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FINAL EXAM STUDY NOTES! CH.8 - Stock Indices and Averages Index – a number that measures a number of stock prices so that a percentage change in this

index can be calculated over time. They serve as the underlying assets for options, futures, and ETFs.

Average – used for the same purpose, but is determined by summing up the number of prices and diving by the number of items (equally weighted).

S&P/TSX Composite Index – determined by the total market capitalization of a portfolio of

the most actively traded Canadian stocks. It’s a market/value-weighted index. The stocks are reviewed every quarter, and stocks can be replaced. A base value of 1000 was set in 1975.

S&P/TSX 60 – base is 100 MidCap index contains 60 stocks that rank below S&P/TSX 60 in market cap, while the SmallCap

index contains the remaining stocks. Dow Jones Industrial Average (DJIA) – most widely quoted measure of NYSE stock

performance, but only includes 30 stocks. It’s a price-weighted average, which reflects the highest quality blue chip stocks in the US. Due to its low risk, it tends to underperform broader indices like the S&P 500.

S&P 500 Index – broader based market-weighted index that measures US stocks. It’s used to measure the investment performance of institutional investments.

NASDAQ Composite Index – contains over 4000 OTC stocks and is market valued. Wilshire 5000 Equity Index measures almost everything, and is the broadest based US

Index. NYSE maintains market valued indices which include listed equities for: composite, industrials,

transportation, finance and real estate, and utilities. Others Include: Nikkei (price weighted), FTSE 100 (UK, market weighted), DAX (Germany,

value-weighted with 30 blue chips).

Financials is NOT a subsector index in the Canadian market. Under the Canadian system, capital gains are taxed at a rate equal to 50% of regular

income.

Pari Passu – when different classes of preferred shares have the same rank in relation to asset and dividend entitlement

CH.9 – Equity Trading Cash Accounts = not granted credit b the securities firm and have to make full payment o the

settlement date (same day for T-bills, 2 days for Gov’t direct and guarantees up to 3 years, and 3 days for all other securities)

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Margin Accounts = enable them to buy or short sell securities by paying only part of the full price, borrowing the remainder from the member (with interest charged). The term “margin” means the amount the investor must contribute to the margin account.

Maximum Loan Values for securities other than bonds and debentures are:

70% for securities eligible for reduced margin 50% for prices of $2 and over that are not eligible for reduced margin 40% for prices of 1.75 to 1.99 20% for prices of to 1.74 No loan value for under 1.50

When a margin falls below a level, there’s a margin call requiring the client to deposit more into their margin account, or else shares will be sold.

E.g. Cost is $2 x 1000 = $2000. ID max Loan = 0.5x2x1000 - $1000. Min Margin Requirement = $2000 - $1000 = $1000. If price decreases, max loan decreases and there is a margin deficit. If the prise rose, the max loan increases and there is a margin surplus.

Short Sales – investor sells securities they don’t own. The investor must leave the proceeds of

the sale with the dealer, and deposit a certain portion of the market value in addition. It’s like the opposite of buying on margin, and the required balances are:

130% for securities eligible for reduced margin 150% for prices of $2 or over $3/share for 1.50 to 1.99 200% of market value for 0.25 to 1.49 100% of market plus 0.25/share for prices under 0.25

E.g. Short sell 1000 shares of stock at $10. The min account balance is 1.3 x 10 x 1000 =

13,000. The proceeds from the sale is $10,000. The min margin requirement is $3000. The min account balance changes depending on MARKET PRICE.

There is no time limit on a short position, but the client must buy the necessary shares if the broker is unable to borrow sufficient shares to do so. Thus, the stocks that are short sold are usually actively traded one. TSX reports short positions twice a month. Hazards of this include: Difficulties in borrowing enough shares

Liability for any dividends paid Possibility of volatile prices should a rush to cover happen The unlited potential loss Responsibility of having an adequate margin

Equity Transactions Traditional equity transactions involve a buyer and a seller who are represented by an

investment dealer. The IAs report the current bid and ask for shares. After a transaction occurs, both the buyer and seller receive a confirmation of the transaction, and are required to settle in 3 business days. IAs can also be principals, where they fill a customer’s order from their own inventory, and the trade is made at the market price.

Buy and Sell Orders

Market Orders – best available price in the market Limit Orders – only if a specific price or better can be obtained Day orders – limit orders that are valid for one day

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Good Till Cancelled/Open Orders – limit orders that remain until filled, for 30, 60, or 90 days

All or None Orders – only filled if the total number of shares can be bought or sold Any Part Order – accept any amount of shares, in round or odd lots Stop Loss – it generates market orders to SELL if the price drops below a certain point;

used to limit losses on long positions

Stop Buy Orders – a market buy order is generated if the price rises above a certain level to limit losses on short positions

Pro Orders – transactions involving partners, directors, shareholders, IAs, or employees The preferential trading rule requires IAs to give priority to client orders over those of non-

clients, which include pro orders (labelled Pro, N-C, or Emp). Market orders are made at the best available price, while day orders are made only if a specific

price or better can be obtained. If an investment order doesn’t specify the time in which the IA has to fill the order, then the

order remains open until the close of the business day or until filled, whichever is sooner. CH. 11 – Financing and Listing Forms of Businesses: Proprietorship – not a separate legal entity, unlimited liability, capital generation restrictions,

income is taxes as personal income. Partnership – at least one general partner who is liable for all business debits. Limited partners

are not involved in daily business acitivty and liability is limited. Corporation – dominant form, separate legal entities, separation of ownership from

management, unlimited life, shareholders have limited liability and can transfer ownership, greater access to capital.

A corp comes into existence when a charter is issued by the government, and may be: letters

patent, memos of association, or articles of incorporation. Private corporations restrict the right of shareholders to transfer shares, limit the number of

holders to less than 50, and prohibit inviting the public to own it. A corp is regulated by the government act which it was incorporated (provincial or federal), its

own charter, and its by-laws (whicha re passed by directors and approved by shareholders) Significant events require the approval of shareholders: liquidation of businesses, changing

amendments, etc. All shareholders have the right to receive proxies and AFS. Proxy – the power of attorney that allows another party to vote on behalf of the shareholder.

If management obtains a sufficient number of proxies it can control the board of directors. During restructuring, a corp may have a voting trust, which shareholders deposit their shares with a trustee to transfer voting control to few individuals.

Structure Corps are required to a have outside directors that are responsible for: appointing officers,

signing authorities, contracts, budgets, and declaration of dividends. They must act like a reasonably prudent person. The board elects a chairman, who (or the president) can be the CEO.

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The max number of shares a corp may issue is the numberof authorized shares. Issued shares refer to the number issued, while outstanding shares are those that are held by investors.

Par Value Shares – no relationship to market value or enetitlement to corporate assets. Advantages of Corporations:

Separate legal entity that can sue and be sued Limited liability Continuity of existence Ease of ownership transfer

Professional management Tex benefits General enhanced capital accessing Growth potential

Disadvantages:

A loss of flexibility Possibility of double taxation Additional admin costs Complications involving withdrawal of capital

The Financing Procedure The investment dealer advises the issuer regarding the amount, timing, pricing, and attributes

of the issue. Sometimes the dealer or broker may become the broker of record, which gives them the right of first refusal on new financing. - A private placement is an arrangement with private investors that doesn’t need a ful

prospectus, just a offering memorandum. - Public offerings are regulated by the Canadian Business Corporations Act and provincial

securities regulations. It must include full, true, and plain disclosure of all material facts – and material facts are those that affects/impacts the market price.

- The dealer will consider the financing structure, stability of earnings, prospects for the future, as well as current market conditions before recommending an option

Debt Financing:

- Interest payments are tax deductible - Not a permanent commitment - Doesn’t dilute ownership - Some of the issuing discount may be tax deductible - Lowest cost financing alternative

Equity Financing:

- No obligation to pay any portion of earnings as dividends - Repayment of capital not required - Management’s actions are not restricted - Greater cushion against insolvency and can improve the credit rating

A prelim prospectus is given to the securities commission and investors, which includes most

information except the price. A red statement means its not final, and a greensheet

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(information circular) highlights the important features of the issue and can be used by the sales department to generate interest.

There is a 75 day waiting period between the issuance of red herrings and final prospectuses. After it is approved, the issue is blue skied and distributed to the public. Must be mailed to all

purchasers of securities on the second business day after the trade. Short Form Prospective Distribution System – saves time and focus on price, distribution

spread, use of proceeds, and security attributes. Allows senior reporting issuers who have made public distributions already (already lots of info). They are common in BOUGHT DEALS, where the underwriter buys all of it and resells it, bearing all risk.

Lead underwriters generally provide after-market stabilization of the issuer’s market price, which must be disclosed on the first page of the prospectus. This may mean selling more securities than the original amount, and buying it back if the price drops.

New share issues are usually traded OTC before listing on an exchange. Advantages of listing:

1. Prestige and goodwill 2. Established value in mergers 3. Market visibility, more information 4. Valuation for tax purposes, increased marketability

Disadvantages include: 1. Additional controls on management 2. Additional costs to the company 3. Market indifference (if trading volumes are low) 4. Additional disclosures required, the need to keep market participants informed

Listing requires the disclosure of info like: 1. The company’s charter and current prospectus 2. The financial statements for the last 3-5 years 3. An opinion from the legal counsel 4. Sample share certificates 5. Annual reports

Listing Requirements Include: 1. The submission of annual and interim financial statements 2. Notification to the exchange about dividends 3. Proposed stock options for employees, underwritings, sale of treasury shares 4. Material changes In business of a listed non-exempt company

A listed security can be cancelled because: it no longer exists, has no assets or bankrupt,

public distribution is no longer sufficient, or it no longer complies with the terms of its listing agreement.

CH. 13 – Fundamental and Technical Analysis Expected profitability and interest rates are the two most important factors affecting the value

of a security. Fundamental Analysis looks at the economy, industry, and company, where the most

important factor is the future profitability of the issuer.

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Technical Analysis looks at stock prices, trading volumes, and market data to find recurring patterns. Both may use quantitative analysis to find patterns of interest rates, economic variables, and stock valuations to measure the factors influencing investment decisions.

Efficient Markets Hypothesis – asset prices fully reflect available information Random Walk Theory – in efficient markets, prices will change randomly (no patterns) Rational Expectations Hypothesis – people make decisions consistent with all available info

– same for everyone and wisely serve their own interests Fundamental Macroeconomic Analysis: Factors

External effects like wars and elections Fiscal Policies, such as taxes, govt spending Monetary Policy, which affects interest rates and corporate profitability. The US

affects Canada strongly, and also monetary policy affects inflation, which affects bond yieds. When inflation happens, the central bank raises interest rates, which leads to less economic growth

o Tilting of the yield curve – when short term interest rises and long term falls. This relieves inflation, while the decline in long term rates makes equities more attractive than bonds. Gains increase as the degree of tilt increases.

Flow of Funds – capital flows from one asset class to another are determined by changes in demand for bonds and stocks. A mutual fund purchase is an important factor influencing the S&P/TSX index. Equity fund purchases rise as interest rates fall.

Inflation – inflation causes uncertainty about the future, which higher interest rates, lowers profitability and price-earnings. The growth on ROE is highly correlated with changes in GDP and inflation.

Industry Analysis S&P/TSX Composite Index is classified into 10 major sectors, and industry growth is compared

to GDP and inflation. IN order to be competitive, companies strive to become: Either a low cost producer, or a producer of a differentiated product All industries have a life cycle:

1. Emerging or initial growth – new goods, may have negative cash flow, low yields, and risky in nature

2. Rapid growth – sales are growing, growth finance by reinvesting earnings and have high P/E ratios with above average risk

3. Mature industries – slowing of growth, more competition, slower sales but greater financial resources. Dividends tend to be higher

4. Declining – growth declines, profit magins fall 5 Competitive Forces determine the industry attractiveness:

1. Ease of entry or exit 2. Degree of competition 3. Availability of substitutes 4. Ability to exert pressure over selling price of products 5. Ability to exert pressure over the purchase price of inputs

ROE calculates profitability relative to the quity investment in a business. ROE = net earnings before extraordinary items / total equity

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Cyclical Industries – earnings are affected to a larger than average amount by downturns in the business cycle. ROE would vary by at least 100% over a complete cycle, while it’s 1/3 for defensive industries and 55% for the entire index. Usually commodity based, or automobiles.

Defensive stocks – sales are less affected by swings in the cycle, such as blue chip stocks. Usually financial and utility companies are strong, but their earnings vary due to interest rate changes.

Speculative industries – great deal of risk, such as penny stocks or tech stocks. Dividend Discount Model = Div/ r – g The model predicts that the value of commons shares will increase as a result of:

- Increases in expected dividends are related to profitability - Increases in the growth rate of these dividends - Decreases in the discount rate

Price-Earnings Ratio Tend to increase during rising stock markets, rising earnings, falling interest rates, and overall

the level of investor confidence. Decline in the riskiness of cash flows and falling inflation will also increase the P/E Ratio.

Technical Analysis Three main assumptions:

1. All market actions are automatically accounted for in price activity, therefore fundamental is not right

2. Prices move in a series of trends and patterns 3. The past repeats itself in the future

Some tools include chart, quantitative, cycle analyses, and sentiment indicators. Moving Averages: adding the closing prices for a stock over a given period of time. If the

overall trend has been down, the MA line will be above the current prices, and if the price breaks through the moving average line from below, it’s a buy signal. If price passes the MA line from above, it generates a SELL signal.

Elliot Wave Theory – the market moves in waves Sentiment – when CONSENSUS finds that more than 75% of those surveyed are bullish, then

the market is overbought, while when it’s below 25%, then it is oversold. MC Questions The rationale for technical analysis is inconsistent with the random walk theory and efficient

markets hypothesis. Technicaly analysis involves looking at trading prices and volumes. Rising inflation causes P/E ratios to decrease due to the upward pressure it exerts on interest

rates. An investor who cares about income should buy shares of a company in a mature life cycle. If the P/E ratio is higher, the price believes that it has greater growth potential because prices

are higher. Inflation leads to more uncertainty, lower profits, and higher interest rates. It also results in

lower P/E multiples. P/E ratio are higher when it is in a growth or speculative industry, and investor confidence is high.

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Blue chip companies do not have growth in sales and earnings. A resistance level is when supply exceed demand and prices beings to fall CH.14 – Company Analysis Earnings statement analysis examines trends, and reasons, by using: -sales -operating ocsts and profitability -profit margin, ROE, cash flow, EPS, and dividend record Balance Sheet analysis gives a picture of overall financial position and examines: -the effect of leverage on earnings -the company’s capital structure -what types of securities have been issued Qualitative analysis can also be taken to measure management effectiveness. Common warning signs to look for in financial statements are:

1) Changes in accounting practices 2) Long term commitments 3) A series of mergers and takeovers

Four areas of firm operations that are often analyzed by ratios are:

1. Liquidity (ability to generate cash in a hurry to meet short-term obligations) 2. Risk analysis (ability to repay and assume more debt) 3. Operating performance (make use of assets to generate profits) 4. Value (relates the market value and returns with the company’s shares to tis accounting

values) Liquidity: Working Capital: current assets – current liability Current Ratio: assets/liabilities Quick Ratio: current assets – inventory / current liabilities Operating cash flow ratio: cash flow / current liabilities Risk Analysis: -Asset Coverage -Debt percentage of total capital -Debt/equity ratio (total debt outstanding/book value of shareholders equity) Cash flow/total debt (operating cash flow / total debt) Interest coverage (EBIT / interest) – most important quantitative test. Higher ratio is better Preferred dividend coverage ( Analyzing VALUE: Dividend Payout Ratio: Total dividends/net earnings Price Earnings Ratio: current market share price/EPS [net earnings – pref div / # of common

shares] CH. 17 – Mutual Funds

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Advantages of mutual funds include: -professional management -diversification -variety of types of funds, purchase and redemption plans, special options -liquidity and transferability -loan collateral -eligibiltiy for margin Disadvantages: -costs/sales fees -unsuitable for short-term investment or emergency reserve -management can make mistakes too Tax complications may arise The Structure of Mutual Funds Investment funds are companies or trusts that sell their shares to the public and invest the

proceeds in a diverse portfolio. The funds earn income by interest, dividends, or capital gains.

Usually open-end trust, which is redeemable and sometimes provide voting rights. The trust itself isn’t taxable, and the fund is established in a trust deed, which describes:

The investment objectives and policy Investment restrictions and details about fund managers Specifies which class of units will be sold to the public

Fund distributors – parties that sell shares or units Custodians – collect and distribute cash for the fund as required (usually trust companies) Load funds charge a commission on the purchase or sale of fund units or shares. Front-end Load – sales commissions when units are purchased Back-end Load – redemption fee when units are sold No-Load funds – don’t charge direct selling charges, but have admin/management fees Trailer Fees??? Switching fee – for switching funds in the same company Management fees – 1% to money market and index funds to 3% to equity funds. Management Expense Ratio = Aggregate Fees Payable in the Year/Average Net Asset Value

for the Year x 100% This is charged directly to the fund, such that if a fund earned 20% and MER was 2%, the

investor gets 18%. F-class funds charge lower MERs. Mutual Fund Dealers Association is a new SRO that regulates the distribution of mutual funds.

Fund buyers must receive copies of the simplified prospectuses no later than two business days after an agreement of purchase. It should include: - Significant holdings in other issuers - Tax status and contracts outstanding

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- Directors, officers, trustees - Financial statements including investment portfolio, changes in net assets, etc.

Unacceptable Sales Practices:

- Quoting a future price - Offering to repurchase securities - Advertising the fact that they are registered

CH. 18 – Mutual Funds: Types and Features Objectives generally cover the degree of safety or risk, whether income or capital gain is the

prime objective, and main securities in the portfolio. They vary significantly between funds.

1. Cash and Money Markets – focus on income and liquidity (low risk and high liquidity, although interest is fully taxable)

2. Fixed Income Funds – steady stream of income, not capital appreciation. Bonds, income trusts, mortgage funds. Mortgages are risker due to longer term interest rate risk

3. Balanced Funds – provide a mix of safety, income, and capital appreciation, which must adhere to min percentages in each asset class. Asset allocation funds are similar without the requirements

4. Equity or Common Stock Funds – objective is capital gains 5. Index Funds – mirror the performance of a market index, and the fees are much lower

The order from low-risk low-return to high-risk and high-return are:

1. Money market 2. Mortgage 3. Bond 4. Balanced 5. Dividend 6. Equity 7. Real estate 8. Speciality

Risk of funds should be measured comparatively by: -standard deviation of returns (total volatility) -beta: the volatility of the fund’s returns relative to those in the market portfolio (risk) -number of years it lost money Avoid: -fund’s history -performance of peer group averages because they are survivorship biased -short term comparisons (min 3years) CH. 19 – Segregated Funds Unlike investment funds, they are exempt from securities laws. The holders don’t own the

assets but are protected by provisions in the contract. They must guarantee that a min of 75% of the payments will be returned at the end of 10 years. There are no probate fees, provide business owners with protection, but contract holders pay more for these benefits.

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Maturity guarantees alter the normal risk return relationship because it allows market gains and

principal protection. There are three forms: 1. Deposit-based guarantees – for each deposit made 2. Yearly policy based guarantees – grouping all contributions made within a 12 month

period, and giveng them the same maturity date. 3. Policy based guarantees that base guarantees on the original policy issue date

Since the index has never been negative over a 10 year spread, there is debate as to whether

seg funds are worth it. Those with RRSPs must be terminated before 69, life income fund holders must be below 90, and the start age is 16.

The proportion of seg funds they should hold is: -risk tolerance -proportion of funds alrdy held in cash and fixed income -time horizon…shorter = less need for seg funds Since seg funds are insurance products, they provide protection from creditors, unlike mutual

funds. In order for this to apply, the fund must: - For plans with revocable beneficiary status, the B must be a spouse, child, or parent of

the contract holder in Quebec - The B must be a spouse, child, or parent of the annuitant in other countries - Non registered plans with irrevocable B’s have no B restrictions (can be loan collateral)

Similar to mutual funds, seg funds have these fees: -legal, admin, registration, mailing, and taxes (higher than MFs) -Trailer and switching fees may also apply

Feature Seg Funds Mutual Funds

Legal Status Insurance contract Security

Asset Ownership Insurance company The Fund

Regulation Body Provincial insurance regulators

Ontario Securities Commission

Maturity Guarantees Min. 75% after 10 years None

Death Benefits Yes (some restrictions) None

Creditor Protection Yes (with conditions) None

Probate Bypass Yes None

CH. 20 – Hedge Funds Hedge funds facer lighter regulation, and more flexibility in asset management. They are similar

to mutual funds because they both pool investments with sales charges, are sold by IDs, and charge management fees. However, they can short, use derivatives for hedging or speculation, may have liquidity restrictions, and sold thru memo offers to accredited investors. They have higher returns (and risk) than MFs.

Eligible hedge fund investors include:

- High net worth and institutional investors – issued through offering memos which disclose less info than prospectuses. Three reasons for being exempt from prospectus:

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o Min. investment exemption - $150,000 o Accredited investor exemption – institutions with net assets of $5million or more o Offering memo exeption

- Retail Investors o Commodity Pools (MFs that use short selling through derivatives) o Closed-end funds (less restrictions) o PPNs – provide exposure to returns of one or more hedge funds and have a

principal return guarantee by a bank or issuer Although there are hedge fund indexes, none of them is exhaustive because the reporting of

information is optional. BENEFITS:

- Offer diversification benefits and lower overall portfolio risk - Risk minimization - Higher absolute returns - Potentially lower volatility with higher returns

RISKS: - Light regulation - Manager and market risk - Complex investment strategies - Liquidity constraints (not liquid…lockups…may charge early redemption fees and/or

require advanced notice) - Incentive fees - Tax - Short-selling and leverage - Business risk because hedge funds are small businesses

IAs must do due diligence before recommending any to the investor, such as:

1. Manager’s investment process and strategy 2. Fund details (AFS availability, historical returns, redemption policy) 3. Investors’ legal and taxation issues 4. Business issues (profitability, stability, financial backing)

Hedge Fund Strategies (Lowest risk to Highest)

1. Relative Value – exploit market inefficiencies or arbitrage opportunities, such as a. Equity Market-Neutral: simultaneously creating long and short portfolios b. Convertible Arbitrage – exploit mispricings in convertible bonds or pref shares

relative to the common stock. c. Fixed Income Arbitrage – price discrepancies b/w interest rate securities and

other securities based on rates. 2. Event Driven – exploit events such as m&a, stock splits, and buybacks.

a. Merger or Risk Arbitrage b. Distressed Securities c. High-Yield Bonds – invest in junk debt securities that may be due for an

upgrade, be a takeover target, or undervalued 3. Directional Strategy – take positions based on beliefs about future movements in

equity, debt, and FX markets. The highest risk.

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a. Long/Short Equity – most popular hedge fund. Net exposure is long – short exposure / capital.

b. Global Macro c. Emerging Markets d. Dedicated Short-Bias e. Managed Futures Funds – commodity and currency markets, many are set up as

commodity pools PPNs – Principal Protected Notes No min investment requirements, and involve three roles which may be the same person – 1.

Guarantor or issuer, 2) the hedge fund manager, and 3) distributor. They are lightly regulated, and include many costs, which include: marketing, trailer, broker, financing, leverage, and set-up fees.

Exchange Traded Funds Trusts that hold shares of companies in market indices in proportion to their weights in the

index. Trade in secondary markets. They differ from mutual funds by: - They trade throughout the day on exchanges - Lower management fees - Lower portfolio turnover, reducing capital gains income and taxes payable - They permit short selling - May be purchased on margin

Popular types are i60s, which is 1/10 of the S&P/TSX 60 Index. Dividends are paid quarterly. CH. 15 – Portfolio Management Investment Management Process: Security selection, asset mix, market timing, and portfolio

management. Returns consist of two components: cash flow yield and price change. Return % = cash flow + (ending value – beginning value) x 100 Beginning value Ex-post returns = past returns. Projected returns = ex-ante returns. The real rate of return

depends on nominal and inflation rates. Real Return = Nominal Rate – Inflation Rate. There are many risks involved (see written notes), but the variability in a security’s total returns

is unavoidable, called systematic market risk. It is estimated that asset allocation accounts for 80-90% of investment returns. Portfolio Management:

1. Determine investment objectives and constraints (risk, return, time horizon, liquidity, taxation) or constraints like ethical, tolerance for risk, legal, etc.

a. Three main investment objectives are income, capital gains (growth), and preservation of capital(safety), with secondary objectives of liquidity and tax minimization

2. Formulate asset allocation strategy

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3. Design investment policy statement – formal written doc that says the guidelines agreed upon by the manager and investor.

4. Implement asset mix 5. Monitor the economy, markets, portfolio, and client 6. Adjust the portfolio and measure performance

Beta = market risk, or volatility. If its less than 1, then it moves x% of the market movements CH. 16 – Portfolio Management Process The Asset Mix -Cash includes money markets, GICS, bonds of one year or less – makes up 5% of a portfolio -Fixed Income include medium to long term bonds, and non convertible preferred shares. -Equity Assets – commons hares, derivatives, options, etc. Equity Cycle Expansion – maintain or increase stocks, since they are growing Peak – stop buying stock and invest in s/t instruments since interests will rise Contraction – lengthen terms of bond holdings and avoid stocks Trough – sell long term bonds (capital gains due to falling interest rates), start buying equity P = Div(1) / r – g This dividend discount model can be used to interpret changes in equity prices:

a. If r is rising and g is falling, prices will fall Young Investor with long time horizon = 5% cash, 20% fiex income, 75% equities Middle-aged with kids = 10% cash, 30% fixed income, 60% equities Retirement = 10%, 60% fixed income, 30% equities The desired long term asset mix is called strategic asset allocation. Some techniques:

1. Tactical asset allocation (moderately active approach that allows managers short-term deviations from long term asset mixes to take adv of market timing)

2. Dynamic AA (adjusts the asset mix as market conditions change) 3. Integrated AA (incorporate all of the above approaches)

Passively managed funds follow a market benchmark and reduce costs (buy and hold strategies, indexing, or ETFs) It requires a systematic monitoring of changes in investor circumstances and market conditions. CH. 10 – Derivatives They derive their value from another underlying asset. They are either options or forwards, and can trade on exchanges or OTC. However, OTC’s termination is more difficult with no third-party guarantee. Instead of gains marked to market daily, they are settled at the end, and delivery happens often. Trading costs are less visible and they are used by corps/institutional. The Canadian Derivatives Clearing Corporation is the only one that issues and guarantees all equity, bond, and stock option positions.

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Buying a call option can leverage a short position, so if the prices go up at least you can buy the share back at a reasonable price/loss. Naked call writers don’t own the securities and must have margin accounts, whereas covered call writers own the stock and don’t have to maintain margins. New option contracts are created in the primary market, and must be issued with the option prospectus. Option sales settle the next business day, and exercise of options ettle in 3 days. They are said to be in-the-money when they make a profit. The intrinsic value is the amount it is in the money, or 0. Time value of money = Option Price – Intrinsic Value Futures and Forwards Both buyers and sellers of futures must deposit and maintain margins on their accounts. The accounts are marked to market daily. Swaps are OTC contracts that are forward contracts that involve an agreement to exchange a series of future cash flows. Hedgers are participants who deal in the underlying commodity or financial asset and manage risk by

1. Selling futures to pre sell inventories (gold) 2. Buying futures to lock in a future purchase price for the asset

Marketing to market refers to the daily settlement of gains and losses between those long and

those short futures contracts.