges are covered based upon earnings available to pay them.

Initial Sales Charge A commission paid to the financial adviser at the time that the policy is purchased. This type of sales charge is also known as an acquisition fee or a front-end load.

Interest Rate Risk The risk that changes in interest rates will adversely affect the value of an investor’s portfolio. For example, a portfolio with a large holding of long-term bonds is vulnerable to significant loss from changes in interest rates.

Insider All directors and senior officers of a corporation and those who may also be presumed to have access to nonpublic or inside information concerning the company; also anyone owning more than 10% of the voting shares in a corporation. Insiders are prohibited from trading on this information. Insider Report A report of all transactions in the shares of a company by those considered to be insiders of the company and submitted each month to securities commissions. Instalment Debentures A bond or debenture issue in which a predetermined amount of principal matures each year. Instalment Receipts A new issue of stock sold with the obligation that buyers will pay the issue price in a specified series of instalment payments instead of one lump sum payment. Also known as Partially Paid Shares. Institutional Client A legal entity that represents the collective financial interests of a large group. A mutual fund, insurance company, pension fund and corporate treasury are just a few examples.

International Financial Reporting Standards (IFRS) A globally accepted high-quality accounting standard already used by public companies in over 100 countries around the world. Interval Funds A type of mutual fund that has the flexibility to buy back its outstanding shares periodically. Also known as closed-end discretionary funds. In-the-Money A call option is in-the-money if its strike price is below the current market price of the underlying security. A put option is in-the-money if its strike price is above the current market price of the underlying security. The in-the-money amount is the option’s intrinsic value. Intrinsic Value That portion of a warrant or call option’s price that represents the amount by which the market price of a security exceeds the price at which the warrant or call option may be exercised (exercise price). Considered the theoretical value of a security (i.e., what a security should be worth or priced at in the market).

Intangible Asset An asset having no physical substance (e.g., goodwill, patents, franchises, copyrights).

Inventory The goods and supplies that a company keeps in stock. A statement of financial position item.

Integrated Asset Allocation An asset allocation strategy that refers to an all-encompassing strategy that includes consideration of capital market expectations and client risk tolerance.

Inventory Turnover Ratio Cost of sales divided by inventory. The ratio may also be expressed as the number of days required to sell current inventory by dividing the ratio into 365.

Interest Money charged by a lender to a borrower for the use of his or her money.

Investment The use of money to make more money, to gain income or increase capital or both.


Investment Advisor (IA) An individual licensed to transact in the full range of securities. IAs must be registered in by the securities commission of the province in which he or she works. The term refers to employees of SRO member firms only. Also known as a Registrant or Registered Representative (RR). Investment Company, or Fund A company which uses its capital to invest in other companies. There are two principal types: closed-end and open-end or mutual fund. Shares in closed-end investment companies are readily transferable in the open market and are bought and sold like other shares. Capitalization is fixed. Open-end funds sell their own new shares to investors, buy back their old shares, and are not listed. Open-end funds are so-called because their capitalization is not fixed; they normally issue more shares or units as people want them. Investment Counsellor A professional engaged to give investment advice on securities for a fee. Investment Dealer A person or company that engages in the business of trading in securities in the capacity of an agent or principal and is a member of IIROC. Investment Industry Association of Canada (IIAC) A member-based professional association that represents the interests of market participants. Investment Industry Regulatory Organization of Canada (IIROC) The Canadian investment industry’s national self-regulatory organization. IIROC carries out its regulatory responsibilities through setting and enforcing rules regarding the proficiency, business and financial conduct of dealer firms and their registered employees and through setting and enforcing market integrity rules regarding trading activity on Canadian equity marketplaces. Investment Policy Statement The agreement between a portfolio manager and a client that provides the guidelines for the manager.

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Investments in Associates The ownership a company has in another company. As a general rule, significant influence is presumed to exist when a company owns 20% or more of the voting rights of the other company. Investor One whose principal concern is the minimization of risk, in contrast to the speculator, who is prepared to accept calculated risk in the hope of making better-than-average profits, or the gambler, who is prepared to take even greater risks. Irrevocable Beneficiary A beneficiary whose entitlements under the segregated fund contract cannot be terminated or changed without his or her consent. Issue Any of a company’s securities; the act of distributing such securities. Issued Shares That part of authorized shares that have been sold by the corporation and held by the shareholders of the company. Junior Bond Issue A corporate bond issue, the collateral for which has been pledged as security for other more senior debt issues and is therefore subject to these prior claims. Junior Debt One or more junior bond issues. Keynesian Economics Economic policy developed by British economist John Maynard Keynes who proposed that active government intervention in the market was the only method of ensuring economic growth and prosperity. See also Monetarism.

mandate to invest in small to medium-sized businesses. To encourage this mandate, governments offer generous tax credits to investors in LSVCCs. Lagging Indicators A selection of statistical data, that on average, indicate highs and lows in the business cycle behind the economy as a whole. These relate to business expenditures for new plant and equipment, consumers’ instalment credit, short-term business loans, the overall value of manufacturing and trade inventories. Large Value Transfer System (LVTS) A Canadian Payments Association electronic system for the transfer of large value payments between participating financial institution. Leading Indicators A selection of statistical data that, on average, indicate highs and lows in the business cycle ahead of the economy as a whole. These relate to employment, capital investment, business starts and failures, profits, stock prices, inventory adjustment, housing starts and certain commodity prices. LEAPS Long Term Equity Anticipation Securities are long-term (2-3 year) option contracts. Leverage The effect of fixed charges (i.e., debt interest or preferred dividends, or both) on per-share earnings of common stock. Increases or decreases in income before fixed charges result in magnified percentage increases or decreases in earnings per common share. Leverage also refers to seeking magnified percentage returns on an investment by using borrowed funds, margin accounts or securities which require payment of only a fraction of the underlying security’s value (such as rights, warrants or options).

the market, while aiming to lose as little of that capital as possible. Liability traders can be considered those who set the direction for agency traders. Whereas agency traders have formal client responsibilities, liability traders have lighter responsibilities or none at all. Life Cycle A model used in financial planning that tries to link age with investing. The underlying theory is that an individual’s asset mix will change, as they grow older. However the life cycle is not a substitute for the “know your client rule”. Limit Order A client’s order to buy or sell securities at a specific price or better. The order will only be executed if the market reaches or betters that price. Limited Liability The word limited at the end of a Canadian company’s name implies that liability of the company’s shareholders is limited to the money they paid to buy the shares. By contrast, ownership by a sole proprietor or partnership carries unlimited personal legal responsibility for debts incurred by the business. Limited Partnership A type of partnership whereby a limited partner cannot participate in the daily business activity and liability is limited to the partner’s investment. Liquidity 1. The ability of the market in a particular security to absorb a reasonable amount of buying or selling at reasonable price changes. 2. A corporation’s current assets relative to its current liabilities; its cash position.

Labour Force The sum of the population aged 15 years and over who are either employed or unemployed.

Liabilities Debts or obligations of a company, usually divided into current liabilities—those due and payable within one year—and long-term liabilities—those payable after one year. A statement of financial position category.

Liquidity Preference Theory A theory that tries to explain the shape of the yield curve. It postulates that investors want to invest for the short-term because they are risk averse. Borrowers, however, want long-term money. In order to entice investors to invest long-term, borrowers must offer higher rates for longer-term money. This being the case, the yield curve should slope upwards reflecting the higher rates for longer borrowing periods.

Labour Sponsored Venture Capital Corporations (LSVCC) LSVCCs are investment funds, sponsored by labour organizations, that have a specific

Liability Traders Have the responsibility to manage a dealer’s trading capital to encourage market flows and facilitate the client orders that go into

Liquidity Ratios Financial ratios that are used to judge the company’s ability to meet its short-term commitments. See Current Ratio.

Know Your Client Rule (KYC) The cardinal rule in making investment recommendations. All relevant information about a client must be known in order to ensure that the registrant’s recommendations are suitable.


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GLOSSARY

Liquidity Risk The risk that an investor will not be able to buy or sell a security quickly enough because buying or selling opportunities are limited. Listed Stock The stock of a company which is traded on a stock exchange. Listing Agreement A stock exchange document published when a company’s shares are accepted for listing. It provides basic information on the company, its business, management, assets, capitalization and financial status. Load The portion of the offering price of shares of most open-end investment companies (mutual funds) which covers sales commissions and all other costs of distribution. London InterBank Offered Rate (LIBOR) The rate of interest charged by large international banks dealing in Eurodollars to other large international banks. Long Position Signifies ownership of securities. “I am long 100 BCE common” means that the speaker owns 100 common shares of BCE Inc. Long-Term Bond A bond with greater than 10 years remaining to maturity. Macroeconomics Macroeconomics focuses on the performance of the economy as a whole. It looks at the broader picture and to the challenges facing society as a result of the limited amounts of natural resources, human effort and skills, and technology. Major Trend Underlying price trend prevailing in a market despite temporary declines or rallies. Managed Account An account whereby a licensed portfolio manager has the discretion to decide and execute suitable investment decisions on behalf of clients. Managed Product A pool of capital gathered to buy securities according to a specific investment mandate. The pool seeds a fund managed by an investment professional that is paid a management fee to carry out the mandate.


Management Expense Ratio The total expense of operating a mutual fund expressed as a percentage of the fund’s net asset value. It includes the management fee as well as other expenses charged directly to the fund such as administrative, audit, legal fees etc., but excludes brokerage fees. Published rates of return are calculated after the management expense ratio has been deducted. Management Fee The fee that the manager of a mutual fund or a segregated fund charges the fund for managing the portfolio and operating the fund. The fee is usually set as fixed percentage of the fund’s net asset value. Managers’ Discussion and Analysis (MD&A) A document that requires management of an issuer to discuss the dynamics of its business and to analyze its financial statements with the focus being on information about the issuer’s financial condition and operations with emphasis on liquidity and capital resources. Margin The amount of money paid by a client when he or she uses credit to buy a security. It is the difference between the market value of a security and the amount loaned by an investment dealer. Margin Agreement A contract that must be completed and signed by a client and approved by the firm in order to open a margin account. This sets out the terms and conditions of the account. Margin Call When an investor purchases an account on margin in the expectation that the share value will rise, or shorts a security on the expectation that share price will decline, and share prices go against the investor, the brokerage firm will send out a margin call requiring that the investor add additional funds or marketable securities to the account to protect the broker’s loan. Marginal Tax Rate The tax rate that would have to be paid on any additional dollars of taxable income earned Market Any arrangement whereby products and services are bought and sold, either directly or through intermediaries.

Market Capitalization The dollar value of a company based on the market price of its issued and outstanding common shares. It is calculated by multiplying the number of outstanding shares by the current market price of a share. Market Maker A trader employed by a securities firm who is authorized and required, by applicable self-regulatory organizations (SROs), to maintain reasonable liquidity in securities markets by making firm bids or offers for one or more designated securities. Market Order An order placed to buy or sell a security immediately at the best current price. Market Risk The non-controllable or systematic risk associated with equities. Market Segmentation Theory A theory on the structure of the yield curve. It is believed that large institutions shape the yield curve. The banks prefer to borrow short term while the insurance industry, with a longer horizon, prefers long-term money. The supply and demand of the large institutions shapes the curve. Marketability A measure of the ability to buy and sell a security. A security has good marketability if there is an active secondary market in which it can be easily bought and sold at a fair price. Marketable Bonds Bonds for which there is a ready market (i.e., clients will buy them because the prices and features are attractive). Marking-to-Market The process in the futures market in which the daily price changes are paid by the parties incurring losses to the parties earning profits. Married Put or a Put Hedge The purchase of an underlying asset and the purchase of a put option on that underlying asset. Material Change A change in the affairs of a company that is expected to have a significant effect on the market value of its securities.

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Mature Industry An industry that experiences slower, more stable growth rates in profit and revenue than growth or emerging industries, for example. Maturity The date on which a loan or a bond or debenture comes due and is to be paid off. Maturity Date The date at which the contract expires, and the time at which any maturity guarantees are based. Segregated fund contracts normally mature in 10 years, although companies are allowed to set longer periods. Maturities of less than 10 years are permitted only for funds such as protected mutual funds, which are regulated as securities and are not segregated funds. Maturity Guarantee The minimum dollar value of the contract after the guarantee period, usually 10 years. This amount is also known as the annuity benefit. Medium-Term Bond A bond with 5 to 10 years remaining to maturity. Microeconomics Analyzes the market behaviour of individual consumers and firms, how prices are determined, and how prices determine the production, distribution, and use of goods and services. Monetarists School of economic theory which states that the level of prices as well as economic output is determined by an economy’s money supply. This school of thought believes that control of the money supply is more vital to economic prosperity than the level of government spending, for example. See also Keynesian Policy.

Money Market That part of the capital market in which short-term financial obligations are bought and sold. These include treasury bills and other federal government securities, and commercial paper, and bankers’ acceptances and other instruments with one year or less left to maturity. Longer term securities, when their term shortens to the limits mentioned, are also traded in the money market. Money Purchase Plan (MPP) A type of Registered Pension Plan; also called a Defined Contribution Plan. In this type of plan, the annual payout is based on the contributions to the plan and the amounts those contributions have earned over the years preceding retirement. In other words, the benefits are not known but the contributions are. Montréal Exchange (ME) See Bourse de Montréal. Mortgage A contract specifying that certain property is pledged as security for a loan. Mortgage-Backed Securities Bonds that claim ownership to a portion of the cash flows from a group or pool of mortgages. They are also known as mortgage pass-through securities. A servicing intermediary collects the monthly payments from the issuers and, after deducting a fee, passes them through (i.e., remits them) to the holders of the security. The MBS provides liquidity in an otherwise illiquid market. Every month, holders receive a proportional share of the interest and principal payments associated with those mortgages. Mortgage Bond A bond issue secured by a mortgage on the issuer’s property.

Monetary Aggregates An aggregate that measures the quantity of money held by a country’s households, firms and governments. It includes various forms of money or payment instruments grouped according to their degree of liquidity, such as M1, M2 or M3.

Moving Average The average of security or commodity prices calculated by adding the closing prices for the underlying security over a pre-determined period and dividing the total by the time period selected.

Monetary Policy Economic policy designed to improve the performance of the economy by regulating money supply and credit. The Bank of Canada achieves this through its influence over short-term interest rates.

Moving Average ConvergenceDivergence (MACD) A technical analysis tool that takes the difference between two moving averages and then generates a smoothed moving average on the difference (the divergence) between the two moving averages.


Multi-Disciplinary Accounts Fee-based accounts that are an evolution of separately managed accounts. With multi-disciplinary accounts, separate models are combined into one overall portfolio model in a single account. Multi-Manager Accounts A type of fee-based account that offers clients and their advisors more choice in terms of product and services. Often, clients are aligned with two or more portfolio models and each portfolio model is a component of the client’s greater diversified holdings. Multiple A colloquial term for the Price/Earnings ratio of a company’s common shares. Mutual Fund An investment fund operated by a company that uses the proceeds from shares and units sold to investors to invest in stocks, bonds, derivatives and other financial securities. Mutual funds offer investors the advantages of diversification and professional management and are sold on a load or no load basis. Mutual fund shares/units are redeemable on demand at the fund’s current net asset value per share (NAVPS). Mutual Fund Dealers Association (MFDA) The Self-Regulatory Organization (SRO) that regulates the distribution (dealer) side of the mutual fund industry in Canada. Mutual Fund Wraps Are established with a selection of individual funds managed within a client’s account. Mutual fund wraps differ from funds of funds. The client holds the actual funds within their account, as opposed to a fund that simply invests in other funds. In most cases, a separate account is established for the client and the selected funds are held inside that dedicated account. Naked Writer A seller of an option contract who does not own an offsetting position in the underlying security or a suitable alternative. NASDAQ An acronym for the National Association of Securities Dealers Automated Quotation System. NASDAQ is a computerized system that provides brokers and dealers with price quotations for securities traded OTC.

G•19

GLOSSARY

National Debt The accumulation of total government borrowing over time .It is the sum of past deficits minus the sum of past surpluses. National Policies The Canadian Securities Administrators have developed a number of policies that are applicable across Canada. These coordinated efforts by the CSA are an attempt to create a national securities regulatory framework. Copies of policies are available from each provincial regulator. National Do Not Call List (DNCL) The Canadian Radio-television and Telecommunications Commission (CRTC) has established Rules that telemarketers and organizations that hire telemarketers must follow. The DNCL Rules prohibit telemarketers and clients of telemarketers from calling telephone numbers that have been registered on the DNCL for more than 31 days. National Registration Database (NRD) A web-based system that permits mutual fund salespersons and investment advisors to file applications for registration electronically. Natural Unemployment Rate Also called the full employment unemployment rate. At this level of unemployment, the economy is thought to be operating at close to its full potential or capacity. Negative Pledge Provision A protective provision written into the trust indenture of a company’s debenture issue providing that no subsequent mortgage bond issue may be secured by all or part of the company’s assets, unless at the same time the company’s debentures are similarly secured. Negotiable A certificate that is transferable by delivery and which, in the case of a registered certificate, has been duly endorsed and guaranteed. Negotiated Offer A term describing a particular type of financing in which the investment dealer negotiates with the corporation on the issuance of securities. The details would include the type of security to be issued, the price, coupon or dividend rate, special features and protective provisions.


Net Asset Value For a mutual fund, net asset value represents the market value of the fund’s share and is calculated as total assets of a corporation less its liabilities. Net asset value is typically calculated at the close of each trading day. Also referred to as the book value of a company’s different classes of securities. Net Change The change in the price of a security from the closing price on one day to the closing price on the following trading day. In the case of a stock which is entitled to a dividend one day, but is traded ex-dividend the next, the dividend is not considered in computing the change. The same applies to stock splits. A stock selling at $100 the day before a two-for-one split and trading the next day at $50 would be considered unchanged. The net change is ordinarily the last figure in a stock price list. The mark +1.10 means up $1.10 a share from the last sale on the previous day the stock traded. Net Profit Margin A profitability ratio that indicates how efficiently the company is managed after taking into account both expenses and taxes. New Account Application Form (NAAF) A form that is filled out by the client and the IA at the opening of an account. It gives relevant information to make suitable investment recommendations. The NAAF must be completed and approved before any trades are put through on an account. New Issue An offering of stocks or bonds sold by a company for the first time. Proceeds may be used to retire outstanding securities of the company, to purchase fixed assets or for additional working capital. New debt issues are also offered by government bodies. New York Stock Exchange (NYSE) Oldest and largest stock exchange in North America with more than 1,600 companies listed on the exchange. NEX A new and separate board of the TSX Venture Exchange that provides a trading forum for companies that have fallen below the Venture Exchange’s listing standards. Companies that have low levels of business activity or who do not carry on active

business will trade on the NEX board, while companies that are actively carrying on business will remain with the main TSX Venture Exchange stock list. No Par Value (n.p.v.) Indicates a common stock has no stated face value. Nominal GDP Gross domestic product based on prices prevailing in the same year not corrected for inflation. Also referred to as current dollar or chained dollar GDP. Nominal Rate The quoted or stated rate on an investment or a loan. This rate allows for comparisons but does not take into account the effects of inflation. Nominee A person or firm (bank, investment dealer, CDS) in whose name securities are registered. The shareholder, however, retains the true ownership of the securities. Non-Client and Professional Orders A type of order for the account of partners, directors, officers, major shareholders, IAs and employees of member firms that must be marked “PRO” , “N-C” or “Emp”, in order to ensure that client orders are given priority for the same securities. Non-Competitive Tender A method of distribution used in particular by the Bank of Canada for Government of Canada marketable bonds. Primary distributors are allowed to request bonds at the average price of the accepted competitive tenders. There is no guarantee as to the amount, if any, received in response to this request. Non-Controlling Interest 1. The equity of the shareholders who do not hold controlling interest in a controlled company; 2. In consolidated financial statements (i) the item in the statement of financial position of the parent company representing that portion of the assets of a consolidated subsidiary considered as accruing to the shares of the subsidiary not owned by the parent; and (ii) the item deducted in the statement of comprehensive income of the parent and representing that portion of the subsidiary’s earnings considered as accruing to the subsidiary’s shares not owned by the parent.

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Non-Cumulative A preferred dividend that does not accrue or accumulate if unpaid. Odd Lot A number of shares which is less than a standard trading unit. Usually refers to a securities trade for less than 100 shares, sometimes called a broken lot. Trading in less than 100 shares typically incurs a higher per share commission. Of Record On the company’s books or records. If, for example, a company announces that it will pay a dividend on January 15 to shareholders of record, every shareholder whose name appears on the company’s books on that date will be sent a dividend cheque from the company. Offer The lowest price at which a person is willing to sell; as opposed to bid which is the highest price at which one is willing to buy. Offering Memorandum This document is prepared by the dealer involved in a new issue outlining some of the salient features of the new issue, but not the price or other issue-specific details. It is used as a pre-marketing tool in assessing the market for the issue as well as for obtaining expressions of interest. Offering Price The price that an investor pays to purchase shares in a mutual fund. The offering price includes the charge or load that is levied when the purchase is made. Offsetting Transaction A futures or option transaction that is the exact opposite of a previously established long or short position. Office of the Superintendent of Financial Institutions (OSFI) The federal regulatory agency whose main responsibilities regarding insurance companies and segregated funds are to ensure that the companies issuing the funds are financially solvent. Officers Corporate employees responsible for the day-to-day operation of the business.


Old Age Security (OAS) A government pension plan payable at age 65 to all Canadian citizens and legal residents.

Option Premium The amount paid to enter into an option contract, paid by the buyer to the seller or writer of the contract.

Ombudsman for Banking Services and Investments (OBSI) An independent organization that investigates customer complaints against financial services providers.

Option Writer The seller of the option who may be obligated to buy (put writer) or sell (call writer) the underlying interest if assigned by the option buyer.

Open-End Fund See Mutual Fund.

Oscillator A technical analysis indicator used when a stock’s chart is not showing a definite trend in either direction. When the oscillator reading reaches an extreme value in either the upper or lower band, this suggest that the current price move has gone too far. This may indicate that the price move is overextended and vulnerable.

Open Interest The total number of outstanding option contracts for a particular option series. An opening transaction would increase open interest, while a closing transaction would decrease open interest. It is used as one measure of an option class’s liquidity. Open Market Operations Method through which the Bank of Canada influences interest rates by trading securities with participants in the money market. Opening Transaction An option transaction that is considered the initial or primary transaction. An opening transaction creates new rights for the buyer of an option, or new obligations for a seller. See also Closing Transaction. Operating Band The Bank of Canada’s 50-basis-point range for the overnight lending rate. The top of the band, the Bank Rate, is the rate charged by the Bank on LVTS advances to financial institutions. The bottom of the band is the rate paid by the Bank on any LVTS balances held overnight by those institutions. The middle of the operating band is the target for the overnight rate. Operating Income The income that a company records from its main ongoing operations. Operating Performance Ratios A type of ratio that illustrates how well management is making use of company resources. Option A right to buy or sell specific securities or properties at a specified price within a specified time. See Put Options and Call Options.

Out-of-the-Money A call option is out-of-the-money if the market price of the underlying security is below its strike price. A put option is out-of-the-money if the market price of the underlying security is above the strike price. Output Gap The difference between the actual level of output and the potential level of output when the economy is using all available resources of capital and labour. Outstanding Shares That part of issued shares which remains outstanding in the hands of investors. Over-Allotment Option An activity used to stabilize the aftermarket price of a recently issued security. If the price increases above the offer price, dealers can cover their short position by exercising an overallotment option (also referred to as a green shoe option) by either increasing demand in the case of covering a short position or increasing supply in the case of over-allotment option exercise. Overcontribution An amount made in excess to the annual limit made to an RRSP. An overcontribution in excess of$2,000 is penalized at a rate of 1% per month. Overlay Manager The overlay manager works with advisors in servicing clients. This is not a referral but a partnership, in which the advisor retains the client’s assets. The service incorporates the existing trusted relationship of the advisor,

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GLOSSARY

whom the client has become comfortable dealing with. Override In an underwriting, the additional payment the Financing Group receives over and above their original entitlement for their services as financial advisors and syndicate managers or leads. Over-the-Counter (OTC) A market for securities made up of securities dealers who may or may not be members of a recognized stock exchange. Over-the-counter is mainly a market conducted over the telephone. Also called the unlisted, inter-dealer or street market. NASDAQ is an example of an over-thecounter market. Paper Profit An unrealized profit on a security still held. Paper profits become realized profits only when the security is sold. A paper loss is the opposite to this. Par Value The stated face value of a bond or stock (as assigned by the company’s charter) expressed as a dollar amount per share. Par value of a common stock usually has little relationship to the current market value and so no par value stock is now more common. Par value of a preferred stock is significant as it indicates the dollar amount of assets each preferred share would be entitled to should the company be liquidated. Pari Passu A legal term meaning that all securities within a series have equal rank or claim on earnings and assets. Usually refers to equally ranking issues of a company’s preferred shares. Participating Preferred Preferred shares which, in addition to their fixed rate of prior dividend, share with the common in further dividend distributions and in capital distributions above their par value in liquidation. Participation Rate The share of the working-age population (15 and older) that is in the labour market, either working or looking for work. Partnership A form of business organization that involves two or more people contributing to the business and legislated under the federal Partnership Act.


Past Service Pension Adjusted (PSPA) An employer may increase a member’s pension by the granting of additional past service benefits to an employee in a defined benefit plan. Plan members who incur a PSPA will have their RRSP contribution room reduced by the amount of this adjustment. Payback Period The time that it takes for a convertible security to recoup its premium through its higher yield, compared with the dividend that is paid on the stock. Peer Group A group of managed products (particularly mutual funds) with a similar investment mandate. Pension Adjustment (PA) The amount of contributions made or the value of benefits accrued to a member of an employer-sponsored retirement plan for a calendar year. The PA enables the individual to determine the amount that may be contributed to an RRSP that would be in addition to contributions into a Registered Pension Plan. Performance Bonds What is often required upon entry into a futures contract giving the parties to a contract a higher level of assurance that the terms of the contract will eventually be honoured. The performance bond is often referred to as margin. Personal Disposable Income The amount of personal income an individual has after taxes. The income that can be spent on necessities, nonessential goods and services, or that can be saved. Phillips Curve A graph showing the relationship between inflation and unemployment. The theory states that unemployment can be reduced in the short run by increasing the price level (inflation) at a faster rate. Conversely, inflation can be lowered at the cost of possibly increased unemployment and slower economic growth. Point Refers to security prices. In the case of shares, it means $1 per share. In the case of bonds and debentures, it means 1% of the issue’s par value, which is almost universally

100. On a $1,000 bond, one point represents 1% of the face value of the bond or $10. See Basic point Political Risk The risk associated with a government introducing unfavourable policies making investment in the country less attractive. Political risk also refers to the general instability associated with investing in a particular country. Pooled Account A type of managed product structure whereby by investors’ funds are gathered into a legal structure, usually a trust or corporation. An investor’s claim to the pool’s returns is proportional to the number of shares or units the investor owns. The pools are often open-ended, which means units are issued when there are net cash inflows to the fund, or units are redeemed when there are net cash outflows. Portfolio Holdings of securities by an individual or institution. A portfolio may contain debt securities, preferred and common stocks of various types of enterprises and other types of securities. Potential Output The maximum amount of output the economy is capable of producing during a given period when all of its available resources are employed to their most efficient use. Preferred Dividend Coverage Ratio A type of profitability ratio that measures the amount of money a firm has available to pay dividends to their preferred shareholders. Preferred Shares A class of share capital that entitles the owners to a fixed dividend ahead of the company’s common shares and to a stated dollar value per share in the event of liquidation. Usually do not have voting rights unless a stated number of dividends have been omitted. Also referred to as preference shares. Preliminary Prospectus The initial document released by an underwriter of a new securities issue to prospective investors.

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Premium The amount by which a preferred stock or debt security may sell above its par value. In the case of a new issue of bonds or stocks, the amount the market price rises over the original selling price. Also refers to that part of the redemption price of a bond or preferred share in excess of face value, par value or market price. In the case of options, the price paid by the buyer of an option contract to the seller. Prepaid Expenses Payments made by the company for services to be received in the near future. For example, rents, insurance premiums and taxes are sometimes paid in advance. A statement of financial position item. Prepayment Risk The risk that the issuer of a bond might prepay or redeem early some or all principal outstanding on the loan or mortgage. Prescribed Rate A quarterly interest rate set out, or prescribed by Canada Revenue Agency under attribution rules. The rate is based on the Bank of Canada rate. Present Value The current worth of a sum of money that will be received sometime in the future. Price-Earnings (P/E) Ratio A value ratio that gives investors an idea of how much they are paying for a company’s earnings. Calculated as the current price of the stock divided current earnings per share. Primary Distribution or Primary Offering of a New Issue The original sale of any issue of a company’s securities. Primary Market The market for new issues of securities. The proceeds of the sale of securities in a primary market go directly to the company issuing the securities. See also Secondary Market. Prime Rate The interest rate chartered banks charge to their most credit-worthy borrowers. Principal The person for whom a broker executes an order, or a dealer buying or selling for its own account. The term may also refer to a person’s capital or to the face amount of a bond.


Principal Protected Note A debt-like instrument with a maturity date whereby the issuer agrees to repay investors the amount originally invested (the principal) plus interest. The interest rate is tied to the performance of an underlying asset, such as a portfolio of mutual funds or common stocks, a market index, a hedge fund or a portfolio of hedge funds. PPNs guarantee only the return of the principal. Private Equity The financing of firms unwilling or unable to find capital using public means—for example, via the stock or bond markets. Private Family Office An extension of the advisor’s client servicing approach. In this approach, instead of having only one advisor, a team of professionals handles all of an affluent client’s financial affairs within one central location. Private Placement The underwriting of a security and its sale to a few buyers, usually institutional, in large amounts. Pro Rata In proportion to. For example, a dividend is a pro rata payment because the amount of dividend each shareholder receives is in proportion to the number of shares he or she owns. Probate A provincial fee charged for authenticating a will. The fee charged is usually based on the value of the assets in an estate rather than the effort to process the will. Productivity The amount of output per worker used as a measure of efficiency with which people and capital are combined in the output of the economy. Productivity gains lead to improvements in the standard of living, because as labour, capital, etc. produce more, they generate greater income. Profit That part of a company’s revenue remaining after all expenses and taxes have been paid and out of which dividends may be paid. Profitability Ratios Financial ratios that illustrate how well management has made use of the company’s resources.

Program Trading A sophisticated computerized trading strategy whereby a portfolio manager attempts to earn a profit from the price spreads between a portfolio of equities similar or identical to those underlying a designated stock index, e.g., the Standard & Poor 500 Index, and the price at which futures contracts (or their options) on the index trade in financial futures markets. Also refers to switching or trading blocks of securities in order to change the asset mix of a portfolio. Prospectus A legal document that describes securities being offered for sale to the public. Must be prepared in conformity with requirements of applicable securities commissions. See also Red Herring and Final Prospectus. Proxy Written authorization given by a shareholder to someone else, who need not be a shareholder, to represent him or her and vote his or her shares at a shareholders’ meeting. Prudent Portfolio Approach An investment standard. In some provinces, the law requires that a fiduciary, such as a trustee, may invest funds only in a list of securities designated by the province or the federal government. In other provinces, the trustee may invest in a security if it is one that an ordinary prudent person would buy if he were investing for the benefit of other people for whom he felt morally bound to provide. Most provinces apply the two standards. Public Float That part of the issued shares that are outstanding and available for trading by the public, and not held by company officers, directors, or investors who hold a controlling interest in the company. A company’s public float is different from its outstanding shares as it also excludes those shares owned in large blocks by institutions. Purchase Fund A fund set up by a company to retire through purchases in the market a specified amount of its outstanding preferred shares or debt if purchases can be made at or below a stipulated price. See also Sinking Fund.

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GLOSSARY

Put Option A right to sell the stock at a stated price within a given time period. Those who think a stock may go down generally purchase puts. See also Call Option. Quick Ratio A more stringent measure of liquidity compared with the current ratio. Calculated as current assets less inventory divided by current liabilities. By excluding inventory, the ratio focuses on the company’s more liquid assets. Quotation or Quote The highest bid to buy and the lowest offer to sell a security at a given time. Example: A quote of 45.40–45.50 means that 45.40 is the highest price a buyer will pay and 45.50 the lowest price a seller will accept. Quotation and Trade Reporting Systems (QTRS) Recognized stock markets that operate in a similar manner to exchanges and provide facilities to users to post quotations and report trades. Rally A brisk rise in the general price level of the market or in an individual stock. Random Walk Theory The theory that stock price movements are random and bear no relationship to past movements. Rate of Return See Yield. Rational Expectations School of economic theory which argues that investors are rational thinkers and can make intelligent economic decisions after evaluating all available information. Real Estate Investment Trust (REIT) An investment trust that specializes in real estate related investments including mortgages, construction loans, land and real estate securities in varying combinations. A REIT invests in and manages a diversified portfolio of real estate. Real GDP Gross Domestic Product adjusted for changes in the price level. Also referred to as constant dollar GDP.


Real Interest Rate The nominal rate of interest minus the percentage change in the Consumer Price Index (i.e., the rate of inflation). Record Date The date on which a shareholder must officially own shares in a company to be entitled to a declared dividend. Also referred to as the date of record. Red Herring Prospectus A preliminary prospectus so called because certain information is printed in red ink around the border of the front page. It does not contain all the information found in the final prospectus. Its purpose: to ascertain the extent of public interest in an issue while it is being reviewed by a securities commission. Redemption The purchase of securities by the issuer at a time and price stipulated in the terms of the securities. See also Call Feature. Redemption Price The price at which debt securities or preferred shares may be redeemed, at the option of the issuing company. Redeposit An open-market cash management policy pursued by the Bank of Canada. A redeposit refers to the transfer of funds from the Bank to the direct clearers (an injection of balances) that will increase available funds. See also Drawdown. Registered Education Savings Plans (RESPs) A type of government sponsored savings plan used to finance a child’s postsecondary education. Registered Pension Plan (RPP) A trust registered with Canada Revenue Agency and established by an employer to provide pension benefits for employees when they retire. Both employer and employee may contribute to the plan and contributions are tax-deductible. See also Defined Contribution Plan and Defined Benefit Plan. Registered Retirement Income Fund (RRIF) A tax deferral vehicle available to RRSP holders. The planholder invests the funds in the RRIF and must withdraw a certain amount each year. Income tax would be due on the funds when withdrawn.

Registered Retirement Savings Plan (RRSP) An investment vehicle available to individuals to defer tax on a specified amount of money to be used for retirement. The holder invests money in one or more of a variety of investment vehicles which are held in trust under the plan. Income tax on contributions and earnings within the plan is deferred until the money is withdrawn at retirement. RRSPs can be transferred into Registered Retirement Income Funds upon retirement. Registered Security A security recorded on the books of a company in the name of the owner. It can be transferred only when the certificate is endorsed by the registered owner. Registered debt securities may be registered as to principal only or fully registered. In the latter case, interest is paid by cheque rather than by coupons attached to the certificate. See also Bearer Security. Registrar Usually a trust company appointed by a company to monitor the issuing of common or preferred shares. When a transaction occurs, the registrar receives both the old cancelled certificate and the new certificate from the transfer agent and records and signs the new certificate. The registrar is, in effect, an auditor checking on the accuracy of the work of the transfer agent, although in most cases the registrar and transfer agent are the same trust company. Regular Delivery The date a securities trade settles – i.e., the date the seller must deliver the securities. See also Settlement Date. Regular Dividends A term that indicates the amount a company usually pays on an annual basis. Reinvestment Risk The risk that interest rates will fall causing the cash flows on an investment, assuming that the cash flows are reinvested, to earn less than the original investment. For example, yield to maturity assumes that all interest payments received can be reinvested at the yield to maturity rate. This is not necessarily true. If interest rates in the market fall the interest would be reinvested at a lower rate. Reinvestment risk recognizes this risk.

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Relative Value Hedge Funds A type of hedge fund that attempts to profit by exploiting irregularities or discrepancies in the pricing of related stocks, bonds or derivatives. Reporting Issuer Usually, a corporation that has issued or has outstanding securities that are held by the public and is subject to continuous disclosure requirements of securities administrators. Reset A contract provision which allows the segregated fund contract holder to lock in the current market value of the fund and set a new maturity date 10 years after the reset date. Depending on the contract, the reset dates may be chosen by the contract holder or be triggered automatically. Resistance Level The opposite of a support level. A price level at which the security begins to fall as the number of sellers exceeds the number of buyers of the security. Restricted Shares Shares that participate in a company’s earnings and assets (in liquidation), as common shares do, but generally have restrictions on voting rights or else no voting rights. Retail Investor Individual investors who buy and sell securities for their own personal accounts, and not for another company or organization. They generally buy in smaller quantities than larger institutional investors. Retained Earnings The cumulative total of annual earnings retained by a company after payment of all expenses and dividends. The earnings retained each year are reinvested in the business. Retractable A feature which can be included in a new debt or preferred issue, granting the holder the option under specified conditions to redeem the security on a stated date – prior to maturity in the case of a bond. Return on Equity A profitability ratio expressed as a percentage representing the amount earned on a company’s common shares. Return on


equity tells the investor how effectively their money is being put to use. Reversal Patterns Formations that usually precede a sizeable advance or decline in stock prices. Reverse Split A process of retiring old shares with fewer shares. For example, an investor owns 1,000 shares of ABC Inc. pre split. A 10 for 1 reverse split or consolidation reduces the number held to 100. Results in a higher share price and fewer shares outstanding. Revocable Beneficiary A beneficiary whose entitlements under the segregated fund contract can be terminated or changed without his or her consent. Right A short-term privilege granted to a company’s common shareholders to purchase additional common shares, usually at a discount, from the company itself, at a stated price and within a specified time period. Rights of listed companies trade on stock exchanges from the ex-rights date until their expiry. Right of Action for Damages Most securities legislation provides that those who sign a prospectus may be liable for damages if the prospectus contains a misrepresentation. This right extends to experts e.g., lawyers, auditors, geologists, etc., who report or give opinions within the text of the document. Right of Redemption A mutual fund’s shareholders have a continuing right to withdraw their investment in the fund simply by submitting their shares to the fund itself and receiving in return the dollar amount of their net asset value. This characteristic is the hallmark of mutual funds. Payment for the securities that have been redeemed must be made by the fund within three business days from the determination of the net asset value. Right of Rescission The right of a purchaser of a new issue to rescind the purchase contract within the applicable time limits if the prospectus contained an untrue statement or omitted a material fact.

Right of Withdrawal The right of a purchaser of a new issue to withdraw from the purchase agreement within two business days after receiving the prospectus. Risk Analysis Ratios Financial ratios that show how well the company can deal with its debt obligations. Risk-Averse Descriptive term used for an investor unable or unwilling to accept the probability or chance of losing capital. See also Risk-Tolerant. Risk-Free Rate The rate of return an investor would receive if he or she invested in a risk free investment, such as a treasury bill. Risk Premium A rate that has to be paid in addition to the risk free rate (T-bill rate) to compensate investors for choosing securities that have more risk than T-Bills. Risk-Tolerant Descriptive term used for an investor willing and able to accept the probability of losing capital. See also Risk-Averse. Sacrifice Ratio Describes the extent to which Gross Domestic Product must be reduced with increased unemployment to achieve a 1% decrease in the inflation rate. Sale and Repurchase Agreements (SRAs) An open-market operation by the Bank of Canada to offset undesired downward pressure on overnight financing costs. SEC The Securities and Exchange Commission, a federal body established by the United States Congress, to protect investors in the U.S. In Canada there is no national regulatory authority; instead, securities legislation is provincially administered. Secondary Issue Refers to the redistribution or resale of previously issued securities to the public by a dealer or investment dealer syndicate. Usually a large block of shares is involved (e.g., from the settlement of an estate) and these are offered to the public at a fixed price, set in relationship to the stock’s market price.

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GLOSSARY

Secondary Market The market where securities are traded through an exchange or over-the-counter subsequent to a primary offering. The proceeds from trades in a secondary market go to the selling dealers and investors, rather than to the companies that originally issued the shares in the primary market. Securities Paper certificates or electronic records that evidence ownership of equity (stocks) or debt obligations (bonds). Securities Acts Provincial Acts administered by the securities commission in each province, which set down the rules under which securities may be issued and traded. Securities Administrator A general term referring to the provincial regulatory authority (e.g., Securities Commission or Provincial Registrar) responsible for administering a provincial Securities Act. Securities Eligible for Reduced Margin Securities which demonstrate sufficiently high liquidity and low price volatility based on meeting specific price risk and liquidity risk measures. Securitization Refers in a narrow sense to the process of converting loans of various sorts into marketable securities by packaging the loans into pools. In a broader sense, refers to the development of markets for a variety of debt instruments that permit the ultimate borrower to bypass the banks and other deposit-taking institutions and to borrow directly from lenders. Segregated Funds Insurance companies sell these funds as an alternative to conventional mutual funds. Like mutual funds, segregated funds offer a range of investment objectives and categories of securities e.g. equity funds, bond funds, balanced funds etc. These funds have the unique feature of guaranteeing that, regardless of how poorly the fund performs, at least a minimum percentage (usually 75% or more) of the investor’s payments into the fund will be returned when the fund matures.


Self-Directed RRSP A type of RRSP whereby the holder invests funds or contributes certain acceptable assets such as securities directly into a registered plan which is usually administered for a fee by a Canadian financial services company. Self-Regulatory Organization (SRO) An organization recognized by the Securities Administrators as having powers to establish and enforce industry regulations to protect investors and to maintain fair, equitable, and ethical practices in the industry and ensure conformity with securities legislation. Canadian SROs include the Investment Industry Regulatory Organization of Canada and, the Mutual Fund Dealers Association. Selling Group Investment dealers or others who assist a banking group in marketing a new issue of securities without assuming financial liability if the issue is not entirely sold. The use of a selling group widens the distribution of a new issue. Sentiment Indicators Measure investor expectations or the mood of the market. These indicators measure how bullish or bearish investors are. Separately Managed Account A managed product structure whereby individual accounts are created for each investor. In either case, an investment manager is guided by an investment mandate. Serial Bond or Debenture See Instalment Debenture. Settlement Date The date on which a securities buyer must pay for a purchase or a seller must deliver the securities sold. For most securities, settlement must be made on or before the third business day following the transaction date. Share of Profit of Associates A company’s share of an unconsolidated subsidiary’s revenue. The equity accounting method is used when a company owns 20% to 50% of a subsidiary. Short-Form Prospectus Distribution System This system allows reporting issuers to issue a short-form prospectus that contains only

information not previously disclosed to regulators. The short form prospectus contains by reference the material filed by the corporation in the Annual Information Form. Short Position Created when an investor sells a security that he or she does not own. See also short sale. Short Sale The sale of a security which the seller does not own. This is a speculative practice done in the belief that the price of a stock is going to fall and the seller will then be able to cover the sale by buying it back later at a lower price, thereby making a profit on the transactions. It is illegal for a seller not to declare a short sale at the time of placing the order. See also Margin. Short-Term Bond A bond with greater than one year but less than five years to maturity. Short-Term Debt Company borrowings repayable within one year that appear in the current liabilities section of the statement of financial position. The most common short-term debt items are: bank advances or loans, notes payable and the portion of funded debt due within one year. Single-Manager Account A type of fee-based account that is directed by a single portfolio manager who focuses considerable time and attention on the selection of securities, the sectors to invest in and the optimal asset allocation. Simplified Prospectus A condensed prospectus distributed by mutual fund companies to purchasers and potential purchasers of fund units or shares. Sinking Fund A fund set up to retire most or all of a debt or preferred share issue over a period of time. See also Purchase Fund. Small Cap Reference to smaller growth companies. Small cap refers to the size of the capitalization or investments made in the company. A small cap company has been defined as a company with an outstanding stock value of under $500 million. Small cap companies are considered more volatile than large cap companies.

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Soft Landing Describes a business cycle phase when economic growth slows sharply but does not turn negative, while inflation falls or remains low. Soft Retractable Preferred Shares A type of retractable preferred share where the redemption value may be paid in cash or in common shares, generally at the election of the issuer. Sole Proprietorship A form of business organization that involves one person running a business whereby the individual is taxed on earnings at their personal income tax rate. SPDRs An acronym for the Standard & Poor Depository Receipts (a type of derivative). These mirror the S&P 500 Index. They are referred to as “Spiders”. Special Purchase and Resale Agreements (SPRAs) An open-market operation used by the Bank of Canada to relieve undesired upward pressure on overnight financing rates. Speculator One who is prepared to accept calculated risks in the marketplace. Objectives are usually short to medium-term capital gain, as opposed to regular income and safety of principal, the prime objectives of the conservative investor. S&P/TSX Composite Index A benchmark used to measure the performance of the broad Canadian equity market. Split Shares A security that has been created to divide (or split) the investment attributes of an underlying portfolio of common shares into separate components that satisfy different investment objectives. The preferred shares receive the majority of the dividends from the common shares held by the split share corporation. The capital shares receive the majority of any capital gains on the common shares. Spot Price The market price of a commodity or financial instrument that is available for immediate delivery.


Spousal RRSP A special type of RRSP to which one spouse contributes to a plan registered in the beneficiary spouse’s name. The contributed funds belong to the beneficiary but the contributor receives the tax deduction. If the beneficiary removes funds from the spousal plan in the year of the contribution or in the subsequent two calendar years, the contributor must pay taxes on the withdrawn amount. Spread The gap between bid and ask prices in the quotation for a security. Also a term used in option trading. SRO Short for self-regulatory organization such as the Investment Industry Regulatory Organization of Canada. Standard Deviation A statistical measure of risk. The larger the standard deviation, the greater the volatility of returns and therefore the greater the risk. Standard Trading Unit A regular trading unit which has uniformly been decided upon by the stock exchanges, in most cases it is 100 shares, but this can vary depending on the price of the stock. Statement of Cash Flow A financial statement which provides information as to how a company generated and spent its cash during the year. Assists users of financial statements in evaluating the company’s ability to generate cash internally, repay debts, reinvest and pay dividends to shareholders. Statement of Changes in Equity A financial statement that shows the total comprehensive income kept in the business year after year. Statement of Comprehensive Income A financial statement which shows a company’s revenues and expenditures resulting in either a profit or a loss during a financial period. Statement of Financial Position A financial statement showing a company’s assets, liabilities and equity on a given date.

Statement of Material Facts A document presenting the relevant facts about a company and compiled in connection with an underwriting or secondary distribution of its shares. It is used only when the shares underwritten or distributed are listed on a recognized stock exchange and takes the place of a prospectus in such cases. Stock Ownership interest in a corporation’s that represents a claim on its earnings and assets. Stock Dividend A pro rata payment to common shareholders of additional common stock. Such payment increases the number of shares each holder owns but does not alter a shareholder’s proportional ownership of the company. Stock Exchange A marketplace where buyers and sellers of securities meet to trade with each other and where prices are established according to laws of supply and demand. Stock Savings Plan Some provinces allow individual residents of the particular province a deduction or tax credit for provincial income tax purposes on investments made in certain prescribed vehicles. The credit or deduction is a percentage figure based on the value of investment. Stock Split An increase in a corporation’s number of shares outstanding without any change in the shareholders’ equity or market value. When a stock reaches a high price making it illiquid or difficult to trade, management may split the stock to get the price into a more marketable trading range. For example, an investor owns one standard trading unit of a stock that now trades at $70 each (portfolio value is $7,000). Management splits the stock 2:1. The investor would now own 200 new shares at a market value, all things being equal, of $35 each, for a portfolio value of $7,000. Stop Buy Orders An order to buy a security only after it has reached a certain price. This may be used to protect a short position or to ensure that a stock is purchased while its price is rising. According to TSX rules these orders become market orders when the stop price is reached.

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GLOSSARY

Stop Loss Orders The opposite of a stop buy order. An order to sell a security after its price falls to a certain amount, thus limiting the loss or protecting a paper profit. According to TSX rules these orders become market orders when the stop price is reached. Stop Orders Orders that are used to buy or sell after a stock has reached a certain price. See Stop Buy Orders, Stop Loss Orders. Strategic Asset Allocation An asset allocation strategy that rebalances investment portfolios regularly to maintain a consistent long-term mix. Street Name Securities registered in the name of an investment dealer or its nominee, instead of the name of the real or beneficial owner, are said to be “in street name.” Certificates so registered are known as street certificates. Strike Price The price, as specified in an option contract, at which the underlying security will be purchased in the case of a call or sold in the case of a put. See also Exercise Price. Strip Bonds or Zero Coupon Bonds Usually high quality federal or provincial government bonds originally issued in bearer form, where some or all of the interest coupons have been detached. The bond principal and any remaining coupons (the residue) then trade separately from the strip of detached coupons, both at substantial discounts from par. Structural Unemployment Amount of unemployment that remains in an economy even when the economy is strong. Also known as the natural unemployment rate, the full employment unemployment rate. Structured Preferreds See Equity Dividend Shares. Structured Product A passive investment vehicle financially engineered to provide a specific risk and return characteristic. The value of a structured product tracks the returns of reference security known as an underlying asset. Underlying assets can consist of a single security, a basket of securities, foreign currencies, commodities or an index.


Subordinated Debenture A type of junior debenture. Subordinate indicates that another debenture ranks ahead in terms of a claim on assets and profits.

Swap An over-the-counter forward agreement involving a series of cash flows exchanged between two parties on specified future dates.

Subscription or Exercise Price The price at which a right or warrant holder would pay for a new share from the company. With options the equivalent would be the strike price.

Sweetener A feature included in the terms of a new issue of debt or preferred shares to make the issue more attractive to initial investors. Examples include warrants and/or common shares sold with the issue as a unit or a convertible or extendible or retractable feature.

Subsidiary Company which is controlled by another company usually through its ownership of the majority of shares. Suitability A registrant’s major concern in making investment recommendations. All information about a client and a security must be analyzed to determine if an investment is suitable for the client in accounts where a suitability exemption does not apply. Superficial Losses Occur when an investment is sold and then repurchased at any time in a period that is 30 days before or after the sale. Supply-Side Economics An economic theory whereby changes in tax rates exert important effects over supply and spending decisions in the economy. According to this theory, reducing both government spending and taxes provides the stimulus for economic expansion. Support Level A price level at which a security stops falling because the number of investors willing to buy the security is greater than the number of investors wishing to sell the security. Surrender Value The cash value of an insurance contract as of the date that the policy is being redeemed. This amount is equal to the market value of the segregated fund, less any applicable sales charges or administrative fees. Suspension in Trading An interruption in trading imposed on a company if their financial condition does not meet an exchange’s requirements for continued trading or if the company fails to comply with the terms of its listing agreement.

Syndicate A group of investment dealers who together underwrite and distribute a new issue of securities or a large block of an outstanding issue. System for Electronic Document Analysis and Retrieval (SEDAR) SEDAR facilitates the electronic filing of securities information as required by the securities regulatory agencies in Canada and allows for the public dissemination of information collected in the filing process Systematic Risk A non-controllable, non-diversifiable risk that is common to all investments within a given asset class. With equities it is called market risk, with fixed income securities it would be interest rate risk. Systematic Withdrawal Plan A plan that enables set amounts to be withdrawn from a mutual fund or a segregated fund on a regular basis. T3 Form Referred to as a Statement of Trust Income Allocations and Designations. When a mutual fund is held outside a registered plan, unitholders of an unincorporated fund is sent a T3 form by the respective fund. T4 Form Referred to as a Statement of Remuneration Paid. A T4 form is issued annually by employers to employees reporting total compensation for the calendar year. Employers have until the end of February to submit T4 forms to employees for the previous calendar year.

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T5 Form Referred to as a Statement of Investment Income. When a mutual fund is held outside a registered plan, shareholders are sent a T3 form by the respective fund. Tactical Asset Allocation An asset allocation strategy that involves adjusting a portfolio to take advantage of perceived inefficiencies in the prices of securities in different asset classes or within sectors. Takeover Bid An offer made to security holders of a company to purchase voting securities of the company which, with the offeror’s already owned securities, will in total exceed 20% of the outstanding voting securities of the company. For federally incorporated companies, the equivalent requirement is more than 10% of the outstanding voting shares of the target company. Tax Free Savings Account (TFSA) A savings vehicle whereby income earned within a TFSA will not be taxed in any way throughout an individual’s lifetime. In addition, there are no restrictions on the timing or amount of withdrawals from a TFSA, and the money withdrawn can be used for any purpose. Tax Loss Selling Selling a security for the sole purpose of generating a loss for tax purposes. There may be times when this strategy is advantageous but investment principles should not be ignored. T-Bills See Treasury bills. Technical Analysis A method of market and security analysis that studies investor attitudes and psychology as revealed in charts of stock price movements and trading volumes to predict future price action. Term to Maturity The length of time that a segregated fund policy must be held in order to be eligible for the maturity guarantee. Normally, except in the event of the death of the annuitant, the term to maturity of a segregated-fund policy is 10 years. Thin Market A market in which there are comparatively few bids to buy or offers to sell or both. The phrase may apply to a single security or


to the entire stock market. In a thin market, price fluctuations between transactions are usually larger than when the market is liquid. A thin market in a particular stock may reflect lack of interest in that issue, or a limited supply of the stock. Tilting of the Yield Curve The yield curve that results from a decline in long-term bond yields while short-term rates are rising. Time to Expiry The number of days or months or years until expiry of an option or other derivative instrument. Time Value The amount, if any, by which the current market price of a right, warrant or option exceeds its intrinsic value. Time-Weighted Rate of Return (TWRR) A measure of return calculated by averaging the return for each subperiod in which a cash flow occurs into a return for a reporting period. Timely Disclosure An obligation imposed by securities administrators on companies, their officers and directors to release promptly to the news media any favourable or unfavourable corporate information which is of a material nature. Broad dissemination of this news allows non-insiders to trade the company’s securities with the same knowledge about the company as insiders themselves. See also Continuous Disclosure. Tombstone Advertisements A written advertisement placed by the investment bankers in a public offering of securities as a matter of record once the deal has been completed. Top-Down Approach A type of fundamental analysis. First, general trends in the economy are analyzed. This information is then combined with industries and companies within those industries that should benefit from the general trends identified. Toronto Stock Exchange (TSX) The largest stock exchange in Canada with over 1,700 companies listed on the exchange.

Trade Payables Money owed by a company for goods or services purchased, payable within one year. A current liability on the statement of financial position. Trade Receivables Money owed to a company for goods or services it has sold, for which payment is expected within one year. A current asset on the statement of financial position. Trading Unit Describes the size or the amount of the underlying asset represented by one option contract. In North America, all exchangetraded options have a trading unit of 100 shares. Trailer Fee Fee that a mutual fund manager may pay to the individual or organization that sold the fund for providing services such as investment advice, tax guidance and financial statements to investors. The fee is paid annually and continues for as long as the investor holds shares in the fund. Transaction Date The date on which the purchase or sale of a security takes place. Transfer Agent An agent, usually a trust company, appointed by a corporation to maintain shareholder records, including purchases, sales, and account balances. The transfer agent may also be responsible for distributing dividend cheques. Treasury Bills Short-term government debt issued in denominations ranging from $1,000 to $1,000,000. Treasury bills do not pay interest, but are sold at a discount and mature at par (100% of face value). The difference between the purchase price and par at maturity represents the lender’s (purchaser’s) income in lieu of interest. In Canada, such gain is taxed as interest income in the purchaser’s hands. Treasury Shares Authorized but unissued stock of a company or previously issued shares that have been re-acquired by the corporation. The amount still represents part of those issued but is not included in the number of shares outstanding. These shares may be resold or used as part of the option package

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GLOSSARY

for management. Treasury shares do not have voting rights nor are they entitled to dividends. Trend Shows the general movement or direction of securities prices. The long-term price or trading volume of a particular security is either up, down or sideways. Trust Deed (Bond Contract) This is the formal document that outlines the agreement between the bond issuer and the bondholders. It outlines such things as the coupon rate, if interest is paid semi-annually and when, and any other terms and conditions between both parties. Trustee For bondholders, usually a trust company appointed by the company to protect the security behind the bonds and to make certain that all covenants of the trust deed relating to the bonds are honoured. For a segregated fund, the trustee administers the assets of a mutual fund on behalf of the investors. TSX Venture Exchange Canada’s public venture marketplace, the result of the merger of the Vancouver and Alberta Stock Exchanges in 1999. Two-Way Security A security, usually a debenture or preferred share, which is convertible into or exchangeable for another security (usually common shares) of the same company. Also indirectly refers to the possibility of profiting in the future from upward movements in the underlying common shares as well as receiving in the interim interest or dividend payments. Underlying Security The security upon which a derivative contract, such as an option, is based. For example, the ABC June 35 call options are based on the underlying security ABC. Underwriting The purchase for resale of a security issue by one or more investment dealers or underwriters. The formal agreements pertaining to such a transaction are called underwriting agreements. Unemployment Rate The percentage of the work force that is looking for work but unable to find jobs.


Unified Managed Account A type of fee-based account that includes the same benefits as multi-disciplinary accounts. Enhancements include performance reports from the respective sub-advisors, outlining distinct models contained within the single custody account. Unit Two or more corporate securities (such as preferred shares and warrants) offered for sale to the public at a single, combined price. Unit Value The value of one unit of a segregated fund. The units have no legal status, and are simply an administrative convenience used to determine the income attributable to contract holders and the level of benefits payable to beneficiaries. Universal Market Integrity Rules (UMIR) A common set of trading rules that are applied in all markets in Canada. UMIR are designed to promote fair and orderly markets. Unlisted A security not listed on a stock exchange but traded on the over-the-counter market. Unlisted Market See also dealer market. Valuation Day The day on which the assets of a segregated fund are valued, based on its total assets less liabilities. Most funds are valued at the end of every business day. Value Manager A manager that takes a research intensive approach to finding undervalued securities. Value Ratios Financial ratios that show the investor the worth of the company’s shares or the return on owning them. Variable Rate Preferreds A type of preferred share that pays dividends in amounts that fluctuate to reflect changes in interest rates. If interest rates rise, so will dividend payments, and vice versa.

Variance Another measure of risk often used interchangeably with volatility. The greater the variance of possible outcomes the greater the risk. Vested The employee’s right to the employer contributions made on his or her behalf during the employee’s period of enrollment. Volatility A measure of the amount of change in the daily price of a security over a specified period of time. Usually given as the standard deviation of the daily price changes of that security on an annual basis. Voting Right The stockholder’s right to vote in the affairs of the company. Most common shares have one vote each. Preferred stock usually has the right to vote only when its dividends are in arrears. The right to vote may be delegated by the shareholder to another person. See also Proxy. Voting Trust An arrangement to place the control of a company in the hands of certain managers for a given period of time, or until certain results have been achieved, by shareholders surrendering their voting rights to a trustee for a specified period of time. Waiting Period The period of time between the issuance of a receipt for a preliminary prospectus and receipt for a final prospectus from the securities administrators. Warrant A certificate giving the holder the right to purchase securities at a stipulated price within a specified time limit. Warrants are usually issued with a new issue of securities as an inducement or sweetener to investors to buy the new issue. Working Capital Current assets minus current liabilities. This figure is an indication of the company’s ability to meet its short-term debts. Working Capital Ratio Current assets of a company divided by its current liabilities.

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Wrap Account Also known as a wrap fee program. A type of fully discretionary account where a single annual fee, based on the account’s total assets, is charged, instead of commissions and advice and service charges being levied separately for each transaction. The account is then managed separately from all other wrap accounts, but is kept consistent with a model portfolio suitable to clients with similar objectives. Writer The seller of either a call or put option. The option writer receives payment, called a premium. The writer in then obligated to buy (in the case of a put) or sell (in the case of a call) the underlying security at a specified price, within a certain period of time, if called upon to do so. Yield – Bond & Stock Return on an investment. A stock yield is calculated by expressing the annual dividend as a percentage of the stock’s current market price. A bond yield is more complicated, involving annual interest payments plus amortizing the difference between its current market price and par value over the bond’s life. See also Current Yield. Yield Curve A graph showing the relationship between yields of bonds of the same quality but different maturities. A normal yield curve is upward sloping depicting the fact that short-term money usually has a lower yield than longer-term funds. When short-term funds are more expensive than longer term funds the yield curve is said to be inverted. Yield to Maturity The rate of return investors would receive if they purchased a bond today and held it to maturity. Yield to maturity is considered a long term bond yield expressed as an annual rate. Yield Spread The difference between the yields on two debt securities, normally expressed in basis points. In general, the greater the difference in the risk of the two securities, the larger the spread. Zero Coupon Bonds See Strip Bonds.


Selected Web Sites

If you are connected to the Internet, you have access to all kinds of financial information. This list is far from complete. Many of these sites will have links to other related sites. Remember to type the site “address” exactly as listed. Some sites track usage by asking you for a password. Do not confuse the need to register and provide a password with the necessity to become a subscriber. Some sites offer a limited amount of information for free and require you to register and pay a fee before you can access more detailed information.


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SELECTED WEB SITES

BANKING Canadian Bankers Association: www.cba.ca

GOVERNMENT SOURCES Bank of Canada: www.bankofcanada.ca or www.banqueducanada.ca Canada Revenue Agency: www.cra-arc.gc.ca Financial Industry Regulatory Authority: www.finra.org Industry Canada: www.ic.gc.ca Office of the Superintendent of Financial Institutions: www.osfi-bsif.gc.ca Statistics Canada: www.statcan.gc.ca U.S. Securities and Exchange Commission: www.sec.gov

HEDGE FUNDS Canadian Hedge Fund Watch: www.canadianhedgewatch.com Dow Jones Credit Suisse Hedge Fund Index: www.hedgeindex.com Greenwich Alternative Investments: www.greenwichai.com Hedge Fund Association: www.thehfa.org Hedge Fund Centre: www.hedgefundcenter.com HedgeFund Intelligence: www.hedgefundintelligence.com

INSURANCE Financial Advisors Association of Canada (ADVOCIS): www.advocis.ca Insurance Canada: www.insurance-canada.ca


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INVESTMENT ORGANIZATIONS Canadian Deposit Insurance Corporation: www.cdic.ca Canadian Derivatives Clearing Corporation: www.cdcc.ca Canadian Investor Protection Fund (CIPF): www.cipf.ca Canadian Securities Institute: www.csi.ca Canadian Society of Technical Analysts: www.csta.org CDS Clearing and Depository Services Inc: www.cds.ca EDGAR: www.edgr.com International Organization of Securities Commissions: www.iosco.org Investment Industry Regulatory Organization of Canada: www.iiroc.ca Mutual Fund Dealers Association of Canada: www.mfda.ca North American Securities Administrators Association: www.nasaa.org System for Electronic Document Analysis and Retrieval: www.sedar.com World Federation of Exchanges: www.world-exchanges.org

INVESTOR SERVICES Advice for Investors: www.adviceforinvestors.com BigCharts: www.bigcharts.com Globeinvestor: www.theglobeandmail.com/globe-investor Investorwords: www.investorwords.com Investopedia: www.investopedia.com iShares: http://ca.ishares.com/home.htm Quicken Financial Network: www.quicken.ca Stockhouse: www.stockhouse.ca Yahoo Finance: http://ca.finance.yahoo.com/


SELECTED WEB SITES

MUTUAL FUNDS Fund Library: www.fundlibrary.com Globe Investor - Funds: www.globefund.com Investment Funds Institute of Canada: www.ific.ca

NEWS ORGANIZATIONS AND PUBLICATIONS Canada Newswire: www.newswire.ca Canoe (Canadian Online Explorer): www.canoe.ca Financial Post: www.financialpost.com Globe and Mail: www.theglobeandmail.com Moneysense: www.moneysense.ca

PROVINCIAL SECURITIES ADMINISTRATORS Alberta: www.albertasecurities.com British Columbia: www.bcsc.bc.ca Manitoba: www.msc.gov.mb.ca Ontario: www.osc.gov.on.ca Québec: www.lautorite.qc.ca New Brunswick: www.nbsc-cvmnb.ca/nbsc Newfoundland and Labrador: www.gs.gov.nl.ca Northwest Territories: www.justice.gov.nt.ca/securitiesregistry Nova Scotia: www.gov.ns.ca/nssc Prince Edward Island: www.gov.pe.ca/securities Saskatchewan: www.sfsc.gov.sk.ca Territory of Nunavut: www.gov.nu.ca Yukon: www.community.gov.yk.ca/corp/securities_about.html


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STOCK EXCHANGES CBOE: www.cboe.com CNSX: www.cnsx.ca Bourse de Montréal: www.m-x.ca Ice Futures Canada: www.theice.com/futures_canada.jhtml Nasdaq: www.nasdaq.com New York Stock Exchange: www.nyse.com NYSE Euronext: http://usequities.nyx.com/ Toronto Stock Exchange: www.tmx.com TSX Venture Exchange: www.tmx.com

TAXATION Canada Revenue Agency: www.cra-arc.gc.ca Canadian Tax Foundation: www.ctf.ca Ernst & Young (Canada): www.ey.com KPMG: www.kpmg.ca PricewaterhouseCoopers: www.pwc.com


Index


Ind•1

Ind•3

INDEX

Index A Accounting practices, 14•9 to 14•10 Accredited investors, 21•5 to 21•6, 21•21 Accrued interest, 6•11, 6•14 to 6•15, 6•26, 6•30, 7•26 to 7•27, 7•29 Acid test, quick ratio, 14•14 Active investment, 19•12 Active investment strategy, 16•11 Adjusted Cost Base, 19•15 disposition of shares, 25•12 to 25•14 identical shares, 25•12 to 25•13 shares with warrants or rights, 25•13 to 25•14 Advance-decline line, 13•25 to 13•26 After-market stabilization, 11•27 to 11•28 After-tax return on common equity, 14•19 to 14•20 Agency traders, 27•12 Agents, 2•10, 2•11 All or none (AON) orders, 9•19 Allocation, segregated funds and mutual funds, 20•11 to 20•12 Alpha, 15•16 Alternative trading systems (ATSs), 1•16 American-style option, 10•17 AMEX Market Value Index, 8•29 Amortization, 12•6 to 12•8 Analyst, 27•8 Annual information form (AIF), 18•7, 18•22 Annuitant, segregated fund, 20•5 Annuities, deferred or immediate, 25•23 Any part orders, 9•18 Arbitration, 3•13 Argonaut Fund, 21•19 Arrears, 8•16 Ask, 1•12 Asset allocation, 15•12, 15•17 to 15•18, 16•16 to 16•22 asset mix, 16•17 to 16•18 balancing asset classes, 16•18 dynamic, 16•21 integrated, 16•22 strategic, 16•19 to 16•20 tactical, 16•21 to 16•22 Asset class timing, 16•8


Asset classes, 15•12 balancing, 16•18 to 16•19 cash, 16•5 equities, 16•6 fixed-income products, 16•5 to 16•6 other asset classes, 16•6 Asset coverage ratios, 14•14 to 14•15 Asset mix, developing, 16•7 to 16•11 Asset-backed commercial paper (ABCP), 24•18 to 24•19 roll-over risk, 24•18 Asset-backed securities, 24•16 to 24•19 special purpose vehicle (SPV), 24•17 tranches, 24•17 to 24•18 Assets, 12•5, 12•6 to 12•10 amortization and depletion, 12•6 to 12•8 capitalization, 12•8 current, 12•9 to 12•10 intangible, 12•8 property, plant and equipment, 12•6 to 12•8 Assigned on an option, 10•17, 10•24, 10•25, 10•26, 10•28 Assuris, 20•15 At-the-money, 10•18 Attribution rules, 25•28 Auction market, 1•12 to 1•14 Audit, 12•19 Auditor’s report, 12•19 sample, 14•33 Authorized shares, 11•17 Autorité des marchés financiers (AMF), 3•6

B Back-end loads, 18•12, 18•13 to 18•14 Balance of payments, 4•30 to 4•31 capital account, 4•30 to 4•31 current account, 4•30 to 4•31 Bank Act, 2•12 revisions, 2•7, 2•12

Bank of Canada, 4•23 to 4•25, 5•10 to 5•17, 13•9 advisor to the Government, 5•11 bank notes, 5•11 cash management, 5•16 to 5•17 debt management, 5•12 drawdowns and redeposits, 5•17 duties and role, 5•10 fiscal agent, 5•11 functions, 5•11 to 5•12 interest rates, 4•23 to 4•25 lender of last resort, 5•13 to 5•14 monetary policy, 4•25 to 4•27, 5•12 to 5•17 open market, 5•14 to 5•16 Bank rate, 5•14, 5•15, 5•14, 5•16 Bankers’ acceptance, 6•24 Banking group agreement, 11•26 Bankruptcy, segregated funds, 20•8 to 20•9 Basis points, 5•13 Bearer bonds, 7•25 Benchmark for portfolio managers, 16•24 Benchmark index for funds, 19•23 Beneficial owner, 3•22 Beneficiary, segregated fund, 20•6 Bid, 1•12 Blue skyed issue, 11•23 Blue-chip shares, 13•15 Bond index fund, 7•28 Bond market, 13•9 Bond pricing principles, 7•5 to 7•11 discount rate, 7•6 to 7•7 fair price, calculating, 7•7 to 7•11 income stream, present value, 7•7 to 7•10 present value (PV), 7•5 to 7•11 principal, present value, , 7•7 to 7•10 term structure of interest rates, 7•15 to 7•16 yield calculations, 7•12 to 7•15 Bond pricing properties, 7•19 to 7•24 coupon rate, 7•6, 7•21 to 7•24 duration, 7•23 to 7•24 interest rates, 7•19 to 7•24 term to maturity, 7•23 yield changes, 7•22 Bond quote, 6•26

Ind•4


Bond rating services, 6•27 to 6•28 Bond residue, 6•10 Bond trading, 7•25 to 7•27 accrued interest, 7•26 to 7•27 clearing and settlement, 7•25 settlement periods, 7•25 to 7•26 Bonds, 1•9 to 1•10, 6•6 to 6•28, 7•5 to 7•29 accrued interest, 6•11, 6•14, 7•26 to 7•27 advantages and disadvantages for issuer, 11•19 to 11•20 call features, 6•10 to 6•12 call protection period, 6•11 Canada Premium Bonds (CPBs), 6•17 Canada Savings Bonds (CSBs), 6•17 to 6•18 Canada yield call, 6•11 to 6•12 coupon rate, 6•7 credit quality, 16•15 denominations, 6•8 direct, 11•15 discount, 6•9 discount rate, 7•6 to 7•7 distinguished from debentures, 6•7 domestic, 6•22 election period, 6•13 Eurobonds, 6•23 extendible or retractable, 6•12 face value, 6•8 foreign, 6•23 Government of Canada, 6•17 to 6•19, 11•14 to 11•15 Guaranteed, 6•20, 11•15 to 11•16 indexes, 7•28 to 7•29 index-linked notes, 6•8 liquid, negotiable, and marketable, 6•9 to 6•10 municipal, 6•20 to 6•21, 11•16 par value, 6•7 premium, 6•9 present value, 7•5 to 7•11 protective provisions, 6•16, 11•16, 11•20 provincial government, 6•19 to 6•20, 11•15 to 11•16 purchase fund, 6•15 to 6•16 quotes and ratings, 6•26 to 6•28 redeemable, 6•10 sinking fund, 6•15 to 6•16 strip, 6•10 tax-deductibility of income payments, 6•6 term to maturity, 6•8 trust deed, 6•7 yield calculations, 7•12 to 7•14


yield spread, 6•11 yield to maturity, 7•12 to 7•14 Book value, 12•6, 12•11, 14•25, 14•27 Book-based format for bonds, 7•26 Bottom-up investment approach, 16•12 to 16•13 Bought deal, 11•24 Bourse de Montréal, 1•12, 10•7, 10•10, 10•11, 10•33 Broker, 16•11 Broker dealer, 27•4 to 27•6 Broker of record, 11•19 Bucketing, 3•19 Budget deficit, 1•6, 5•7 to 5•8, 5•18 Budget surplus, 1•6, 5•7 to 5•8, 5•18 Budget, federal, 1•8, 5•7 to 5•8, 5•18 Business cycle, 4•13 to 4•19 economic indicators, 4•16 to 4•18 identifying recessions, 4•18 to 4•19 phases, 4•13 to 4•16 Business risk, 15•10 Business trusts, 22•5, 22•8 to 22•9 Buy and sell orders, 9•18 to 9•21

C CAC 40 Index, 8•30 Caisses populaires, 2•14 Call options, 10•6, 10•15 buying call options, 10•21 to 10•22 distinguished from rights and warrants, 10•36 writing call options, 10•24 Call protection period, 6•11 Callable bonds, 6•10 Callable preferreds, 8•17 Canada Business Corporations Act (CBCA), 11•8 Canada Deposit Insurance Corporation (CDIC), 3•5 to 3•6, 6•25 Canada Education Savings Grant (CESG), 25•26 Canada Investment and Savings (CI&S), 5•12 Canada Pension Plan (CPP), 2•16 Canada Premium Bonds (CPBs), 6•17, 6•18 to 6•19 Canada Savings Bonds (CSBs), 6•17, 6•18 to 6•19 payroll savings plan, 6•18

real return bonds (RRBs), 6•19 real return bonds (RRBs), 6•19 Canada yield call, 6•11 to 6•12 Canadian bond indexes, 7•28 Canadian Derivatives Clearing Corporation (CDCC), 10•8 Canadian dollar and the exchange rate, 4•32 Canadian Investor Protection Fund (CIPF), 3•10 to 3•12 Canadian Life and Health Insurance Association Inc. (CLHIA), 20•14 Canadian National Stock Exchange (CNSX), 1•13, 1•14, 1•16 Canadian Originated Preferred Securities (COPrS), 24•16 Canadian Payments Association (CPA), 5•13 to 5•14 Canadian Securities Administrators (CSA), 3•7 Canadian Securities Course (CSC), 3•15 Canadian Unlisted Board Inc. (CUB), 1•16 CanDeal, 1•17 CanPX, 1•17 Capital, 1•5 to 1•8, 4•11, 4•12, 4•23 characteristics, 1•5 to 1•6 need for, 1•6 sources, 1•6 to 1•8 users, 1•7 to 1•8 Capital account, 4•30 to 4•31 Capital gains, tax treatment, 8•11 Capital loss, 8•11, 25•15 to 25•17, 25•20 Capital losses, tax treatment, 8•11, 25•15 to 25•17, 25•20 Capital Pool Company (CPC), 11•29 to 11•30 Capital stock, 11•17 Capital structure, 14•7, 14•14 Capitalizing, 12•8 Carrying charge, 25•9 to 25•10 Cash accounts, 9•5 to 9•6 free credit balances, 9•6 Cash and cash equivalents, 12•10 Cash flow, 14•16 to 14•17 Cash flow statement, 12•16 to 12•19 change in cash flow, 12•18 to 12•19 financing activities, 12•18 investing activities, 12•18 operating activities, 12•17 to 12•18 Cash flow/total debt ratio, 14•15 to 14•16 Cash management, 5•16 to 5•17

Ind•5

INDEX

Cash-secured put write, 10•28 to 10•29 Cash-settled futures, 10•30 CBID, 1•17 CDS Clearing and Depository Services, Inc. (CDS), 2•11, 7•26 Chairman of the board, 11•12 Chart analysis, 13•19 to 13•24 continuation patterns, 13•21 to 13•22 head-and-shoulders formation, 13•20 to 13•21 neckline, 13•21 resistance level, 13•20 reversal patterns, 13•20 support level, 13•20 symmetrical triangle, 13•21 to 13•22 Chartered banks, 2•12 to 2•13 Bank Act, 2•12, 2•13, 2•16 Schedule I banks, 2•12 to 2•13 Schedule II banks, 2•13 Schedule III banks, 2•13 Chinese walls, 2•13 Clearing and Depository Services Inc. (CDS), 2•11, 7•26, 8•5 Clearing corporation, 10•8 Clearing system for securities, 2•11 Client scenarios, 26•28 to 26•34 Collecting information, 26•6 to 26•7 communicating and educating, 26•7 Closed-end discretionary funds, 22•5 Closed-end funds, 2•16, 22•5 to 22•6 advantages, 22•5 to 22•6 disadvantages, 22•6 Closet indexing, 19•12 to 19•13 Code of ethics, 26•12 to 26•13 Coincident indicators, 4•17 Collateral trust bond, 6•22 Collecting Data and Information, on clients, 26•6 to 26•7 Commercial paper, 6•24 to 6•25 Commodities, 10•10 Commodity futures, 10•31 Commodity pools, 21•6 Common shares, 1•7, 1•11, 8•5 to 8•13 benefits of ownership , 8•5 to 8•6 capital appreciation, 8•6 dividends, 8•6 to 8•9 equity financing, 11•16 to 11•17 pros and cons for issuer, 11•20 reading stock quotations, 8•13 restricted, 8•9 to 8•10 stock split, 8•12


tax treatment, 8•10 to 8•11 voting rights, 8•9 to 8•10 Communication with clients, 26•7 financial statements, 14•9 to 14•12 preferred share investment quality, 14•27 to 14•28 ratio analysis, 14•12 to 14•26 sample financial statements, 14•31 to 14•33 Competitive tender, 11•14 Conduct and Practices Handbook, 2•9, 3•14, 3•15 Conduct in accordance with securities acts, 26•20 Confidentiality, 26•20 Confirmation, 9•14 to 9•15 Consolidations, 8•12 Constant proportion portfolio insurance (CPPI), 24•7 Consumer loan companies, 2•16 Consumer Price Index (CPI), 4•26 to 4•27 Continuation patterns, 13•21 to 13•22 Continuous disclosure, 3•20 to 3•21, 11•23 to 11•24 Contraction, 4•14 Contrarian investors, 13•24 Contribution in kind, 25•20 Conversion price, 6•13 Conversion privilege, 6•13 Convertible arbitrage strategy, 21•15 Convertible bonds, 6•13 to 6•15 characteristics, 6•14 forced conversion, 6•14 to 6•15 market performance, 6•15 Convertible preferreds, 8•18 to 8•21 example, 8•19 features, 8•16 to 8•17 Corporate bonds, 6•21 to 6•24 collateral trust bond, 6•22 corporate note, 6•22 domestic bonds, 6•22 equipment trust certificate, 6•22 Eurobonds, 6•23 floating-rate securities, 6•22 foreign bonds, 6•23 mortgage bond, 6•21 preferred debentures, 6•23 to 6•24 protective provisions, 6•16, 11•16, 11•20 strip bonds, 6•10 subordinated debentures, 6•22 Corporate note, 6•22 Corporate treasury department, 27•4

Corporations, 11•6 to 11•12 advantages and disadvantages, 11•7 to 11•8 by-laws, 11•9 corporations officers , 11•12 directors, 11•12 private or public, 11•9 structure, 11•11 to 11•12 voting and control, 11•9 to 11•10 Correlation, 15•14 to 15•16 Cost method for equity income, 12•14 Cost of goods sold, 12•9, 12•10 Cost of Sales, 12•13, 12•24 Cost-push inflation , 4•28 Country risk evaluation, 1•5 to 1•6 Coupon rate on bond, 6•7, 6•8, 7•6, 7•12, 7•14, 7•19 to 7•22, 7•26 Covenants, 11•20 Covered call writing, 10•25 Covered put writing, 10•28 Credit Assessment, 14•28 Credit quality, bonds, 16•15 to 16•16 Credit unions, 2•14 deposit insurance, 3•7 Cum dividend, 8•7 Cum rights, 10•36, 10•37, 10•38 Currency translation, 12•15 Current account, 4•30 to 4•31 exchange rate and the canadian dollar, 4•32 Current assets, 12•9 to 12•10 Current liabilities, 12•11 to 12•12 Current ratio, 14•13 Cycle analysis, 13•25 Cyclical industries, 13•15 Cyclical unemployment, 4•22

D Daily valuation method, 19•22 DAX Index, 8•29 Day orders, 9•19 Dealer, 11•19 to 11•20 advice on protective provisions, 11•20 advice on security design, 11•19 broker of record, 11•19 new issue, 11•18 to 11•20 Dealer markets, 1•14 to 1•16 Death benefit, segregated fund, 20•7 to 20•8 Debentures, 1•9, 6•7, 11•18, 11•19 Debt, 1•9 national debt, 5•8, 5•9, 5•18 Debt financing, 11•18

Ind•6


Debt instruments, 1•9 Debt management, and Bank of Canada, 5•12 Debt/equity ratio, 14•15 to 14•16 Decision makers in economy, 4•7 Declining industries, 13•14 Declining-balance method, 12•7 Dedicated short bias, 21•20 Deemed disposition, 25•16, 25•20, 25•28 Default risk, 10•8, 15•11 Defensive industries, 13•15 Deferred annuity, 25•23 Deferred preferred shares, 8•23 Deferred sales charge, 18•13 to 18•14 Deferred tax liabilities, 12•11, 12•23 Defined benefit plan (DBP), 25•18 Defined contribution plan (DCP), 25•18 Deflation, 4•30 Delayed floaters, 8•22 Delayed opening, 11•33 Delisting, 11•33 Demand and supply, 4•7 to 4•9 Demand-pull inflation , 4•28 Depletion, 12•6 to 12•8 Depreciation, 12•6 to 12•8 Derivatives, 1•10, 1•15, 10•3 to 10•40, 15•13 clearing corporation, 10•8 commodities, 10•10 corporations and businesses, 10•13 to 10•14 dealers, 10•14 default risk, 10•8 exchange-traded, 10•7 exchange-traded vs OTC, 10•7 to 10•9 expiration date, 10•6 financial, 10•10 to 10•11 forwards, 10•6 hedging, 10•13 to 10•14 investors, individual, 10•11 investors, institutional, 10•12 to 10•13 mutual funds, use by, 18•24 to 18•25 over-the-counter (OTC), 10•7 to 10•9 performance bond, 10•6, 10•32 regulation, 10•8 to 10•9 underlying assets, 10•6, 10•10 to 10•11 who are the users of derivatives?, 10•11 to 10•14 zero-sum game, 10•7 Determinants, 4•33 to 4•34


Direct bonds, 11•15 to 11•16 Directors of a corporation, 11•12 Directors’ circular, 3•23 continuous, 3•20 to 3•21, 11•23 to 11•24 early warning, 3•24 full, true and plain, 3•14 Discount rate on bond, 7•6 to 7•7 Discouraged workers, 4•21 to 4•22 Discretionary accounts, 23•7 to 23•8 Disinflation, 4•29 of debt securities, 25•14 of shares, 25•12 to 25•14 Distressed debt, 1•10 Distressed securities strategy, 21•17 Diversification, 15•11, 15•13, 15•14, 15•15 Dividend Discount Model (DDM), 13•16 to 13•17 Dividend payments, in company analysis, 14•27 Dividend payout ratios, 14•21 Dividend record, 14•6 Dividend record date, 8•7 Dividend reinvestment plan, 8•8 to 8•9 Dividend tax credit, 8•10 to 8•11, 8•18 Dividend yield, 14•23 to 14•24 Dividends, 8•6 to 8•9 cum, 8•7 declaring and claiming, 8•7 ex-dividend, 8•7 preferred, 8•14 to 8•15 regular and extra, 8•7 reinvestment plans, 8•8 to 8•9 stock, 8•9 Dollar cost averaging, 8•9 Domestic bonds, 6•22 Dominion Bond Rating Service (DBRS), 6•27 to 6•28, 14•28 Dow Jones Industrial Average (DJIA), 8•24, 8•28 Drawdown, 5•17 corporate financing report, 11•18 hedge funds, 21•11 to 21•13 Duration of bond, 7•23 to 7•24 Duty of care, 26•14 to 26•15 Dynamic asset allocation, 16•21

E Early redemption fee, 18•15 Early warning disclosure, 3•24 Earnings per common share (EPS), 14•21 to 14•23 Economic cycles, 16•8 to 16•11 equity cycles and, 16•8 to 16•11

Economic growth, 4•9 to 4•12 effect of interest rates, 4•24 industrialized countries, 4•11 to 4•12 measuring GDP, 4•10 productivity and growth, 4•11 to 4•12 Economic indicators, 4•16 to 4•18 Economic slowdown, 4•19 Economic theories, 5•5 to 5•6 Keynesian economics, 5•5 monetarist theory, 5•6 rational expectations theory, 5•5 supply-side economics, 5•6 Economies of scale, 13•12 Efficient market hypothesis, 13•7 Election period, 6•13 Electronic trading systems, 1•16 to 1•17 Elliott Wave Theory, 13•25 Emerging growth industries, 13•13 Emerging markets hedge funds, 21•19 Endowment, 27•5 Equilibrium price, 4•8 Equipment trust certificate, 6•22 Equity, 12•5, 12•10 to 12•11, 12•15 to 12•16, 12•23 Equity capital, 11•13 Equity cycles, 16•7, 16•8 economic cycles and, 16•8 to 16•11 Equity financing, 11•16 Equity index derivatives, 10•6, 10•32 Equity market-neutral strategy, 21•15 Equity value per common share, 14•25 to 14•26 Equity value per preferred share, 14•27 Equity value ratios, 14•25, 14•27 Escrowed shares, 11•29 Ethical trading, 3•18 to 3•19 Ethics, 26•12 to 26•21 Code of Ethics, 26•12 to 26•13 investment constraint, 15•22 to 15•23 Standards of Conduct, 26•13 to 26•21 Eurobonds, 6•23 European-style option, 10•17 Ex rights, 10•37, 10•38 Ex-ante return, 15•7 Exchange offering prospectus, 11•29 Exchange rate, 4•31 to 4•35 Exchange-trade fund (ETF) wraps, 23•9 to 23•10

Ind•7

INDEX

Exchange-traded funds (ETFs), 10•20, 22•9 to 22•14 Ex-dividend, 8•7 to 8•8 Ex-dividend date, 8•7 Exercise price, 10•16 Exercise rights on an option, 10•6, 10•17 Expansion phase of business cycle, 4•14 Expectations theory, 7•17 individual stock, 15•6 to 15•8 Expenditure approach to GDP, 4•10 Expiration date on derivatives, 10•6 Ex-post return, 15•7 Extendible bonds, 6•12 to 6•13 Extension date, 6•13 Extra dividend, 8•7

F Face value of bond, 6•8 F-class fund, 18•16 Federal budget, 5•7 to 5•8, 5•19 Fee-based accounts, 23•4 to 23•13 advantages and disadvantages, 23•7 discretionary accounts, 23•7 to 23•8 ETF wrap, 23•9 to 23•10 managed accounts, 23•5 to 23•6, 23•8 to 23•12 multi-disciplinary accounts, 23•12 multi-manager accounts, 23•10 to 23•13 mutual fund wraps, 23•11 non-managed accounts, 23•6 overlay manager, 23•10 to 23•11, 23•12 private family office, 23•13 proprietary managed program, 23•9 separately managed accounts, 23•11 to 23•12 single-manager accounts, 23•8 to 23•10 unified managed accounts, 23•12 to 23•13 FIFO (first-in-first-out), 12•9 to 12•10 Final good, 4•9 Final prospectus, 11•22 to 11•23 Financial derivatives, 10•10 to 10•11 currencies, 10•11 equity index, 10•6, 10•32 interest rates, 10•11 Financial futures, 10•31, 10•32, 10•33


Financial institutions, 2•7 distribution of mutual funds, 18•34 to 18•35 Financial instruments, 1•9 to 1•10 debt instruments, 1•9 derivatives and others, 1•10 equity, 1•10, 11•16 investment funds, 1•9, 2•16 Financial leverage, 6•6 Financial markets, trends, 1•17 Financial planning process, 26•5 to 26•9 Collecting data, 26•6 to 26•7 determining goals and objectives, 26•5 to 26•7, 26•9, 26•11 noting problems and constraints, 26•8 plan development and implementation, 26•9 reviews and revisions, 26•9 Financial planning pyramid, 26•11 Financial ratios, 14•12 to 14•26 liquidity ratios, 14•12, 14•13 to 14•14 operating performance ratios, 14•12, 14•19 to 14•21 risk analysis ratios, 14•12, 14•14 to 14•18 value ratios, 14•12, 14•21 to 14•26 Financial statements, 3•20 to 3•21, 12•2 to 12•25, 14•31 to 14•33 external comparisons, 14•11 to 14•12 interpreting, 14•9 to 14•12 notes to, 12•19, 14•9 specimen sample, 12•23 to 12•25, 14•31 to 14•33 trends, 14•10 to 14•11 after-market stabilization, 11•27 to 11•28 Bank of Canada, 11•14 to 11•15 bonds, 6•19 to 6•21, 11•15 to 11•16 bought deal, 11•24 Canada Premium Bonds (CPBs), 6•18 Canada Savings Bonds (CSBs), 6•18 competitive tender system, 11•14 corporate financing process, 11•18 to 11•28 dealer, choosing, 11•19 to 11•20 debt financing, 11•18 decisions involved, 11•16 delisting, 11•33 distributors, 11•14 due diligence report, 11•18 equity financing, 11•16

financing alternatives, 11•18 listing procedure, 11•30 to 11•31 listing, pros and cons, 11•31 to 11•32 marketable bonds, 6•17 method of offering, 11•21 negotiated offering, 11•16 non-competitive tender, 11•14 to 11•15 primary dealers, 11•14 primary or secondary offering, 11•21 private placement, 11•21 public offerings, 11•21 security types, pros and cons, 11•19 to 11•20 step-by-step summary, 11•25 syndicate, 11•16 transparency, 11•15 treasury bills (T-bills), 6•18, 7•11 to 7•12, 15•7 to 15•10 withdrawing trading privileges, 11•32 to 11•33 Financing, corporations, 1•8, 11•13 to 11•28 Financing, federal government [y], 1•8, 6•17 to 6•19 Financing, individuals, 1•7 Financing, municipal government, 1•8, 6•20 to 6•21 Financing, provincial government, 1•8 First mortgage bonds, 6•21 Fiscal agent, 11•15 Bank of Canada as, 5•11 to 5•12 Fiscal policy, 5•7 to 5•9, 13•8 effects on the economy, 5•8 to 5•9 Fiscal year, 25•6 Fixed and floating, 4•34 Fixed exchange rate, 4•34 Fixed floaters, 8•22 Fixed-dollar withdrawal plan, 19•17 to 19•20 Fixed-income arbitrage strategy, 21•15 Fixed-income securities, 1•9, 6•6 to 6•7, 15•10 Fixed-period withdrawal plan, 19•19 Fixed-reset feature, 8•22 Floating exchange rate, 4•35 Floating-rate preferreds, 8•22 Floating-rate securities, 6•8, 6•22 Flow of funds, 13•10 Forced conversion, 6•14 to 6•15 Foreign bonds, 6•23 Foreign exchange risk , 15•10 Foreign investment in Canada, 1•7

Ind•8


Foreign-pay preferreds, 8•23 Forward agreement, 10•31 Forwards, 10•6, 10•31 Free credit balances, 9•6 Frictional unemployment, 4•22 Friedman, Milton, 5•6 Front running, 3•19 Front-end loads, 18•12 to 18•13 FTSE 100 Index, 8•29 Fully diluted earnings per share, 14•22 Fund management styles, 19•12 to 19•13 active investment, 19•12 indexing, 19•12 to 19•13 passive investment strategy, 19•12 Fundamental industry analysis, 13•11 to 13•16 Fundamental macroeconomic analysis, 13•7 to 13•11 Fundamental valuation models, 13•16 to 13•18 dividend discount model (DDM), 13•16 to 13•17 price-earnings (P/E) ratio, 13•17 to 13•18 Funds of hedge funds (FoHF), 21•21 to 21•22 advantages, 21•21 to 21•22 disadvantages, 21•22 types, 21•21 Futures, 10•7, 10•10 to 10•11, 10•31 to 10•35 commodities, 10•10, 10•13, 10•31 exchanges, 10•33 financials, 10•10 to 10•11, 10•31 Futures contract, 10•31, 10•32, 10•33 Futures strategies, 10•33 to 10•34 buying futures to manage risk, 10•34 buying futures to speculate, 10•33 corporations, 10•34 to 10•35 selling futures to manage risk, 10•34 selling futures to speculate, 10•34 simpler than options, 10•33 temporary switches, 10•12

G General partnership, 11•6 German DAX Index, 8•29 Glide path, 19•10 Global bond indexes, 7•28 Global macro strategy, 21•19


Good through orders, 9•20 Good till cancelled (GTC) orders, 9•19 Good-faith deposit, 10•6, 10•32 Goodwill, 12•8 Government debt, 5•7, 5•8, 5•9, 5•18, 13•8 Government policy challenges, 5•17 to 5•18 Government securities distributors, 11•14 Government spending, 5•8, 13•8 Green shoe option, 11•28 Greensheet, 11•23 Gross Domestic Product, 4•9 measuring, 4•9 real and nominal, 4•10 to 4•11 Gross profit, 12•13 Gross profit margin ratio, 14•19 Growth capital, 1•10 Growth industries, 13•13 Growth investing, 16•12 Growth securities, 15•19 Guaranteed bonds, 6•20, 11•15 to 11•16 Guaranteed Investment Certificates (GICs), 6•25 to 6•26 Guaranteed minimum withdrawal benefit (GMWB) plan, 20•16 to 20•17

H Halt in trading, 11•33 Head-and-shoulders formation, 13•20 to 13•21 Hedge fund strategies, 21•14 to 21•20 convertible arbitrage, 21•15 dedicated short-bias, 21•20 Directional, 21•17 to 21•20 distressed securities, 21•17 emerging markets, 21•19 equity market-neutral, 21•15 event-driven, 21•17 fixed-income arbitrage, 21•16 global macro, 21•19 high-yield bond, 21•17 long/short equity, 21•17 to 21•18 managed futures, 21•20 merger or risk arbitrage, 21•17 relative value, 21•15 to 21•16 Hedge funds, 16•6, 21•2 to 21•23 benefits, 21•9 defined, 21•5 due diligence, 21•12 to 21•13 funds of hedge funds (FoHF), 21•21 to 21•22

history, 21•7 institutional investors, 21•6, 27•5, 27•10 mutual funds, compared with, 21•5 to 21•6 retail investors, 21•6 to 21•7 risks of investing, 21•9 to 21•12 size of the market, 21•8 tracking performance, 21•8 who can invest?, 21•6 to 21•7 Hedging, 10•13 to 10•14 defined, 10•12 derivatives, 10•13 to 10•14 legal question, 10•14 High-water mark, 21•11 High-yield bond strategy, 21•17 Historical returns, 15•7 to 15•8, 15•12 Holding period return, 15•7

I ICE Futures Canada, 1•13, 10•7, 10•8, 10•20, 10•33 Immediate annuities, 25•23 Incentive fees, 21•10 to 21•11 Income approach to GDP, 4•10 Income splitting, 25•27 Income Tax, 12•15 Income tax expense, 12•15, 12•24 Income taxes, 25•2 to 25•28 borrowed funds, 25•10 calculating, 25•7 capital gains and losses, 25•6, 25•11 to 25•17, 25•20, 25•24, 25•28 carrying charges, 25•9 to 25•10 debt securities, 25•14 dividends, 25•7 to 25•8 federal and provincial, 25•5 to 25•7 interest income, 25•7, 25•8, 25•9, 25•14 marginal tax rate, 25•7 to 25•8 minimizing taxable investment income, 25•8 payment, 25•17 share dispositions, 25•12 to 25•14 superficial losses, 25•15 to 25•16 system in Canada, 25•5 to 25•6 tax loss sale, 25•17 tax rates, 25•7 taxation year, 25•6 types of income, 25•6

Ind• 9

INDEX

Income trusts, 22•6 to 22•7 business trusts, 22•5, 22•8 to 22•9 real estate investment trusts (REITs), 22•7 taxation, 22•8 to 22•9 two primary categories, 22•7 Incorporation, 11•6 to 11•10 advantages and disadvantages, 11•7 to 11•8 jurisdiction, 11•8 procedure, 11•6 to 11•10 Index funds, 19•9 to 19•10 hedge funds, 21•8 mutual fund management style, 19•12 portfolio management style, 16•12 Index-linked GICs, 24•10 to 24•12 Index-linked notes, 6•8 Indirect investment, 1•5 Individual variable insurance contract (IVIC), 20•5 Industry analysis, 13•11 to 13•16 competitive forces, 13•14 product or service, 13•11 to 13•12 stage of growth, 13•13 to 13•14 stock characteristics, 13•14 to 13•16 Industry rotation, 16•14 to 16•15 Inflation, 4•25 to 4•28, 13•7 to 13•9, 13•10 to 13•11, 13•17 causes, 4•28 costs, 4•27 to 4•28 differentials, 4•33 impact, 13•10 to 13•11 real interest rate, and, 4•25 real rate of return, and, 7•15 to 7•16 risk, 15•10 Information circular, 11•10 Initial public offering (IPO), 11•13, 11•21, 11•27 to 11•28 Insider reporting, 3•25 Insider trading, 3•24 to 3•25 Insiders, defined, 3•24 Instalment debentures, 1•8, 6•20 corporate treasuries, 27•4 definition, 1•8 endowments, 27•5 hedge funds, 27•5 insurance companies, 27•4 mutual funds, 27•5 pension funds, 27•5 suitability standards, 27•7 trusts, 27•6 Institutional salesperson, 27•8


Institutional securities firms, 2•7 to 2•8 Institutional traders, 27•8 Insurance Companies Act (Canada), 2•15 Insurance industry, 2•14 to 2•16 life insurance companies, 2•14 to 2•15 products and services, 2•15 property and casualty insurance, 2•14 to 2•15 regulation, 2•15 to 2•16 Intangible assets, 12•8 to 12•9 Integrated asset allocation, 16•22 Integrated firms, 2•7 Interest coverage ratios, 14•17 to 14•18 Interest rate, 4•23 to 4•25 bond prices and, 7•19 to 7•20 differentials, 4•33 effect on economy, 4•24 expectations, 4•24 to 4•25 factors, 4•23 to 4•24 nominal and real, 4•24 to 4•25 term structure, 7•15 to 7•16 Interest rate anticipation, 16•16 Interest rate risk, 15•10 International Financial Reporting Standards (IFRS), 12•8, 12•11, 12•19 Interval funds, 22•5 In-the-money, 10•18 of options, 10•18 of rights, 10•37 to 10•38 of warrants, 10•39 to 10•40 Inventories, 12•9 Inventory turnover ratio, 14•20 to 14•21 Investigations, 3•21 Investment advisors (IAs), 1•11, 3•14 registration and training, 3•14 to 3•15 Investment banker, 27•9 Investment constraints, 15•22 to 15•23 legal, 15•23 liquidity, 15•22 tax requirements, 15•22 time horizon, 15•22 unique circumstances, 15•23 Investment dealers, 2•7 Investment funds, 1•9, Investment Funds Standards Committee (IFSC), 19•5 Investment Industry Association of Canada (IIAC), 3•9

Investment Industry Regulatory Organization of Canada (IIROC), 1•17, 13•8 to 3•9, 3•15 Investment objectives, 15•20 to 15•22 growth of capital, 15•21 income, 15•20 to 15•21 marketability, 15•21 overview of portfolio management, 15•17 portfolio risk and return, 15•18 to 15•23 safety of principal, 15•20 tax minimization, 15•20 Investment policy statement, 15•23 Investment representatives (IRs), 3•15 Investments in associates, 12•9, 12•23 Investors’ rights, 3•21 to 3•22 Irrevocable designation of beneficiary, 20•6 Issued shares, 11•17

J Jones, Alfred, 21•7

K Keynes, John Maynard, 5•5 Keynesian economics, 5•5 Know your client, 3•16 Krugman, Paul, 26•14

L Labour force, 4•20 Labour Force Survey, 4•20 Labour market in Canada, 4•22 participation rate, 4•20 unemployment rate, 4•20 to 4•23 Labour-sponsored venture capital corporation (LSVCC), 18•17 to 18•18 advantages, 18•17 to 18•18 disadvantages, 18•18 Laddering, 16•6 Lagging indicators, 4•18 Large Value Transfer System (LVTS), 5•16 Laws of Demand and Supply, 4•7

Ind•10


Leading indicators, 4•16 to 4•17 Bank Act, 2•13 to 2•16 Bank of Canada Act, 5•10 to 5•11 Bankruptcy and Insolvency Act, 20•9 Cooperative Credit Associations Act, 2•14 Insurance Companies Act, 2•15 Trust and Loan Companies Act, 2•15 Lender of last resort, 5•13 to 5•14 options, 10•23 warrants, 10•39 to 10•40 Liabilities, 12•5, 12•11 to 12•12 current, 12•11 to 12•12 long-term debt, 12•11 Liability traders, 27•12 to 27•13 Life cycle, 26•10 to 26•11 Life expectancy-adjusted withdrawal plan, 19•19 Life insurance companies, 2•14 to 2•15 Limit orders, 9•19 Limited partnership, 11•6 hedge funds, 21•6 Liquid bonds, 6•9 Liquidity, 1•13 common shares, 14•8 hedge funds, 21•10 portfolio management, 15•22 Liquidity preference theory, 7•18 Liquidity ratios, 14•12, 14•13 to 14•14 current ratio (working capital), 14•13 quick ratio (acid test), 14•14 Liquidity risk, 15•10 Listed private equity, 22•15 to 22•17 Listing agreement, 11•30 to 11•31 Loan companies, 2•16 Lockup, 21•10 Long margin accounts, 9•6 to 9•9 Long position, 9•5 Long Term Capital Management (LTCM), 21•16 Long/short equity strategy, 21•17 to 21•19 Long-term debt, 12•11 Long-Term Equity AnticiPation Securities (LEAPS), 10•17


M Macroeconomic analysis, 13•7 to 13•11 fiscal policy impact, 13•8 flow of funds impact, 13•9 inflation impact, 13•10 to 13•11 monetary policy impact, 13•9 to 13•10 Macroeconomics, 4•6 Managed accounts, 23•5 to 23•6, 23•8 to 23•12 Managed futures funds, 21•20 Managed products, 17•6 to 17•7 advantages, 17•10 to 17•11 changing compensation models, 17•16 compared with structured products, 17•10 disadvantages, 17•12 evolving market, 17•14 to 17•16 risks, 17•13 types, 17•8 to 17•9 Management expense ratio (MER), 18•16 Management of securities firm, 2•8 to 2•9 Management styles, 16•11 to 16•16 equity managers, 16•12 to 16•15 fixed-income managers, 16•15 to 16•16 Margin, 9•6 to 9•7 Margin Account Agreement Form, 9•6 Margin accounts, 9•5, 9•6 to 9•9 examples of margin transactions, 9•8 to 9•9, 9•11 to 9•12 long positions, 9•7 to 9•9 risks, 9•9 Margin call, 9•7, 9•8 Marginal tax rate, 25•7 Market, 4•7 Market capitalization, 11•17 Market equilibrium, 4•7 to 4•9 Market inefficiencies, 13•7 Market makers, 1•14, 1•15 Market orders, 9•18, 9•20 Market segmentation theory, 7•18 Market theories, 13•6 to 13•7 Market timing, 15•21 Marketable bonds, 6•10, 6•17 Marking-to-market, 10•32 Material change, 3•20 Material fact, 11•22 Mature industries, 13•13 to 13•14 Maturity date, 6•6, 6•8 Maturity guarantees, 20•6 to 20•7 tax treatment, 20•12 to 20•13 Merger arbitrage strategy, 21•17

MFDA Investor Protection Corporation (IPC), 3•12 Microeconomics, 4•6 Modified Dietz method, 19•22 Monetarist theory, 5•6 Monetary aggregates, 4•25 Monetary policy, 5•12 to 5•17, 13•7 to 13•10 bond market, 13•9 goal, 5•12 government debt, 13•8 implementing policy, 5•13 to 5•14 open market operations, 5•14 to 5•16 yield curve, 13•9 to 13•10 Money, 4•25 medium of exchange, 4•25 store of value, 4•25 unit of account, 4•25 Money market funds, 19•5 to 19•6 Money purchase plan (MPP), 25•18 Monitoring, 14•9, 16•22 to 16•23 client objectives, 16•23 economy, 16•23 markets, 16•23 Montreal Exchange (MX), 1•13 Moody’s Canada Inc, 6•27 Mortgage, 6•21 Mortgage bond, 6•21 Mortgage-backed securities, 24•20 to 24•22 pass-through securities, 24•20 prepayment risk, 24•20 Moving average, 13•22 to 13•23 Moving average convergencedivergence (MACD), 13•24 Multi-disciplinary accounts, 23•12 Multi-manager accounts, 23•10 to 23•12 Municipal securities, 6•20 to 6•21, 11•16 Mutual Fund Dealers Association (MFDA), 3•9, 18•19 Investor Protection Corporation (MFDA IPC), 3•12 Mutual Fund Fee Impact Calculator, 18•12 Mutual fund wraps, 23•11 Mutual funds, 1•9, 18•2 to 18•35, 19•2 to 19•25 advantages, 18•6 to 18•7 annual information form (AIF), 18•7, 18•22 asset allocation, 19•7 balanced funds, 19•6 to 19•7 charges, 18•12 to 18•16 comparing fund types, 19•10 to 19•11

Ind•11

INDEX

corporations, 18•9 custodians, 18•10 derivatives, use of, 18•24 to 18•25 directors, 18•9 disadvantages, 18•7 to 18•8 distributors, 18•10, 18•19, 18•22 dividend funds, 19•8 to 19•9 equity funds, 19•7 to 19•9 ethical conduct, 18•18 to 18•19 F-class, 18•16 financial institutions as distributors, 18•34 to 18•35 financial statements, 18•7, 18•14, 18•20, 18•22 fixed-income, 19•6 guidelines and restrictions, 18•26 to 18•27 index funds, 19•9 to19•10 labour-sponsored funds, 18•17 to 18•18 load funds, 18•12 to 18•14 management fees, 18•15 to 18•16 managers, 18•9 to 18•10 money market, 19•5 to 19•6 Money Market Funds, 19•5 National Instrument 81-101 (NI81-101), 18•20, 18•22 National Instrument 81-102 (NI81-102), 18•12, 18•20, 18•25 National Registration Database, 3•16, 18•23 net asset value per share (NAVPS), 18•5, 18•11 to 18•16 net purchases, 13•10 open-end trust, 18•8 organization, 18•9 to 18•10 pricing, 18•11 to 18•12 prohibited management practices, 18•24 prohibited selling practices, 18•25 to 18•26 redemption, 19•17 to 19•20 registrar, 18•10 registration, 18•22 to 18•23 regulations, 18•18 to 18•28, 18•34 to 18•35 regulatory organizations, 18•19 reinvesting distributions, 19•16 to 19•17 requirements, general, 18•20 restrictions, 18•26 to 18•27 risk, 19•10 to 19•11 risk and return for different types, 19•10 to 19•11 sales communications, 18•27


segregated funds, compared with, 20•9 to 20•10 simplified prospectus, 18•20 to 18•22 specialty funds, 19•9 structure of mutual funds, 18•8 to 18•9 suspension of redemptions, 19•20 taxes, 19•13 to 19•15 transfer agent, 18•10 trusts, 18•8 withdrawal plans, 19•17 to 19•20

N Naked call writing, 10•25 to 10•26 NASDAQ Composite Index, 8•29 National debt, 5•8, 5•9, 5•18 National Do Not Call List (DNCL), 3•19 National Instrument 81-101 (NI81101), 18•20, 18•22 National Instrument 81-102 (NI81102), 18•12, 18•20, 18•25 National Policies, 3•14 National Registration Database (NRD), 3•16, 18•23 Natural unemployment rate, 4•22 Near-cash items, 15•12 Neckline, 13•21 Negotiable bonds, 6•9 Negotiated offering, 11•16 Net asset value per share (NAVPS), 18•5, 18•11 to 18•16 Net assets values of mutual and segregated funds, 20•11 to 20•12 Net current assets, 14•13 Net profit margin, 14•19 Net return on common equity, 14•19 to 14•20 Net tangible assets, 14•14 New Account Application Form, 3•16, 15•20 NEX, 11•30 Nikkei Stock Average (225) Price Index, 8•29 No par value (n.p.v.) shares, 11•17 No-load funds, 18•12, 18•15 Nominal GDP, 4•10 to 4•11 Nominal interest rate, 4•24 to 4•25 Nominal rate of return, 7•16, 15•9 Nominee, 3•22 Non-callable preferred shares, 8•17 Non-competitive tender, 11•14 Non-controlling interest, 12•11, 12•15, 12•16 Non-systematic risk, 15•11

Notes to financial statements, 12•19, 14•9 Notional units, 20•5

O Odd lot, 8•5 Offer, 1•12 Offering memorandum, 21•6 for mutual fund share or unit, 18•11 to 18•12 for rights, 10•36 to 10•37 Office of the Superintendent of Financial Institutions (OSFI), 3•5, 20•14 Ombudsman for Banking Services and Investments (OBSI), 3•13 Open interest, 10•20 Open market operations, 5•14 to 5•16 Open-end funds, 1•9, 2•16 Open-end trust, 18•8 Operating costs (amortization excluded), 14•6 Operating performance ratios, 14•12, 14•19 to 14•21 after-tax return on invested capital, 14•19 to 14•20 gross profit margin, 14•19 inventory turnover, 14•20 to 14•21 net profit margin, 14•19 return on common equity (ROE), 14•19 to 14•20 Option premium, 10•16 Option strategies, 10•21 to 10•29 buying calls to manage risk, 10•23 to 10•24 buying calls to speculate, 10•22 to 10•23 buying puts to manage risk, 10•27 buying puts to speculate, 10•26 to 10•27 cash-secured put writing, 10•28 to 10•29 covered call writing, 10•25 naked call writing, 10•25 to 10•26 naked put writing, 10•29 strategies for corporations, 10•29 to 10•30 Options, 1•10, 10•15 to 10•30 American-style, 10•17 assignment, 10•17 at-the-money, 10•18 calls, 10•6, 10•15 defined, 10•6 equity, 10•10

Ind•12


European-style, 10•17 exchanges, 10•20 exercise price, 10•16 exercising, 10•17 in-the-money, 10•18 intrinsic value, 10•19 leverage, 10•23 offsetting transaction, 10•17 opening transaction, 10•17 out-of-the-money, 10•18 premium, 10•6, 10•15, 10•16 puts, 10•6, 10•15 strike price, 10•16 time value, 10•19 trading unit, 10•16 Oscillators, 13•24 Other income, 12•12, 12•13 to 12•14, 12•24 Out-of-the-money, 10•18 Output gap, 4•28 Outstanding shares, 11•17 Over-allotment option, 11•27 to 11•28 Overlay manager, 23•10 to 23•11, 23•12 Overnight rate, 5•13 to 5•14 Override, 11•26 derivatives, 1•15, 10•7 markets, 1•14 to 1•16

P Par value of bond, 6•7 Par value shares, 11•17 Pari passu, 8•14 Participating preferred shares, 8•23 Participation rate, 4•20 Partnership, 11•6 Passive management, 16•12, 19•12 Past Service Pension Adjustment (PSPA), 25•18 Peak, 4•14 Peer group, 19•24 Pension Adjustment (PA), 25•18 Pension plans, 2•16, 25•17 to 25•18 Performance bond, 10•6, 10•32 Performance of funds, 19•20 to 19•25 benchmark index, 19•23 complicating factors, 19•24 to 19•25 NAVPS, change in, 19•21 to 19•22 peer group, 19•24 quotes, reading, 19•21 to 19•22 standard performance data, 19•23 time-weighted rate of return, 19•22 to 19•23


Phillips curve, 4•29 Point changes and percentage changes, 8•27 Political risk, 15•10 Pooled account, 17•7 Porter, Michael, 13•14 Portfolio funds, 20•17 Portfolio management, 15•3 to 15•23, 16•2 to 16•26 developing an asset mix, 16•5 to 16•11 evaluating portfolio performance, 16•24 to 16•26 investment constraints, 15•22 to 15•23 investment objectives, 15•20 to 15•22 management styles, 16•11 to 16•16 monitoring markets and client, 16•23 monitoring the economy, 16•24 overview of the process, 15•17 return and risk objectives, 15•18 to 15•19 risk and return, 15•5 to 15•12 risk tolerance, 15•18 to 15•19 Portfolio, designing, 15•5 Potential GDP, 4•28 Pre-authorized contribution plan (PAC), 18•6 Preferred debentures, 6•23 Preferred dividend coverage ratio, 14•27 Preferred shares, 1•12, 8•14 to 8•23, 11•17, 14•27 to 14•28 call feature, 8•17 Canadian Originated Preferred Securities (COPrS), 24•16 common shares, vs., 8•15 to 8•16 convertible, 8•18 to 8•21 cumulative and non-cumulative, 8•16 debt issue, vs., 8•15 deferred, 8•23 disadvantages to issuer, 11•19 to 11•20 dividend tax credit, 8•10 to 8•11, 8•18 dividends, 8•14 to 8•15, 14•27 floating or variable rate, 8•22 foreign-pay, 8•23 investment quality assessment, 14•27 to 14•28 pari passu, 8•14 participating, 8•23 preference as to assets, 8•14 preference share, 8•14

preferred shareholder, position of, 8•14 purchase or sinking fund, 8•17 rating, 14•28 reasons for purchasing, 8•15 to 8•16 retractable, 8•21 to 8•22 selecting, 14•28 straight, 8•17 to 8•18 variable or floating rate, 8•22 voting privileges, 8•17 Preliminary prospectus, 11•22 to 11•23 Prepaid expenses, 12•10 Present value, 7•5 to 7•11 President of a corporation, 11•12 Price-earnings (P/E) ratio, 13•17, 14•24 to 14•25 Primary dealers, 11•14 Primary distribution, 2•7, 2•10 Primary market, 1•11, 1•20 Primary offering of securities, 11•21 Principal, 6•6 Principal-protected notes (PPNs), 24•5 to 24•10 constant proportion portfolio insurance (CPPI), 24•7 distributor, 24•6 guarantor, 24•5 hedge fund-linked notes, 24•5 index-linked notes, 24•5 manufacturer, 24•5 risks, 24•8 to 24•9 tax treatment, 24•9 to 24•10 zero-coupon bond plus call option, 24•6 to 24•7 Principals, 2•10 to 2•11 Private equity, 1•10 to 1•11 financing by, 1•10 to 1•11 listed private equity, 22•15 to 22•17 size of market, 1•11 Private family office, 23•13 Private offering, 11•13 Private placement, 11•21 Probate, bypassing with segregated funds, 20•8 Productivity, economic growth and, 4•11 to 4•12 Professional (Pro) orders, 9•21 Professionalism, 26•17 to 26•19 Prohibited sales practices, 3•19 Property and casualty insurance, 2•15 Property, plant and equipment, 12•6 Proprietary managed program, 23•9

Ind•13

INDEX

Prospectus, 11•22 to 11•27 final, 11•22 to 11•23 preliminary, 11•22 to 11•23 red herring, 11•22 securities offered, description of, 11•22 short form, 11•23 to 11•24 simplified, 18•20 to 18•22 Protective provisions, 6•16, 11•16, 11•20 Provincial bond, 6•19 to 6•20 Provincial regulators, 3•6 to 3•7 Proxy, 3•22, 11•10 Public float, 11•17 Public offerings, 11•21 Purchase fund, 6•15 to 6•16 Put options, 10•6, 10•15

Q Qualitative analysis, 14•8 Quantitative analysis, 13•19, 13•22 to 13•24 Quantum Fund, 21•19 Quick ratio (acid test), 14•14 Quotation and trade reporting systems (QTRS), 1•16

R Random walk theory, 13•6 Rate of return, 7•15 to 7•16, 15•6 to 15•10, 15•12 to 15•13 ex-ante or ex-post, 15•7 historical, 15•7 to 15•8, 15•12 nominal and real, 7•15 to 7•16, 15•9 portfolio, 15•12 to 15•13 risk-free, 15•9 to 15•10 single security, 15•6 Rating services, 14•28 Ratio withdrawal plan, 19•17 to 19•18 Rational expectations hypothesis (market), 13•6 Rational expectations theory (economics), 5•5 Ratios, 14•12 to 14•26 context, must be used in, 14•12 price-earnings (P/E), 13•17 to 13•18, 14•24 to 14•25 Real estate investment trusts (REITs), 22•7 to 22•8 Real GDP, 4•10 to 4•11 Real interest rate, 4•25 Real rate of return, 7•15 to 7•16, 15•9 Real return bonds, 6•19


Rebalancing, 16•20 Recession, 4•14 identifying, 4•18 Record date, 10•37 Recovery phase, 4•15 Red herring prospectus, 11•22 Redeemable bond, 6•10 Redeeming mutual fund units or shares, 19•13 to 19•15 reinvesting distributions, 19•16 to 19•17 suspension of redemptions, 19•20 tax consequences, 19•13 to 19•15 types of withdrawal policy, 19•17 to 19•20 Redemption price, 18•11, 18•14 Redeposit, 5•17 Registered bonds, 7•26 Registered Education Savings Plan (RESP), 25•25 to 25•26 Registered Pension Plan (RPP), 25•17 to 25•18 Registered Retirement Income Fund (RRIF), 25•23 Registered Retirement Savings Plan (RRSP), 25•18 25•22 advantages and disadvantages, 25•22 contributions, 25•19 to 25•20 self-directed plans, 25•19 single vendor plans, 25•19 spousal, 25•20, 25•22, 25•27 termination, 25•21 to 25•22 Registrar of mutual fund, 18•10 Registration of dealers and advisors, 3•14 to 3•15 Regular dividend, 8•7 Reinvesting distributions, 19•16 to 19•17 Reinvestment risk, 7•14 to 7•15 Reporting issuer, 3•24, 11•23 to 11•24 Research associate, 27•8 Reset dates (segregated funds), 20•6 to 20•7, 20•12 to 20•14, 20•16 Resistance level, 13•20 Restricted shares, 8•9 to 8•10 Retail investors, 1•7 Retail securities firms, 2•7 Retained earnings, 8•6, 12•10 to 12•11, 12•16, 14•21, 14•23, 14•31, 14•32 Retained earnings statement, 12•16 Retractable bonds, 6•12 to 6•13 Retractable preferred, 8•21 to 8•22 Retraction date, 6•13

Return, 15•12 to 15•13, 16•25 expected, 15•6 to 15•8, 15•12 to 15•13, 16•19 to 16•20, 16• 22 measuring portfolio returns, 16•24 to 16•26 portfolio, 15•12 to 15•13 relationship with risk, 15•5 to 15•6, 15•12 to 15•16 Return objective, 15•18 to 15•19 Return on common equity (ROE), 13•16, 14•19 Return on equity, 13•16 Revenue, 12•12 to 12•13, 14•5 Reversal patterns, 13•20 Reverse stock splits, 8•12 Revocable designation of beneficiary, 20•6 Right of action for damages, 3•21 to 3•22 Right of redemption, 19•17 Right of rescission, 3•21 Right of withdrawal, 3•21 Rights, 10•36 to 10•39 cum rights, 10•37, 10•38 ex rights, 10•37 to 10•38 intrinsic value, 10•38 offering price, 10•36 record date, 10•37 secondary market, 10•37 statutory rights for investors, 3•21 to 3•22 trading rights, 10•38 to 10•39 Risk, 15•5, 15•10 to 15•16 measures of, 15•11 to 15•12 mutual funds, 19•10 to 19•11 portfolio, 15•13, 15•18 to 15•19, 16•25 reduction by diversifying, 15•11, 15•13, 15•14 to 15•16 risk/return relationship, 15•12 to 15•16, 16•25 systematic and non-systematic, 15•11 types, 15•10 to 15•11 Risk analysis ratios, 14•12, 14•14 to 14•18 asset coverage, 14•14 to 14•15 cash flow/total debt, 14•16 to 14•17 debt/equity, 14•15 to 14•16 interest coverage, 14•17 to 14•18 preferred dividend coverage, 14•27 Risk and return relationship, 15•12 to 15•16 Risk categories, 15•19 Risk objective, 15•18 to 15•19 Risk tolerance, 15•5, 15•18 to 15•19

Ind•14


Risk-adjusted rate of return, 16•25 to 16•26 Risk-free rate of return, 15•9 to 15•10

S S&P 500, 8•28 S&P 500 Index, 8•28 S&P/TSX 60 Index, 8•27 S&P/TSX Composite Index, 8•25 to 8•27 criteria for inclusion, 8•27 to 8•28 Global Industry Classification Standard (GICS), 8•26 S&P/TSX Venture Composite Index, 8•27 to 8•28 Sacrifice ratio, 4•29 Safety of principal, 15•20 Sale and leaseback limitation, 6•16 Sale and Repurchase Agreements (SRAs), 5•14, 5•15 Sale of assets or merger (protection), 6•16 Sales (in company analysis), 14•5 Satement of changes in equity, 12•15 to 12•16, 12•24 Satement of comprehensive income, 12•12 to 12•15, 12•24 Savings banks, 2•16 Secondary market, 1•12, 2•10 to 2•11 Secondary offering of securities, 11•21 Sector rotation, 16•14 to 16•15 Securities and Exchange Commission (SEC), 3•14 Securities firms, 2•6 to 2•11 clearing system, 2•11 dealer, principal and agency functions, 2•10 to 2•11 National Registration Database, 3•16, 18•23 organization within, 2•8 to 2•9 overview, 2•5 to 2•6 registration, 3•14 to 3•16 types, 2•7 to 2•8 Securities legislation, 3•14 to 3•18 SEDAR (System for Electronic Document Analysis and Retrieval), 18•7 Segregated funds, 20•2 to 20•17 age restrictions, 20•6 Assuris, 20•15 bankruptcy, 20•8 to 20•9 beneficiaries, 20•6 costs, 20•9 creditor protection, 20•8


death benefits, 20•7 to 20•8 death benefits tax, 20•14 disclosure documents, 20•10 features, 20•5 to 20•6 GMWBs, 20•16 to 20•17 maturity guarantees, 20•6, 20•9, 20•10, 20•12 to 20•14 mutual funds, compared with, 20•9 to 20•10 net asset values, 20•11 to 20•12 OSFI’s key requirements, 20•14 owners and annuitants, 20•5 portfolio funds, 20•17 probate, bypassing, 20•8 regulation, 20•14 reset dates, 20•6 to 20•7, 20•13, 20•14, 20•16 taxation, 20•11 to 20•14 Self-directed RRSP, 25•19 Self-regulatory organizations (SROs), 2•5, 3•8 to 3•9, 3•14 mutual funds, 18•19 Selling Group, 11•27 Sentiment indicators, 13•24 Separately managed accounts, 17•7, 23•11 to 23•12 Serial bond, 6•20 Settlement date, 9•5, 9•16 Settlement procedures, 9•16 Share capital , 11•17, 12•10, 12•18, 12•23 authorized shares, 11•17 issued shares, 11•17 outstanding shares, 11•17 par value or no par value, 11•17 Share of profit of associates, 12•14, 12•17, 12•24 Shareholders, 11•6, 11•7, 11•10 to 11•11 meetings, 11•10 voting and control, 11•9 to 11•10 voting by proxy, 11•10 Shareholders’ equity, 12•10 to 12•11 Sharpe ratio , 16•25 to 16•26 Short form prospectus, 11•23 to 11•24 Short position, 9•5, 11•27 to 11•28 Short selling, 9•9 to 9•14 covering, 9•13 dangers, 9•14 declaring a short sale, 9•13 margin requirements, 9•11 to 9•12 profit or loss on, 9•12 to 9•13 time limit on, 9•13 Short-bias funds, 21•20

Simplified prospectus, 18•20 to 18•22 Single-manager fee-based account, 23•8 to 23•10 Sinking fund, 6•15 to 6•16 Small cap and mid-cap equity funds, 19•8 Soft landing, 4•18 Soft retractable preferred, 8•21 Sole proprietorship, 11•6 Sophisticated investors, 21•6 Special Purchase and Resale Agreements (SPRAs), 5•14 Specialty and sector funds, 19•9 Specific risk, 15•11 Speculative industries, 13•15 to 13•16 Spending by governments, 5•6 to 5•8, 5•13 Split shares, 24•13 to 24•16 capital shares, 24•13 to 24•15 example, 24•14 preferred shares, 24•13 to 24•15 risks, 24•14 to 24•15 tax implications, 24•15 to 24•16 Splitting income, 25•27 Spousal RRSP, 25•20, 25•22, 25•27 Standard & Poor’s Bond Rating Service, 6•27, 14•28 Standard deviation, 15•12 Standard trading units, 8•5, 8•13 Standards of conduct, 26•12 to 26•21 Statement of cash flows, 12•16 to 12•19, 12•24, 14•32 Statement of changes in equity, 14•32 Statement of comprehensive income, 14•5, 14•32 Statement of comprehensive income analysis, 14•5 to 14•6 Statement of financial position, 12•5 to 12•12, 12•23, 14•6, 14•31 Statement of financial position analysis, 14•6 to 14•8 Statement of financial position analysis - capital structure, 14•7 Statement of financial position analysis - leverage, 14•7 to 14•8 Statement of material facts, 11•29 contrasted with stock index, 8•25 Dow Jones Industrial Average (DJIA), 8•24, 8•28 Nikkei Stock Average (225) Price Index, 8•29 Stock dividends, 8•9

Ind•15

INDEX

Stock exchange, 1•12 to 1•14 around the world , 1•14 Canadian exchanges, 1•12 to 1•14 Stock indexes, 8•24 to 8•30 Canadian, 8•25 defined, 8•24 to 8•25 international, 8•29 to 8•30 U.S., 8•28 to 8•29 value-weighted, 8•24 Stock quotations, reading, 8•13 Stock savings plan, 8•11 Stock split, 8•12 Stop buy orders, 9•10, 9•21 Stop loss orders, 9•20 Straight preferreds, 8•17 to 8•18 Straight-line method, 12•6 to 12•7 Strategic asset allocation, 16•19 to 16•20 Street certificates, 8•7 Street form, 3•22 Strike price, 10•16 Strip bonds, 6•10 Structural unemployment, 4•22 Structured products, 17•5 advantages, 17•11 changing compensation models, 17•16 compared with managed products, 17•10 disadvantages, 17•13 evolving market, 17•14 to 17•16 risks, 17•13 to 17•14 types, 17•8 to 17•9 Subordinated debentures, 6•22 Subscription price for rights, 10•37 Superficial loss, 25•15 to 25•16 Supply, 4•7 to 4•9 Supply and demand, 4•7 to 4•9, 4•23 Supply-side economics, 5•6 Support level, 13•20 Surplus, national budget, 1•6, 5•7, 5•18 Suspensions in trading, 11•33 Sweetener, 10•39 Swiss Market Index, 8•30 Switching fees, 18•15 Symmetrical triangle patterns, 13•21 to 13•22 Syndicate, 11•15 to 11•16 Systematic risk, 15•11


T T3 Form, 19•13 T5 Form, 19•13 Tactical asset allocation, 16•21 to 16•22 Takeover bid circular, 3•23 Takeover bids, 3•23 to 3•24 Target-date fund, 17•16, 19•10 Tax avoidance, 25•5 Tax deferral plans, 25•17 to 25•27 deferred annuities, 25•23 Registered Education Savings Plan (RESP), 25•25 to 25•26 Registered Pension Plan (RPP), 25•17 to 25•18 Registered Retirement Income Fund (RRIF), 25•23 Registered Retirement Savings Plan (RRSP), 25•18 to 25•22 Tax-Free Savings Account (TFSA), 25•24 to 25•25 Tax loss selling, 25•16 to 25•17 Tax planning, 25•27 to 25•28 discharging debts of family member, 25•28 fiscal policy, and, 13•8 gift to children or parents, 25•28 income splitting, 25•27 to 25•28 investment choices, and, 15•22 loan to family member, 25•28 main types of taxes, 5•8 paying expenses, 25•28 splitting CPP benefits, 25•28 spousal RRSPs, 25•20, 25•22, 25•27 Tax-Free Savings Account (TFSA), 25•24 to 25•25 Technical analysis, 13•5 to 13•6, 13•17 to 13•26 breadth of market, 13•25 chart analysis, 13•19 to 13•22 cycle analysis, 13•25 four main methods, 13•19 fundamental analysis, vs., 13•19 sentiment indicators, 13•24 three assumptions, 13•18 to 13•19 volume changes, 13•25 Term deposits, 6•25 Term structure of interest rates, 7•15, 7•16 Term to maturity, 6•8, 16•15 Tiger Management, 21•20 Time horizon, 15•22 Time value of option, 10•19 Time-weighted rate of return, 19•22 to 19•23 TMX Group, 1•13, 1•14, 1•17

Tombstone advertisement, 11•26 Top-down analysis, 16•11 Top-down investment approach, 16•14 Toronto Stock Exchange (TSX), 1•13 to 1•14, 1•16 market indexes, 8•25 Total Return Indexes, 8•29 Trade payables, 12•12, 12•17, 12•23 Trade receivables, 12•10, 12•17, 12•18, 12•23 Trading and settlement procedures, 9•15 to 9•17 other transaction models, 9•16 settlement procedures, 9•16 trading procedures, 9•15 to 9•16 Trading ex rights, 10•37 Trading unit of option, 10•16 Trailer fee, 18•14 to 18•15 Training, investment advisors, 2•9, 3•14 Tranches, 24•17 to 24•18 Transfer agent for fund, 18•10 Transparency, 11•15 Treasury bills (T-bills), 6•18, 7•11 to 7•12, 15•7 to 15•10 Treasury shares, 11•21 Trend analysis, 14•10 to 14•11 Trend ratios, 14•11 Trough, 4•15 Trust companies, 2•14 Trust Deed Restrictions, 11•20 bond issue, 6•7, 6•14 mutual fund, 18•8 to 18•9 security, 11•20 Trustee for voting trust, 11•11 Trustworthiness, honesty and fairness, 26•15 to 26•17 TSX Venture Exchange, 1•13, 1•14, 1•16

U Underlying assets, 10•6, 10•10 to 10•40 Underwriting, 11•24 insurance companies, 2•15 underwriting agreement, 11•26 Unemployment, 4•22 to 4•23 cyclical, 4•22 frictional, 4•22 structural, 4•22 Unemployment rate, 4•14, 4•20 to 4•23 actual, 4•23 natural, 4•22 Unethical practices, 3•18 to 3•19

Ind•16


Unified managed account, 23•12 to 23•13 Unique circumstances in policy design, 15•23 Universal Market Integrity Rules (UMIR), 3•9 Universe Bond Index, 7•28 Unsolicited Orders, 18•30, 26•15

V Value Line Composite Index, 8•29 Value managers, 16•13 to 16•14 Value ratios, 14•21 to 14•26 dividend payout, 14•21 dividend yield, 14•23 to 14•24 earnings per common share (EPS), 14•21 to 14•23 equity value, 14•25 to 14•26 price-earnings (P/E), 14•24 to 14•25 working capital ratio, 14•13 Value-weighted index, 8•24 Variable rate preferreds, 8•22 Variable-rate securities, 6•22 Variance, 15•11 Venture capital, 1•10 Volatility in bond prices, 7•19 to 7•24 duration as a measure of, 7•23 to 7•24 Volatility in stock prices, 15•16 Voting rights, 8•9 Voting trust, 11•11

W Wages, 4•22, 4•27, 4•28 Waiting period, 11•22 Warrants, 10•39 to 10•40 intrinsic value, 10•39 to 10•40 leverage, 10•40 time value, 10•40 Wealth Management Essentials course, 2•9, 3•15 Weighted average method, 12•10 What is company Analysis?, 14•5 to 14•9 Window dressing, 3•18 Withdrawal plans from mutual funds, 19•17 to 19•20 Working capital ratio (current ratio), 14•13


Y Yield, 7•6 current yield on a bond, 7•12 impact of yield changes, 7•22 on a T-bill, 7•11 to 7•12 Yield curve, 7•16 to 7•18, 13•9 to 13•10 Yield spread, 6•11 Yield to maturity (YTM), 7•6, 7•12 to 7•15 calculating YTM on a bond, 7•12 to 7•15

Z Zero coupon bond, 6•10 plus call option, 24•6

Canadian Securities Course (CSC) Textbook Vol. 1

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