IFSE - CIFC - Unit 5 Questions and Answers Graded A

IFSE - CIFC - Unit 5 Questions and Answers Graded A Mutual Funds Investments that hold a collection of different securities such as equities and bonds. Holdings Collectively, the securities in a mutual fund The 3 main investment objectives 1. Safety of Principal 2. Income 3. Growth Safety of Principal Strive to protect investors from losing any of their original investment. Investors expect to get back at a minimum the amount of money they put into the investment. Income Provide investors with a regular source of income over the course of their investment time horizon. Growth Have the potential to appreciate over time. Investors purchase with this this investment objective in the hope that the market price of the securities when they sell their investments will be higher than the original purchase price. Reason why Government issue securities To raise capital. Government can borrow money from the public by issuing fixed income securities (short-term, medium-term, long-term) Short-term Government Securities - mature within 5 years or less. Includes treasury bills, and provincial or municipal short-term papers Medium-term Government Securities - Mature between 5 and 10 years. Ex: Federal, provincial, or municipal bonds Long-term Government Securities Mature in 10 years or more. Ex: Government of Canada bonds Common Shares Share ownership that entitles investors to a portion of the company's earnings and some control of the corporation Preferred Shares Share ownership that entitles investors to receive a fixed amount of the company's earnings on an ongoing basis. This type of share ownership typically does not give investors control of the corporation When corporations don't want to divide ownership any further They can borrow money from the public by issuing bonds: - money market securities, including both banker's acceptances and commercial papers - medium- and long-term bonds Fixed Income Securities Essentially loans provided by investors. The debt security includes contractual obligation stating that the issuing government/corporation must pay interest and return the principal to the investor by the maturity date. Par Value Aka face value or face amount Coupon Rate Used to calculate the regular interest payments paid by a bond, aka coupon payment. It is fixed throughout the life of the fixed income security Money Market Securities Fixed income investments that typically mature under a year. Very liquid. Price of this security doesn't fluctuate very much making them safe and stable investments. Main types of Money Market Securities - treasury bills - provincial and municipal short-term papers - bankers' acceptances - commercial papers Treasury Bills (T-Bills) - issued by the Canadian government to finance their short-term cash needs - don't pay periodic interest to investors - sold at a discount, then pay out at maturity (face value) - very low risk since guaranteed by the Government of Canada - terms of maturity offered at auction are 98, 182, and 364 days - their prices are inversely proportional to interest rates - safety of principal and income Provincial and Municipal Short-term Papers - debt securities issued by the provincial or municipal government to pay for capital spending - sold at a discount, then pay face value at maturity - safety of principal and income - slightly higher risk as offer slightly higher interest income Banker's Acceptance (BA) - issued by corporations but guaranteed by a commercial bank - for a stamping fee, the bank guarantees the corporation's debt and is ultimately responsible to repay investors should the corporation default on its payments - bought at a discount - pay higher interest rate therefore riskier as guaranteed by bank rather than government - safety of principal and income Commercial Paper (CP) - issued by corporations seeking short-term loans to fund short-term cash shortages - purchased at a discount - at maturity face value is paid - higher interest and higher risk as not backed by government or bank - corporation borrows money under its own name and credit rating - interest rate depends on stability of corporation and its likelihood of loan repayment - safety of principal and income Bonds - fixed income securities with maturity greater than 1 year - regular income and stability of principal - riskier ones backed by corporations with poor credit rating entice investors with higher coupon rates - when price is $100 means it is at par - secured by specific assets of the issuer (property, inventories, equipment, etc.) Coupon Bonds - forces the issuer to pay the coupon payments - if issuer defaults on coupon payments or principal, bondholder can force issuer into bankruptcy to sell their assets and use proceeds to repay bondholders Debentures - similar to bonds but not secured by real assets or collateral - backed by the reputation and credit worthiness of the issuer - higher level of income than regular secured bonds - medium risk because not secured by real assets and lower priority than bondholders if company goes bankrupt Convertible Bonds - type of coupon bond that offer investors the option to convert the bonds into common shares, which confer ownership interest in the company issuing the bonds - pre-set price within specified time frame - due to conversion option, usually smaller coupon rate Callable Bonds - issuer reserves right to buy back bond from the bondholder within a specified time period at a specified price, usually at premium to face value - higher interest rate as investors may have to sell bond back at an inconvenient time Extendible Bonds - allows investor to extend term of the bond within specified limits - convenient when bond is close to maturity and paying out a relatively high interest - lower rate of interest to obtain this feature Retractable Bonds Bonds that allow the bondholder to sell them back to the issuer at predetermined prices at specified times earlier than the maturity date Zero Coupon Bonds - no coupon payments - sold at a discount - paid out at maturity at face value - face value and maturity are pre-determined so investors know exactly how much interest they will receive - usually held in RRSPs - higher risk as payout isn't throughout as with coupon payments but only at maturity (interest rates may rise in the meantime) Mortgage Bonds - invest in a pool of mortgages - regular interest income and safety of principal - low risk as backed by real assets - Ex: CMBs Relationship Between Bond Prices and Interest Rates Inversely proportional Relationship Between Bond Prices and Yield Directly proportional Normal Yield Curve X-axis: Yield Y-axis: Maturity - upward-sloping yield curve indicates that long-term interest rates are generally higher than short-term interest rates. The higher yield reflects investor's expectation that rates will rise in the future Inverted Yield Curve X-axis: Yield Y-axis: Maturity - downward-sloping yield curve indicates that short-term interest rates are generally higher than long-term interest rates. Investors expect rates to decline. A recession may be forthcoming Flat Yield Curve X-axis: Yield Y-axis: Maturity - short and long term rates are the same. Usually indicates that the market is in transition trying to determine the direction of interest rates. Possible sign of economic slowdown 6 Main Risks of Investing with Bonds 1. Inflation Risk 2. Interest Risk 3. Reinvestment Risk 4. Liquidity Risk 5. Sovereign Risk 6. Default Risk Inflation Risk of a Bond AKA purchasing power risk. When the return of a bond does not keep up with the inflation rate. Interest Rate Risk of a Bond Risk of price of bond will fall de to a rise in interest rates. As interest rates rise, prices of bonds decline, and inversely. Reinvestment Risk of a Bond Coupon payments will be reinvested at a lower interest rate than the rate on the original investment Liquidity Risk of a Bond If a bondholder cannot find a buyer for their bond when they need to sell it. Sovereign Risk of a Bond A government or government backed agency may be unable to make interest payments or return principal amount. This may happen due to unfavourable economic conditions Default Risk of a Bond AKA credit risk. When the bond issuer is unable to pay scheduled coupon payments due to financial difficulty. Worst case scenario, principal will not be re-paid. If issuer defaults on coupon payments, the investor may be able to recover some of their investment Credit Rating - Highest rating is AAA - Lowest rating is D - low risk range from AAA to BBB- - high risk are BB or lower (aka junk bonds) Equities Units that represent ownership shares in corporations. First made available through an initial public offering (IPO). Trades in a secondary market such as the Toronto Stock Exchange (TSX). Preferred for non-registered accounts Common Shares of Equities - Receive dividends. Amount and frequency depend on the company's earnings and what the board of directors decides - have voting rights - have minimal claim on corporation's assets if company goes bankrupt Preferred Shares of Equities - Receive dividends. Priority over other shareholders. Amount is fixed and frequency of payments is consistent - no voting rights. If yes, very minimal - have primary claim on corporation's assets if the company goes bankrupt Dividends Company's share profits to the shareholders based on the corporation's performance. Declaration date is when the dividend is authorized and announced to the public. Convertible Preferred Shares of Equities Gives the shareholder the option to convert shares into a fixed number of common shares at a predetermined price within a specified period Participating Preferred Shares of Equities Offers the opportunity to receive additional dividends if the company's profit exceeds a stated level. May also have provision that entitles investors to receive an additional amount of the company's assets if the company is liquidated Cumulative Preferred Shares of Equities Requires that unpaid dividends accrue and be paid in full before dividends are paid to common shareholders. Non-cumulative dividends do not carry forward missed payments (dividends may be missed if the company does not make a profit). Callable Preferred Shares of Equities Allows the issuer to redeem the preferred shares at a pre-determined price within a defined period Retractable Preferred Shares of Equities Entitles the shareholder to sell the shares back to the issuer at a pre-determined price and time in the future Derivatives Any financial instrument whose value is derived from the value of some other "underlying" asset Main Types of Derivatives 1. Options 2. Future Contracts 3. Forward Contracts Hedging Involves taking an offsetting position, such as entering into an agreement with another party to sell or buy an asset at a predetermined price to prevent loss Speculation An involvement in risky business transactions in an effort to make a quick or large return Options Derivatives Contracts that give an investor the right to buy or sell a predetermined amount of an underlying security at a set price for a set period of time Call Options The option to buy securities at a specified price and time in the future Put Options The option to sell securities at a specified price and time in the future Future Contracts The seller agrees to provide a certain standardized commodity to the buyer on a specific future date at an agreed-on price. There is a legal obligation to buy or sell an underlying asset. Forward Contracts An agreement that allows a buyer to purchase an underlying asset from a seller for pre-set price at a specific future date. There is a legal obligation to buy or sell the underlying asset.