Solution manual for Fundamentals of Investing, 14th Edition by Scott B. Smart

Manual by Robert Hartwig Worcester State University for Fundamentals of Investing Fourteenth Edition Scott B. Smart Chad J. Zutter University of Pittsburgh Copyright © 2020 Pearson Education, Inc. Director, Higher Education Product Management—Business & Economics: Adrienne D’Ambrosio Editorial Assistant: Catherine Cinque Managing Producer: Alison Kalil Senior Content Producer: Meredith Gertz Copyright © 2020, 2017, 2014 by Pearson Education. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. For information regarding permissions, request forms, and the appropriate contacts within the Pearson Education Global Rights and Permissions department, please visit ISBN-13: 978-0-13-489778-3 ISBN-10: 0-13-489778-1 Contents Chapter 1 The Investment Environment 1 Chapter 2 Securities Markets and Transactions 16 Chapter 3 Investment Information and Securities Transactions 34 Chapter 4 Return and Risk 50 iv Contents Chapter 5 Modern Portfolio Concepts 76 Chapter 6 Common Stocks 103 Chapter 7 Analyzing Common Stocks 120 Chapter 8 Stock Valuation 145 Chapter 9 Market Efficiency and Behavioral Finance 162 Chapter 10 Fixed-Income Securities 182 Chapter 11 Bond Valuation 201 Chapter 12 Mutual Funds and Exchange-Traded Funds 227 Chapter 13 Managing Your Own Portfolio 246 Chapter 14 Options: Puts and Calls 266 Chapter 15 Futures Markets and Securities 287 Web Chapter 16 Investing in Preferred Stock 299 Web Chapter 17 Tax-Advantaged Investments 307 Web Chapter 18 Real Estate and Other Tangible Investments 322 © 2020 Pearson Education, Inc. Chapter 1 The Investment Environment  Outline Learning Goals I. Investments and the Investment Process A. Attributes of Investments 1. Securities or Property 2. Direct or Indirect 3. Debt, Equity, or Derivative Securities 4. Low- or High-Risk Investments 5. Short- or Long-Term Investments 6. Domestic or Foreign B. The Structure of the Investment Process Concepts in Review II. Types of Investments A. Short-Term Investments B. Common Stock C. Fixed-Income Securities 1. Bonds 2. Convertible Securities 3. Preferred Stock D. Mutual Funds E. Exchange-Traded Funds F. Hedge Funds G. Derivative Securities 1. Options 2. Futures H. Other Popular Investments Concepts in Review III. Making Your Investment Plan A. Writing an Investment Policy Statement 1. Summarize your current situation 2. Specify your investment goals 3. Articulate your investment philosophy 4. Set investment selection guidelines 5. Assign responsibility for selecting and monitoring investments B. Considering Personal Taxes 1. Basic Sources of Taxation 2. Types of Income 2 Smart/Zutter • Fundamentals of Investing, Fourteenth Edition © 2020 Pearson Education, Inc. a. Ordinary Income b. Capital Gains and Losses 3. Investments and Taxes 4. Tax-Advantaged Retirement Savings Plans C. Investing over the Life Cycle D. Investments over the Business Cycle Concepts in Review IV. Meeting Liquidity Needs with Short-Term Investments A. The Role of Short-Term Investments 1. Interest on Short-Term Investments 2. Risk Characteristics 3. Advantages and Disadvantages of Short-Term Investments B. Common Short-Term Investments C. Investment Suitability Concepts in Review V. Careers in Finance A. Commercial Banking B. Corporate Finance C. Financial Planning D. Insurance E. Investment Banking F. Investment Management G. Developing Skills for Your Career 1. Critical Thinking 2. Communication and Collaboration 3. Financial Computing Skills Concepts in Review Summary Key Terms and Concepts Discussion Questions Problems Case Problems 1.1 Investments or Golf? 1.2 Preparing Susan Bowen’s Investment Plan  Key Concepts 1. The meaning of the term investment and the implications it has for individual investors 2. Review the factors used to differentiate between different types of investments Chapter 1 The Investment Environment 3 © 2020 Pearson Education, Inc. 3. The importance of and basic steps involved in the investment process 4. Popular types of investments including short-term investments, common stock, mutual funds and exchange-traded funds, fixed-income securities such as bonds, preferred stock, and convertibles 5. Derivative securities such as options and futures 6. Other popular investments such as real estate, tangibles, and tax-advantaged investments 7. Writing an investment plan 8. Building a diversified portfolio consistent with investment goals 9. Sources of taxation, types of taxable income, and the effect of taxes on the investor 10. Developing an investment program that considers differing economic environments and the life cycle 11. The use of short-term securities in meeting liquidity needs 12. The merits and suitability of various popular short-term investments, including deposit accounts and money market securities  Overview This chapter provides an overview of the scope and content of the text. 1. The term investment is defined, and the various investment opportunities available to investors are classified by types. 2. The structure of the investment process is examined. This section explains how the marketplace brings together suppliers and demanders of investment funds. 3. The key participants in the investment process—government, business, and individuals—are described, as are institutional and individual investors. 4. Returns are defined as rewards for investing. Returns to an investor take two forms—current income and increased value of the investment over time. In this section, the instructor need only define return, since there will be another opportunity to develop the concept of return in Chapter 4; also, providing information about recent investment returns always engages students’ attention. In classrooms with Internet access, viewing charts of stock returns over the last month, year, 5 years, and recent changes in interest rates will be especially useful. 5. Next, the following investments available to individual investors are discussed: short-term investments common stock, fixed-income securities, mutual funds, exchange-traded funds, hedge funds, real estate, tangibles, tax-advantaged investments, and options and futures. The text describes their risk-return characteristics in a general way. The instructor may want to expand on the advantages and disadvantages of investing in each, although they will be treated in greater detail in subsequent chapters. It is vital for any investor to establish investment goals that are consistent with his or her overall financial objectives. 6. Writing an investment plan involves summarizing one’s current situation, specifying investment goals, articulating an investment philosophy, setting investment selection guidelines, and assigning responsibility for selecting and monitoring investments. 7. Personal taxes are discussed in terms of types of income and tax rates. The investment process is affected by current tax laws. Examples of tax shelters, especially tax-advantaged retirement vehicles, and tax planning are provided. 8. Once investment goals are established, it is important to understand how the investment process is affected by different economic environments. The chapter talks about types of investments such as stocks, bonds, and tangibles as they are affected by business cycles, interest rates, and inflation. 4 Smart/Zutter • Fundamentals of Investing, Fourteenth Edition © 2020 Pearson Education, Inc. 9. Liquidity is defined, and short-term securities that can be used to meet liquidity requirements are described. The discussion includes a look at short-term interest rates and the risk characteristics of various short-term securities. 10. The next section covers the various types of short-term vehicles available to today’s investor. The text provides enough detail about everything from passbook accounts to money market funds to commercial paper that students should get a good grasp of the differences between the vehicles. Information on current rates brings realism into the classroom and enhances student perception of the lecturer as a knowledgeable instructor.  Failures in Finance: Critical Thinking Question The ability to borrow short-term funds at low interest rates was critical to Lehman Brothers operations. By disguising these repurchase agreements as sales of assets rather than very shortterm loans, Lehman inflated revenues and made their balance sheet look much stronger than it actually was. At this point in its history, Lehman was highly leveraged and facing declining liquidity. The inability to obtain cheap, short-term loans would mean the death of the company which, of course, did ensue. For the individuals involved, large sums in the form of bonuses and investments in the firm were riding on the firm’s survival. It might be worth mentioning that the practice was borderline acceptable under British law, but it did not conform to U.S. GAAP.  Answers to Concepts in Review 1.1 An investment is any asset into which funds can be placed with the expectation of preserving or increasing value and earning a positive rate of return. An investment can be a security or a property. Individuals invest because an investment has the potential to preserve or increase value and to earn income. It is important to stress that this does not imply that an investment will in fact preserve value or earn income. Investing often involves taking risk, so an investment’s actual performance will often differ from its expected performance. 1.2 (a) Securities and property are simply two classes of investments. Securities are investments issued by firms, governments, or other organizations that represent a legal claim on the resources of the issuer. For example, a bond represents a loan that the borrower is legally obligated to repay, and a stock represents a proportionate ownership in a firm. An option, on the other hand, represents the legal right to either buy or sell an asset at a predetermined price within a specified time period. Property constitutes investments in either real property (land and buildings) or tangible personal property (e.g., Rembrandt paintings, Ming vases, or gold coins). These days, some students are likely to ask about cryptocurrencies, which have characteristics of both transactional currencies and speculative security investments. (b) With a direct investment, an individual acquires a direct claim on a security or property. For example, an investment in one share of IBM stock directly provides the stockholder a proportionate ownership in IBM. An indirect investment provides an indirect claim on a security or property. For example, if you buy one share of Fidelity Growth Fund (a mutual fund) or an ETF that tracks the S&P 500 index, you are in effect buying a portion of a portfolio of securities owned by the fund. Thus, you will have a claim on a fraction of an entire portfolio of securities. Many funds also invest in a variety of debt instruments. (c) An investment in debt represents funds loaned in exchange for the receipt of interest income and repayment of the loan at a given future date. The bond, a common debt instrument, pays specified interest over a specified time period, then repays the face value of the loan. (Chapters 10 and 11 cover bonds in detail.) An equity investment Chapter 1 The Investment Environment 5 © 2020 Pearson Education, Inc. provides an investor an ongoing fractional ownership interest in a firm. The most common example is an investment in a company’s common stock. We will study equity instruments in greater detail in Chapters 6 through 8. Derivative securities are securities derived from debt or equity securities and structured to exhibit characteristics and value based upon the underlying securities. Options are derivative securities that allow an investor to sell or buy another security or asset at a specific price over a given time period. For example, an investor might purchase an option to buy Facebook stock for $50 within nine months. (d) Short-term investments typically mature within one year while long-term investments have longer maturities, including common stock, which has no maturity at all. However, long-term investments can be used to satisfy short-term financial goals. 1.3 Investors expect to be paid for accepting risk. Low or no risk investments typically offer low rates of return while riskier investments, meaning that returns are less predictable, tend to offer potentially higher returns. 1.4 In finance, risk reflects the uncertainty surrounding the return that an investment will generate. Risk refers to the chance that the return from an investment will differ from its expected value. Low-risk investments are those considered safe with respect to the return of funds invested and the receipt of a positive rate of return. High-risk investments are those that have more uncertain future values and levels of earnings. 1.5 Foreign investments are investments in the debt, equity, derivative securities of foreignbased companies, and property in a foreign country. Both direct and indirect foreign investments sometimes provide investors more attractive returns or lower-risk investments compared to purely domestic investments, but beyond that they are useful instruments to diversify a purely domestic portfolio. 1.6 The investment process brings together suppliers and demanders of funds. This may occur directly (as with property investments). More often the investment process is aided by a financial institution (such as a bank, savings and loan, savings bank, credit union, insurance company, or pension fund) that channels funds to investments and/or a financial market (either the money market or the capital market) where transactions occur between suppliers and demanders of funds. 1.7 (a) The various levels of government (federal, state, and local) generally require more funds for projects and debt repayment than they receive in revenues. Thus, governments are net demanders of funds. The term net refers to the fact that, while governments both supply and demand funds in the investment process, on balance they demand more than they supply. (b) Businesses are also net demanders, requiring funds to cover short- and long-term operating and investment (growth) needs. While business firms often supply funds, on balance they also demand more than they supply. (c) Individuals are the net suppliers of funds to the investment process. They put more funds into the investment process than they take out. Individuals play an important role in the investment process—supplying the funds needed to finance economic growth and development. 1.8 Institutional investors are investment professionals who are paid to manage other people’s money. They are employed by financial institutions like banks and insurance companies, by nonfinancial businesses, and by individuals. Individual investors manage their own personal funds in order to meet their financial goals. Generally, institutional investors tend to be more sophisticated because they handle much larger amounts of money, and they tend to have a broader knowledge of the investment process and available investment techniques. 6 Smart/Zutter • Fundamentals of Investing, Fourteenth Edition © 2020 Pearson Education, Inc. 1.9 Short-term investments usually have lives of less than one year. These investments may be used to store temporarily idle funds until suitable long-term investments are found. Due to their safety and convenience, they are popular with those who wish to earn a return on temporarily idle funds or with the very conservative investor who may use these short-term investments as a primary investment outlet. In addition to their storage function, short-term investments provide liquidity—they can be converted into cash quickly and with little or no loss in value. This characteristic is very useful when investors need to meet unexpected expenses or take advantage of attractive opportunities. 1.10 Common stock is an equity investment that represents a fractional ownership interest in a corporation. The return on a common stock investment derives from two sources: dividends, which are periodic payments made by the firm to its shareholders from current and past earnings, and capital gains, which result from selling the stock at a price above the original purchase price. Because common stock offers a broad range of return-risk combinations, it is one of the most popular investments s. 1.11 a. Bonds are debt obligations of corporations or governments. A bondholder receives a stated interest return, typically semi-annually, plus the face value at maturity. Bonds are usually issued in $1,000 denominations, pay semi-annual interest, and have 10 - to 30- year maturities. Bonds offer fixed/certain returns, if held until maturity. b. A convertible security is a fixed-income security, either a bond or preferred stock, which has a conversion feature. Typically, it can be converted into a specified number of shares of common stock. Convertible securities are quasi-derivative securities, as their market value would depend on the price of the common stock and the conversion ratio. c. Preferred stock is very much like common stock in that it represents an ownership interest in a corporation. But preferred stock pays only a fixed stated dividend, which has precedence over common stock dividends, and does not share in other earnings of the firm. d. A mutual fund is a company that invests in a large portfolio of securities, whereas a money market mutual fund is a mutual fund that solely invests in short term “money market” securities. Investors might find mutual funds appealing because a large, welldiversified portfolio may be more consistent with their investment goals in terms of risk and return. As we will see later, a mutual fund offers the investor the benefits of diversification and professional management. Mutual funds do not offer fixed/certain returns. Exchange-traded funds are similar to mutual funds but are traded throughout the day on exchanges and priced continuously. e. Similar to mutual funds, hedge funds pool investors’ funds to invest in securities, but hedge funds are open to a narrower group of investors than mutual funds. Hedge funds may employ high-risk strategies. They do not offer a fixed return and the management fees are much higher than for typical mutual funds. Although the term hedge implies limiting risks with derivatives, many hedge funds use derivatives to increase leverage rather than for managing risk. f. Options are derivative securities that provide holders the right to buy or sell another security (typically stock) or property at a specified price over a given time period. Factors like the time until expiration, the underlying stock price behavior, and supply and demand conditions affect the returns. g. Futures represent contractual arrangements in which a seller will deliver or a buyer will take delivery of a specified quantity of an asset at a given price by a certain date. Unlike an option, which gives the investor the right to purchase or sell another security, futures Chapter 1 The Investment Environment 7 © 2020 Pearson Education, Inc. contracts obligate the investor to deliver or take delivery of the asset. The primary factor affecting returns on commodity contracts is the price of the underlying asset. 1.12 Before establishing an investment program, an investor should write down an Investment Policy Statement. The elements of this statement include an overview of the investor’s current situation, a description of the investor’s goals and investment philosophy, a list of investment selection guidelines, and a statement explaining how, when, and by whom the investment portfolio will be monitored. 1.13 Federal income taxes are charged against all income individuals receive from all sources (with the exception of interest received on some bonds issued by state and local governments). a. Active (ordinary “earned”) income is the broadest category and includes income from wages, salaries, bonuses, tips, pension income, and alimony. It is made up of income earned on the job as well as most other forms of noninvestment income. b. Portfolio (investment) income is earnings generated from various types of investment holdings. For the most part, it consists of interest, dividends, and capital gains earned on most types of investments. Passive income is a special category that consists of income derived chiefly from real estate, limited partnerships, and other forms of tax shelters. c. Capital gains are the profits earned on the sale of capital assets—pleasure or investment. They are measured by the amount by which the proceeds from the sale of the capital asset exceed its original purchase price. Currently, long-term capital gains are taxed at preferential rates to ordinary income. Capital gains are appealing to investors because they are not taxed until they are actually realized. d. A capital loss is the amount by which the proceeds from the sale of a capital asset are less than its original purchase price. Up to $3,000 of net losses can be applied against ordinary income in any one year, with the unused portion carried forward to offset future income. e. Due to the opportunities and challenges created by the tax laws, tax planning is an important part of the investment process. Tax planning involves looking at an individual’s current and projected earnings and developing strategies that will defer or minimize the level of his or her taxes. Tax plans involve current income, capital gains, or tax-sheltered investments. For example, one strategy is to take losses as they occur and to delay realizing profits in order to minimize current taxable income. f. In general, tax-advantaged retirement plans allow individuals to defer taxes on the contribution and/or portfolio earnings until some future date when retirement withdrawals take place. There are employer-sponsored plans (such as 401(k) accounts), individual-created plans (such as Keogh plans), and individual retirement accounts (IRAs). 1.14 Investors tend to follow different investment strategies as they move through different stages of their life cycle. a. Investors who are in their twenties and thirties tend to prefer growth-oriented investments that stress capital gains rather than income. These investors have little investable funds, and capital gains are seen as the quickest way to build up investment capital. b. By middle age, investing becomes less speculative or aggressive. Quality-growth investments, such as conservative stocks and mutual funds, are employed, and more attention is given to income-producing securities, such as high-quality bonds. The foundation is being set for retirement. 8 Smart/Zutter • Fundamentals of Investing, Fourteenth Edition © 2020 Pearson Education, Inc. c. As the investor moves into the retirement years, preservation of capital and current income become the principal concerns. High-quality stocks and bonds and money market instruments are used as the investor’s objective is to live as comfortably as possible from the investment income. 1.15 Stocks and equity-related securities (such as mutual funds and convertibles) are highly responsive to the economic cycle. During recovery and expansion, stock prices are up. As the decline approaches, stock prices begin to decline as well. The months just prior to a recession tend to show the lowest returns on stocks while the months immediately following the end of a recession have the highest returns. Unfortunately, turning points in the business cycle are notoriously hard to predict and can only be pinpointed with certainty well after they have happened. 1.16 An asset is liquid if it can be converted to cash (sold) easily and quickly, with little or no loss in value. You would want to hold liquid assets as emergency funds or to accumulate funds for some specific purpose. IBM stock is a liquid investment. IBM common shares are heavily traded, and investor can sell IBM shares quickly without incurring high transactions costs or triggering a decline in the value of the shares. Keep in mind, however, that the value of IBM shares fluctuate, so it is not necessarily a safe investment even though it is a liquid investment. While the common stock of large, widely traded companies is a liquid investment, some stocks are not heavily traded, so selling shares in some companies would trigger significant transactions costs and perhaps even a decline in the value of the shares. 1.17 Purchasing power risk for short-term investments occurs when the rate of return on these investments falls short of the inflation rate. This generally happens to fixed-rate investments such as passbook savings accounts. Most other short-term investments have managed to provide rates of return about equal to the inflation rate when one looks at these short-term rates over long periods of time. Default (nonpayment) risk is very small with most high quality or money market short-term investments. The deposits in banks and other federally insured savings institutions are protected up to $250,000 per account by the Federal Deposit Insurance Corporation, an agency of the federal government. U.S. Treasury bills are perfectly safe and sometimes called a risk-free investment. Commercial paper and repurchase agreements are extremely safe, based upon past experience, even though there have been rare instances of problems. These latter two instruments are also not insured. Money market mutual funds have also had an exceptionally safe history. Of course, the safest money market funds are those that invest solely in government securities and are virtually default-risk-free. 1.18 Passbook savings accounts and NOW accounts (a checking account), offered by banks, generally pay a low rate of interest and have no minimum balance. Passbook savings and NOW accounts are primarily used by investors as savings accounts, providing the investor with a highly liquid pool of funds. MMDAs are bank deposit accounts with limited checkwriting privileges. Asset management accounts are comprehensive deposit accounts and combine checking, investing, and borrowing activities. MMDAs and asset management accounts are more likely used by investors to earn a competitive short-term return while maintaining liquidity. Each type of account, except for asset management accounts, is insured. All but the passbook account typically require a minimum balance, which varies. 1.19 a. I bonds are savings bonds issued by the U.S. Treasury. They earn interest at a rate that varies with inflation. Interest is exempt from state and local taxes. They are issued in denominations that make them affordable to everyone and mature in 30 years but can be redeemed after one year. b. U.S. Treasury bills are short-term (less than one year) debt obligations of the federal government. T-bills are exempt from state and local income taxes. They are regarded as Chapter 1 The Investment Environment 9 © 2020 Pearson Education, Inc. the safest but generally lowest yielding of all investments, and the secondary market for T-bills is highly liquid. c. Certificates of deposits (CDs) are savings instruments that must remain on deposit for a specified period. Premature withdrawals incur interest penalties. Because of the requirement that they remain on deposit, CDs are less liquid than T-bills, but they are convenient to buy and hold, offer competitive returns, and have federal insurance protection. d. Commercial paper is unsecured short-term debt issued by corporations with very high credit standings. The secondary market for commercial paper is very limited and yields are comparable to yields on large-denomination CDs. Typically, only larger institutions deal directly in this market because the denominations range from $25,000 to the more commonly issued $100,000. Commercial paper is not federally insured. e. Bankers’ acceptances are short-term credit arrangements between business firms and banks. Firms use banker’s acceptances to finance transactions, most often involving firms in foreign countries or firms with unknown credit capacities. Banker’s acceptances typically are denominated in $100,000 units, are low-risk securities, and have active secondary markets. Yields are slightly below CD yields and commercial paper and above T-bills. f. Money market mutual funds (MMMFs) pool capital of many investors and invest it exclusively in high-yielding, short-term securities, such as T-bills, large CDs, commercial paper, and other similar “money market” securities. Because these highyielding securities are in denominations of $10,000 to $1 million, the MMMF makes them available in a format that is affordable to individual investors. MMMFs are convenient, offer check writing privileges, and yields are based on the ability of the fund manager to invest in various short-term securities. Although they are not federally insured funds, their default risk is nearly zero because the securities they invest in are very low risk and the fund is relatively diversified. 1.20 The senior managers in a corporation, such as the chief financial officer (CFO), have the primary responsibility of managing the firm’s capital resources and investments. Because so much of the CFO’s primary responsibilities require an understanding of investment principles, a CFO must understand market forces but more importantly communicate in such a way that investors understand the value of the firm and the securities the firm has issued. 1.21 Because insurance companies have large sums of investment capital under management, they require the skills of a person highly trained in investment principles. Since this person is asked to manage risk for individuals as well as businesses, the decisions they make and the strategies they devise will assist the insurance companies’ customers in the creation of their individual successful asset and risk management strategies.  Suggested Answers to Discussion Questions 1.1 a. Because you fall into the category of a young investor, after meeting basic liquidity needs your key investment goals should be to save for the education of your children and quite possibly to purchase a house. Appropriate investments should focus on longer term goals, such as the education of your children and, though it may seem remote, retirement. b. You should consider the effects of taxes when investing, maximizing your use of tax sheltered investments such as 401(k) plans and taking advantage of the preferential tax treatment of capital gains and dividends. Your focus should be on maximizing the aftertax return on your investments. Finally, it is important to know that the tax treatment of 10 Smart/Zutter • Fundamentals of Investing, Fourteenth Edition © 2020 Pearson Education, Inc. various investments and forms of income can and does change. For example, in 2018 the treatment of state and local taxes and mortgage interest on federal income tax returns radically affected the value of home ownership, especially in states with high taxes, incomes, and property values. c. Because you have a relatively long investment horizon, it is appropriate to focus your portfolio on higher-risk investments such as common stocks. 1.2 Short-term investments play an important part in your investment program. Most importantly, they will provide a pool of reserves that can be used for emergencies such as replacing cars, appliances, and clothing that wear out over time. Returns on safe, short-term investments were well below the inflation rate during the period 2009–17. In 2018, the Federal Reserve began a program to “normalize” interest rates so that they might more closely keep pace with inflation and provide some cushion for stimulus in a future recession. Type of Investment Minimum Balance Interest Rate Federal Insurance Method and Ease of Withdrawing Funds a. Passbook savings account None Close to 0.00% in recent years. Yes, up to $250,000 per account In person or through teller machines; very easy b. NOW account No legal minimum, but often set at $500 or $1,000 At or near passbook rates Yes, up to $250,000 per account Unlimited checkwriting privileges c. Money market deposit account (MMDA) No legal minimum, but often set at $2,500 Slightly above passbook rates Yes, up to $250,000 per account Limited checkwriting privileges d. Asset management account Typically $5,000 to $20,000 Similar to MMDAs Yes, up to $250,000 in banks, varies elsewhere Limited checkwriting privileges e. Series I savings bond Initial deposit is 50% of face value At or near 0.00% in recent years. No, but federal government issue Penalty of three months interest for early withdrawal f. U.S. Treasury bill $100 Slightly above passbook and NOW accounts No, but federal government issue Secondary market exists g. Certificate of deposit Tailored to investor needs Slightly above asset management account No, but as secure as most bank savings and checking accounts Penalty for early withdrawal h. Commercial paper $100,000 plus. Often included in MMMF portfolios Comparable to certificates of deposit No Very liquid Chapter 1 The Investment Environment 11 © 2020 Pearson Education, Inc. i. Banker’s acceptance Large denominations; not a typical retail investment Comparable to certificates of deposit No Active secondary market, but not open to individual investors except through funds j. Money market mutual fund (money fund) No legal minimum Slightly below passbook savings account No, but invests in government and bank issues May take a few days to receive check from fund  Solutions to Problems 1.1 a. Goal $500,000 $44,300 at 8% for 25 yrs. 150,000 Additional requirement $350,000 b. Saving $104.75 each year produces $5,000 in savings at retirement, but Stefani needs to accumulate 70 times that much ($350,000 is 70 times greater than $5,000). Stefani needs to save 70 times $104.74, or $7,332.50 each year. If she does, then the combined value at age 65 of all of her assets will be very close to $500,000. (Note: The problems assumes that Stefani’s average rate of return will be about 8.4%.) 1.2 a. Tax on the Smith’s income of $130,000. Looking at the joint tax return rates, we find: (10%  $19,050) + [12%  ($77,400 – $19,050 + [22%  ($130,000 – 77,400] = $20,479 (rounded to nearest whole dollar) Tax on the Jones’s income of $65,000. Looking at the joint tax return rates, we find: (10%  $19,050) + [12%  ($65,000 – $19,050)] = $7,419 b. The Smiths make twice as much as the Joneses. The ratio of the Smith’s to the Jones’s taxable income is ($130,000/$65,000) = 2 The ratio of the Smith’s to the Jones’s taxes is ($20,479/$7,419) = 2.76. Hence higher income earners pay a higher proportion of their income as tax. 1.3 The solution uses the current tax rate on dividends, which is 15%. In addition, this solution ignores the 3.8% tax on net investment income imposed by the Affordable Care Act on high income families or individuals even though the Consalvo family’s annual income likely meets the income thresholds. a. $50,000/$50 = 1,000 shares of stock. b. 1,000 shares  $2 = $2,000 per year before tax. $2,000  0.85 = $1,700 after tax. c. ($1,700  10) + $50,000 = $67,000. d. $50,000  0.05 = $2,500 per year before tax. $2,500  0.68 = $1,700 after tax. e. ($1,700  10) + $50,000 = $67,000. f. Both investment options generate the same expected after-tax income. Therefore, ignoring risk, the Consalvos would be indifferent to either investment. 1.4 a. Their ordinary income is $128,000, consisting of $125,000 of salary and wages, $1,000 in interest income, and $2,000 of short-term capital gains. Mike and Julie will be in the 22% marginal tax bracket based on their taxable income, which includes the ordinary income and the other investment income ($3,000 in dividends and $2,000 in long-term capital gains). Therefore, on the $1,000 of interest income they will pay $220 in tax. 12 Smart/Zutter • Fundamentals of Investing, Fourteenth Edition © 2020 Pearson Education, Inc. b. The $3,000 in dividends is subject to the lower 15% tax rate, so they will pay $450 in taxes on their dividend income. c. This is a long-term capital gain and is therefore subject to tax at 15% given the Bedard’s tax bracket. They will pay $300 in taxes on this gain. d. This gain is a short-term capital gain and is taxed like ordinary income. Because the Bedard’s are in the 22% tax bracket, they will pay $440 in taxes on this $2,000 gain. 1.5 a. If they remain single, their tax bills will be the same because they make the same income. So each will pay: 0.10($9,525) + 0.12($38,700 – $9,525) + 0.22($70,000 – $38,700) = $11,339.50 each. Their total tax bill will be double this amount, or $22,679. If they are married, their combined income will be $140,000. Using the tax brackets for married taxpayers filing joint returns, their taxes will be: 0.10($19,050) + 0.12($77,400 – $19,050 + 0.22($140,000 – $77,400) = $22,679. In this case, Kim and Kanye pay the same total taxes whether they are married or single. b. If they remain single, they will each pay the following in taxes: 0.10($9,525) + 0.12($38,700 – $9,525) + 0.22($82,500 – $38,700) + 0.24($157,500 – $82,500) + 0.32($200,000 – $157,500) + 0.35($400,000 – $200,000) = $115,689.50 So their combined tax bill is double that amount or $$231,379. As a married couple, here is their tax bill: 0.10($19,050) + 0.12($77,400 – $19,050) + 0.22($165,000 – $77,400) + 0.24(315,000 – $165,000) + 0.32($400,000 – 315,000) + 0.35($600,000 – $400,000) + 0.37($800,000 – $600,000) = $235,379 Notice that in this scenario, Kim and Kanye pay a “marriage penalty” because their combined taxes are higher when they are married than when they are single. This happens because income above $400,000 is taxed at higher rates, 35% and 37%, that would not be reached if they filed as individuals. 1.6 Rate Joint Amt. taxed at rate Tax at top of bracket Income Tax After-tax earning Average tax rate 10% 0-19,050 $ 19,050 1,905.00 $ 10,000 $ 1,000 $ 9,000 10% 12% 19,051–77,400 $ 58,350 8,907.00 $ 80,000 $ 9,479 $ 70,521 12% 22% 77,401–165,000 $ 87,600 28,179.00 $ 300,000 $ 60,579 $ 239,421 20% 24% 165,001–315,000 $ 150,000 64,179.00 $ 500,000 $ 126,379 $ 373,621 25% 32% 315,001–400,000 $ 85,000 91,379.00 $1,000,000 $ 309,379 $ 690,621 31% 35% 400,001–600,000 $ 200,000 161,379.00 $1,500,000 $ 494,379 $1,005,621 33% 37% 600,000+ $2,000,000 $ 679,379 $1,320,621 34% Chapter 1 The Investment Environment 13 © 2020 Pearson Education, Inc. Rates Joint Amt. taxed at rate Tax at top of bracket Income Tax After-tax earnings Average tax rate 10% 0-19,050 $ 19,050 1,905.00 $ 10,000 $ 1,000 $ 9,000 10% 12% 19,051-77,400 $ 58,350 8,907.00 $ 80,000 $ 9,479 $ 70,521 12% 22% 77,401-165,000 $ 87,600 28,179.00 $ 300,000 $ 60,579 $ 239,421 20% 24% 165,001-315,000 $ 150,000 64,179.00 $ 500,000 $ 126,379 $ 373,621 25% 32% 315,001-400,000 $ 85,000 91,379.00 $ 1,000,000 $ 309,379 $ 690,621 31% 35% 400,001-600,000 $ 200,000 161,379.00 $ 1,500,000 $ 494,379 $ 1,005,621 33% 37% 600,000+ $ 2,000,000 $ 679,379 $ 1,320,621 34% 0% 5% 10% 15% 20% 25% 30% 35% 40% $- $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 Average tax rate b. The table and the chart clearly illustrate that average tax rates are progressive, that is, they are higher on higher levels of income. Note: These calculations assume joint filing rates, but the conclusions  Solutions to Case Problems Case 1.1 Investments or Golf? This case illustrates the many facets of the investment process; it involves much more than common stock. The authors recognize the value of physical education and emphasize the importance of sports, but a course in investments offers the student a lifetime of financial benefits. Thus, our arguments for selecting the investments course should not be interpreted as a negative statement on physical education but rather as a positive discussion of the merits of investments. a. The term investments refers to the process of identifying, evaluating, selecting, and monitoring the placement of funds with a view toward preserving or increasing value and/or earning a positive return. Joshua has simply identified one investment (stock). He will not know how to evaluate, select, or monitor other investments nor will he know how to adjust his investments in appropriate ways at various stages in the life cycle without a course in investing. In addition to looking at his own investments, a course in investing will give Joshua a new perspective on the role of investments in the economy. He will learn that as an investor, he is actually supplying funds to government and business, which will enable the continued strength and growth of the general economy. b. Clearly, Joshua has ignored short-term securities, bonds, options, commodities and financial futures, mutual funds, real estate, tangibles, tax shelters, and limited partnerships. Each one of these choices offers another risk-reward relationship that may meet certain unique investment requirements that cannot be met by common stock alone. c. Joshua does not have the knowledge needed to carry out the investment process described in question a. Knowing about common stocks is not the same as understanding investments, and it is not necessarily true that common stock is the best investment available to Joshua. Besides, the investment decision has to be compatible with his goals and risk preferences. Individual stocks are far riskier than, say an investment in CDs or even mutual funds that invest in a well-diversified portfolio of stocks. There are other considerations, too. Does Joshua have plans for the future when he will need the money? If so, is it a short-term or a long-term need? Answers to these questions will 14 Smart/Zutter • Fundamentals of Investing, Fourteenth Edition © 2020 Pearson Education, Inc. help determine whether he should make short-term or long-term investments. In summary, to gain an understanding of the investment decision and management process, Joshua should pass up the golf course in favor of the investments course. Case 1.2 Preparing Susan Bowen’s Investment Plan This case allows students to evaluate a proposed investment plan aimed at achieving certain retirement goals. a. The amount currently available to Susan includes $120,000 from the proceeds of the life insurance and $75,000 from her savings account, or a total of $195,000. At 6% compounded annually, her money will be worth: If she retires at age 62 (seven-year investment): $195,000  (1.03)7 = $239,825 (You can find this in Excel by typing the formula = fv(0.03,7,0,– 195,000.) Add $112,500 from the sale of her home, and Susan will have $425,000. If she retires at age 65 (10-year investment): $195,000  (1.03)10 = $262,064 (You can find this in Excel by typing the formula = fv(0.03,10,0, –195,000).) Add $225,000 from the sale of her home, and Susan will have $302,108. b. Value of Susan’s assets at 62 = Value of savings account + Value of house: $239,825 + $225,000 = $464,825 Similarly, value of assets at 65 = $262,064 + $255,000 = $517,064. Because Susan receives $79 for each $1,000 that she invests in the annuity, we can calculate her annual income starting at age 62 as follows: ($464,825/$1,000)  $79 = $36,721 per year Similarly, if Susan’s assets at age 65 are $517,064 and if for each $1,000 that she invests in the annuity she will receive $89.94 in income, her income starting at age 65 would be: ($517,064/$1,000)  $89.94 = $46,505 c. Annual Retirement Income Age 62 Retirement Age 65 Retirement Annual Social Security & Pension Fund Benefits $31,200 $38,400 +Annuity Income 36,721 46,505 Total Annual Retirement Income $67,921 $84,905 d. Susan believes she needs $85,000 per year (before taxes) of retirement income. Without considering the change in her tax status upon retirement, she will not satisfy this goal if she retires at age 62. At age 65, she very nearly meets her requirement. The nature of tax legislation and the reduction in Susan’s tax liability upon retirement may make retirement at age 65 viable. e. Susan’s plan is extremely conservative and low risk. The returns from the plan are very secure and probably assured. Susan can be confident that the accumulated worth of her investments will be available to her at retirement. Her plan to retire at age 65 meets her retirement-income goal. Susan’s plan offers low risk and low return. Through only a slight Chapter 1 The Investment Environment 15 © 2020 Pearson Education, Inc. increase in risk, she might improve her return on investment and have more “cushion” to allow for inflation and unexpected expenditures. Susan could purchase highly rated bonds, CDs, and other blue chip security investments. In this manner, her risk aversion would be satisfied, and she would earn a higher return on her investments. This should permit more likely achievement of her retirement-income objectives. Therefore, with very little increase in risk, Susan could invest her funds so as to increase the probability that she will meet or surpass her requirement of an annual retirement income of $85,000. As much as she values the opinions of her psychic consultants, she should periodically get a second opinion from her health care provider and update her financial plan accordingly. © 2020 Pearson Education, Inc. Chapter 2 Securities Markets and Transactions  Outline Learning Goals I. Securities Markets A. Types of Securities Markets 1. The Primary Market a. Public Offerings: The IPO Process b. Public Offerings: The Investment Bank’s Role c. Public Offerings: The Direct Listing Process 2. The Secondary Market B. Broker Markets and Dealer Markets 1. Broker Markets 2. The New York Stock Exchange a. Trading Activity b. Listing Policies 3. Options Exchanges 4 Futures Exchanges 5. Dealer Markets a. Nasdaq Stock Market b. The Over-the-Counter Market C. Electronic and High-Frequency Trading 1. Electronic Communications Networks 2. High-Frequency Trading D. General Market Conditions: Bull or Bear Concepts in Review II. Globalization of Securities Markets A. Growing Importance of International Markets B. International Investment Performance C. Ways to Invest in Foreign Securities D. Risks of Investing Internationally Concepts in Review III. Trading Hours and Regulation of Securities Markets A. Trading Hours of Securities Markets B. Regulation of Securities Markets Concepts in Review IV. Basic Types of Securities Transactions A. Long Purchase B. Margin Trading 1. Essentials of Margin Trading a. Magnified Profits and Losses b. Advantages and Disadvantages of Margin Trading 2. Making Margin Transactions Chapter 2 Securities Markets and Transactions 17 © 2020 Pearson Education, Inc. a. Initial Margin b. Maintenance Margin 3. The Basic Margin Formula 4. Return on Invested Capital 5. Uses of Margin Trading C. Short Selling 1. Essentials of Short Selling a. Making Money When Prices Fall b. Who Lends the Securities? c. Margin Requirements and Short Selling d. Advantages and Disadvantages 2. Uses of Short Selling Concepts in Review Summary Key Terms and Concepts Discussion Questions Problems Case Problems 2.1 Darren’s Dilemma: What to Buy? 2.2 Ravi Dumar’s High-Flying Margin Account  Key Concepts 2.1 The types of securities markets in which transactions are made 2.2 Explain public offering process. 2.3 The operations, function, and nature of broker (organized securities exchanges) and dealer (the over-the-counter) market 2.4 Explain how orders are executed in the various markets 2.5 Discuss transaction costs of trading including the bid/ask spread 2.6 The historical and current significance of the New York Stock Exchange and recent changes 2.7 Discuss other financial markets including options exchanges and futures exchanges 2.8 History of the Nasdaq and the OTC market 2.9 Introduce electronic trading (ECNs) and high-frequency trading (HFT) 2.10 How market conditions are classified as Bull or Bear 2.11 The importance of international securities markets and a discussion on the performance and risk involved in these investments 2.12 Discuss ways to invest in foreign securities 2.13 Extended hours trading and regulation of the securities markets 2.14 The basic long transaction 2.15 The motives for margin transactions and the procedures for making them 2.16 Margin requirements, formulas for initial and maintenance margin, and the uses of margin trading 2.17 The short sale transaction, why one shorts securities, and the uses of short selling 18 Smart/Zutter • Fundamentals of Investing, Fourteenth Edition © 2020 Pearson Education, Inc.  Overview 2.1 The text divides securities markets into money markets and capital markets. The instructor should explain the difference. 2.2 Both primary and secondary transactions are carried out in capital markets. The instructor should define these transactions for students and explain the role of the investment banker in the selling of new securities (primary transactions). 2.3 Initial public offerings (IPOs) are the most important transaction in the primary market. The sequence of events includes filing a prospectus with SEC, a quiet period, the distribution of the “red herring” preliminary prospectus, and finally the first day of trading. First day returns and the number of IPOs vary greatly over time with market conditions. Most IPOs take place with the assistance of an investment banking firm. In the underwriting process, the investment bankers buy all of the stock from the issuing firm and bear the risk of reselling at a profit. The instructor should discuss the gross proceeds of an IPO and underpricing offerings. 2.4 The secondary markets include various broker markets and dealer markets. The liquidity function of the secondary market and why this is important to investors should be explained to students. How do market makers help provide liquidity? Instructors should explain the difference between a bid price and an ask price and how a market order will be executed. Competition tends to keep the spreads between bid and ask prices fairly narrow. 2.5 Broker markets include the organized securities exchanges, while dealer markets include the Nasdaq (the National Association of Securities Dealers Automated Quotation System) and over-the-counter (OTC) markets. The instructor should emphasize the importance of the NYSE. The instructor might also discuss these aspects of organized security exchanges: the membership of an exchange; its listing policies; the role of the brokers, traders, and specialists; trading activity; and the auctioning process. 2.6 The chapter introduces options and discuss the Chicago Board Options Exchange (CBOE). It also discusses futures exchanges, futures contracts, and how futures are traded. 2.7 The dealer markets are described next. The instructor should point out that the Nasdaq and OTC markets are not physical institutions like the organized securities exchanges. The instructor should also mention that while there is only one specialist for each stock on an exchange, there may be several or even many dealers for large companies traded on Nasdaq. The distinctions between broker and dealer markets are blurring as more and more trades are executed electronically. Nasdaq includes larger companies than the over-the-counter market, with companies listed on the OTC Bulletin Board being larger than those included in the OTC Pink Sheets. The instructor should also point out that shares normally traded in the broker markets may trade in the dealer market, in what is known as the third market. 2.8 Electronic communications networks (ECNs) are computer-based trading systems that electronically match buy and sell orders among individual traders. Dealers make their profit by buying securities at a bid price and selling at a higher ask price. ECNs cut out the dealer and function and the payment of the bid/ask spread. Instructors should have students explore other alternative trading systems and high-frequency trading (HFT) and HFT strategies. 2.9 Instructors should lead the class in a discussion of bull markets and bear markets. How are they defined? Have students look up some history on these terms and how they came to be associated with rising and falling markets. Have students list some recent bull and bear markets. 2.10 The chapter then discusses the globalization of international securities markets, including a description of investing in the foreign securities marketplace, how to buy foreign securities, and the risks of international investment. Related issues are the existence of after-hours Chapter 2 Securities Markets and Transactions 19 © 2020 Pearson Education, Inc. trading and the mergers of stock markets foreshadowing the creation of a worldwide stock exchange, the NYSE Euronext which now includes the Paris, Brussels, Amsterdam and Lisbon exchanges. 2.11 The chapter discusses returns from international investing and outlines the various options available for international investing including multinational corporations, global and country mutual funds, and ADRs. The instructor needs to provide some discussion of the risks of investing internationally such as differences in securities regulation, accounting practices, and currency exchange risk. 2.12 The next section introduces extended trading hours as well as various regulations applicable to brokers, investment advisers, and stock exchanges. Recent legislation, such as the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, was passed in the wake of financial scandals and designed to protect investors and consumers. If they were not already discussed in Chapter 1, the instructor might want to bring in any recent litigation or securities market trial currently being covered by the press (e.g., the 2012 conviction of former Goldman Sachs trader Rajat Gupta, currently serving a two year sentence for insider trading violations). Widespread allegations of malfeasance on the part of financial firms leading up to the crisis of 2007–2008 have perhaps added to the importance of this topic. Ethical issues and insider trading are interesting and serve to make a point about the challenges facing those attempting to regulate the exchanges. 2.13 The text now moves to the different types of transactions, beginning with long purchases. The next section deals extensively with margin trading, including the magnification of profits and losses, initial and maintenance margin, and the formulas for their calculation. A number of review problems and a case at the end of the chapter will aid students in understanding the concept of margin. 2.14 The final section of the chapter deals with short selling, including the mechanics and uses of short sales. The text explains initial and maintenance margin requirements and the calculation of profit and loss on short sale transactions.  Answers to Concepts in Review 2.1 a. In the money market, short-term securities such as CDs, T-bills, and bankers’ acceptances are traded. Long-term securities such as stocks and bonds are traded in the capital markets. b. A new security is issued in the primary market. Once a security has been issued, it can be bought and sold in the secondary market. c. Broker markets are organized securities exchanges that are centralized institutions where securities listed on a particular exchange are traded. The dealer market is a complex system of buyers and sellers linked by a sophisticated telecommunication network. Dealer markets include Nasdaq and OTC markets. 2.2 The investment banker is a financial intermediary who specializes in selling new security issues in what is known as an initial public offering (IPO). Underwriting involves the purchase of the security issue from the issuing firm at an agreed-on price and bearing the risk of reselling it to the public at a profit. For very large issues, an investment banker brings in other bankers as partners to form the underwriting syndicate and thus spread the financial risk. The investment banker also provides the issuer with advice about pricing and other important aspects of the issue. In a public offering, a firm offers its shares for sale to the general public after registering the shares with the SEC. Rather than issue shares publicly, a firm can make a rights offering, in 20 Smart/Zutter • Fundamentals of Investing, Fourteenth Edition © 2020 Pearson Education, Inc. which it offers shares to existing stockholders on a pro rata basis. In a private placement of its shares, a firm sells directly to groups of investors, such as insurance companies and pension funds, and does not register with the SEC. 2.3 a. 5. The prospectus describes the key aspects of a security offering. b. 2. Underwriting is buying securities from firms and reselling them to investors. c. 6. The NYSE is the largest stock exchange in the world. d. 4. The Nasdaq OMX BX is a regional stock exchange. e. 3. Listing requirements are the conditions a firm must meet before its stock can be traded on an exchange. f. 1. The OTC trades unlisted securities. 2.4 The dealer market is really a system of markets spread all over the country and linked together by a sophisticated telecommunication system. It accounts for about 40% of the total dollar volume of all shares traded. These markets are made up of traders known as dealers, who offer to buy or sell stocks at specific prices. The “bid” price is the highest price offered by the dealer to purchase a security; the “ask” price is the lowest price at which the dealer is willing to sell the security. The dealers are linked together through Nasdaq. In order to create a continuous market for unlisted securities, IPOs, both listed and unlisted, are sold in the dealer market. About 3,000 Nasdaq stocks are included in the Nasdaq/National Market System, which lists, carefully tracks, and provides detailed quotations on these actively traded stocks. The Nasdaq Global Select Market contains the 1,450 biggest and most actively traded companies. An additional 1,000 firms are included in the Nasdaq National Market listing. Another 700 firms that are generally smaller can be found on the Nasdaq Capital Markets list. Companies that do not make the Nasdaq listing standards are traded on the OTC market’s Bulletin Board or “Pink Sheets.” Trading in large blocks of outstanding securities, known as secondary distributions, also takes place in the OTC market in order to reduce potential negative effects of such transactions on the price of listed securities. Third markets are over-the-counter transactions made in securities listed on the NYSE, the Amex, or any other organized exchange. Mutual funds, pension funds, and life insurance companies use third markets to make large transactions at a reduced cost. Fourth markets include transactions made directly between large institutional investors. Unlike the third market, this market bypasses the dealer; however, sometimes an institution will hire a firm to find a suitable buyer or seller and facilitate the transaction. 2.5 Electronic Communications Networks (ECNs) are automated computer-based trading systems that electronically execute orders by matching the buy and sell orders submitted by individual traders. ECNs eliminate the dealer function and the payment of the bid/ask spread. 2.6 A bull market is a favorable market normally associated with rising prices, investor optimism, economic recovery, and governmental stimulus. In contrast, bear markets are associated with falling prices, investor pessimism, economic downturn, and government restraint. 2.7 The globalization of securities markets is important because today investors seek out securities with high returns in markets other than their home country. They may invest in companies based in countries with rapidly growing economies or choose international investments to diversify their portfolios. The U.S. securities markets, while still the world’s largest, no longer dominate the investment scene. In recent years, foreign exchanges have provided investors with high returns. Only once since 1980 has the United States finished number one among the major stock markets of the world. In spite of a strong U.S. market Chapter 2 Securities Markets and Transactions 21 © 2020 Pearson Education, Inc. with double digit returns in 2017, 34 countries around the world had higher returns; Hong Kong, Denmark, and France all bested the Dow’s 25% return. 2.8 To achieve some degree of international diversification, an investor can make foreign security investments either indirectly or directly. An investor can diversify indirectly by investing in shares of U.S.-based multinational companies with large overseas operations that receive more than 50% of their revenues from overseas operations. Investors can make these transactions conventionally through their stockbrokers; the procedure is similar to buying a domestic security. An investor can also purchase foreign securities indirectly by purchasing shares in a mutual fund that primarily invests in these securities. The investor can also purchase foreign stocks and bonds directly on foreign exchanges, buy shares of foreign companies that are traded on organized or over-the-counter U.S. exchanges, or buy American depositary receipts (ADRs) and Yankee bonds. 2.9 The investor must be aware of the additional risks involved in buying foreign securities: country risk, government policies, market regulation (or lack thereof), and foreign currency fluctuations. Investors must consider risks beyond those in making any security transaction. In particular, investors in foreign markets must bear risks associated with doing business in the foreign country, such as trade policies, labor laws, taxes, and political instability. Because investing internationally involves purchasing securities in foreign currencies, trading profits and losses are affected not only by security price changes, but by foreign exchange risk. This risk is caused by the varying exchange rates between two countries. Profits in a foreign security may translate into losses once the foreign currency has been exchanged for dollars. Similarly, transaction losses can result in gains. To further complicate matters, many foreign companies earn much of their profits in U.S. dollars, and U.S. companies may earn much of their profit in foreign currencies. The bottom line is that investors must be aware that the value of the foreign currency relative to the dollar can have profound effects on returns from foreign security transactions. 2.10 The exchanges, Nasdaq, and electronic communications networks (ECNs) offer extended trading sessions before and after regular hours. Most of the after-hours markets are crossing markets, in which orders are only filled if they can be matched with identical opposing orders at the desired price. Many large brokerage firms, both traditional and online, offer their clients after-hours trading services. ECNs handle after-hours trading for their client brokerages. Obviously, the two investors would have different expectations about subsequent share price performance. The development of securities markets around the globe has essentially created continuous trading in stocks. After-hours trading sessions carry more risk. Price