Guide To Financial Industry

The Guide to Financial Industry

The Guide to Financial Industry

Prepared by Frederic Goblet 01/13/98

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The Guide to Financial Industry

The Guide to Financial Industry Table of Content

THE GUIDE TO FINANCIAL INDUSTRY....................................................................................2 INTRODUCTION.........................................................................................................................6 WHAT IS AN INVESTMENT ? ....................................................................................................7 The Investment Process......................................................................................................7 THE MARKET AND THE INSTITUTIONS ..................................................................................9 THE INVESTMENT BANKS ............................................................................................................9 The Investment Bank ..........................................................................................................9 THE INSTITUTIONAL INVESTORS.................................................................................................10 THE CUSTODIAN ......................................................................................................................10 What is Custody ?.............................................................................................................10 The Custodian...................................................................................................................10 THE SUBCUSTODIAN ................................................................................................................12 Role of the Subcustodian ..................................................................................................12 TRUSTEE ................................................................................................................................13 THE BROKER ..........................................................................................................................14 THE SECURITY EXCHANGES ......................................................................................................14 The New York Stock Exchange.........................................................................................15 The American Stock Exchange .........................................................................................16 Regional Stock Exchanges................................................................................................16 NASDAQ ..........................................................................................................................16 The Chicago Board Options Exchange..............................................................................17 Country Specific Exchanges (National Exchanges)............................................................17 THE MARKET INDEXES .............................................................................................................18 W HAT IS A TRADE, HOW DOES IT WORK ? ...................................................................................19 Securities Settlement ........................................................................................................22 Delivery vs. Payment ........................................................................................................23 Clearing House Funds vs. Same Day Funds .....................................................................23 Free Delivery.....................................................................................................................23 Book Entry vs. Physical.....................................................................................................23 Trade Date........................................................................................................................24 Contractual Settlement Date .............................................................................................24 Actual Settlement Date......................................................................................................24 Failed Trades ....................................................................................................................24 DK (Don't Know) ...............................................................................................................25 Market Conventions ..........................................................................................................25 THE INVESTMENT MANAGERS ...................................................................................................27 THE DEPOSITORIES AND CLEARANCE SYSTEMS ..........................................................................28 Book Entry ........................................................................................................................28 Immobilization ...................................................................................................................29

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The Guide to Financial Industry Dematerialization...............................................................................................................29 Depository Trust Company (DTC) .....................................................................................29 Participant Trust Company (PTC)......................................................................................30 Federal Reserve Bank (+ see Regulators).........................................................................30 EUROCLEAR....................................................................................................................30 Cedel ................................................................................................................................31 PRIMARY MARKET....................................................................................................................31 SECONDARY MARKET...............................................................................................................31 THE OVER-THE- COUNTER MARKET ..........................................................................................31 THE REGULATORS ...................................................................................................................32 THE CENTRAL BANK OF THE U.S.A. : THE FEDERAL RESERVE SYSTEM .........................................32 How the Fed works ...........................................................................................................33 Member Banks..................................................................................................................33 The Federal Reserve’s many Roles...................................................................................33 THE G30 , THE GROUP OF THIRTY ............................................................................................34 S.W.I.F.T. SOCIETY FOR W ORLDWIDE INTERBANK FINANCIAL TELECOMMUNICATIONS ...................35 TYPES OF INVESTMENT ........................................................................................................37 INVESTMENT STRATEGIES ...................................................................................................38 RISK-RETURN TRADE-OFF ............................................................................................38 DIVERSIFICATION ...........................................................................................................38 ASSET ALLOCATION.......................................................................................................39 THE CONCEPT OF RISK (β β ,…) AND RETURN .......................................................................42 What is Risk ?...................................................................................................................42 The Types of Risk .............................................................................................................42 How to measure risk ? ......................................................................................................43 Measuring Systematic Risk ...............................................................................................44 The Required Rate of Return.............................................................................................45 THE BALANCE SHEET AND THE INCOME STATEMENT......................................................46 THE BALANCE SHEET ................................................................................................................46 Assets...............................................................................................................................46 Liabilities ...........................................................................................................................46 Owner's equity ..................................................................................................................47 THE INCOME STATEMENT ..........................................................................................................47 THE TIME VALUE OF MONEY ................................................................................................49 THE NET PRESENT VALUE ........................................................................................................49 REQUIRED RATE OF RETURN ....................................................................................................49 EXPECTED RATE OF RETURN ....................................................................................................49 PRESENT VALUE FORMULA .......................................................................................................50 FUTURE VALUE FORMULA .........................................................................................................50 THE STOCK MARKET .............................................................................................................51 GOING PUBLIC ........................................................................................................................51 THE PRICE ..............................................................................................................................52 The Price ..........................................................................................................................52 The Spread .......................................................................................................................52 The Ticker.........................................................................................................................53 Reading the Newspaper ....................................................................................................53 THE SUPPLY AND DEMAND........................................................................................................54 HOW TO VALUE A STOCK ?........................................................................................................58 EARNINGS PER SHARES (EPS).................................................................................................58 Prepared by Frederic Goblet 01/13/98

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The Guide to Financial Industry PRICE/EARNINGS RATIO ...........................................................................................................58 THE STOCK PRICE ...................................................................................................................58 DIVIDENDS ..............................................................................................................................59 The Dividend Yield ............................................................................................................59 STOCK SPLIT ..........................................................................................................................60 VALUABLE STOCK MARKET TERMS ............................................................................................60 Common Stock .................................................................................................................60 Preferred stock..................................................................................................................60 The Right to Vote ..............................................................................................................61 Book Value .......................................................................................................................61 Debt /Equity Ratio .............................................................................................................62 Tender Offer .....................................................................................................................62 Insider Trading ..................................................................................................................62 Warrant.............................................................................................................................62 Program Trading ...............................................................................................................62 Rule of 72 .........................................................................................................................63 Capitalization.....................................................................................................................63 Arbitrage ...........................................................................................................................63 Blue Chips ........................................................................................................................64 Bull Market Vs Bear Market...............................................................................................64 SHORT SELLING ......................................................................................................................64 BUYING W ARRANTS .................................................................................................................65 BUYING ON MARGIN .................................................................................................................65 THE FIXED INCOME SECURITIES THE MONEY MARKET VS THE CAPITAL MARKET ......67 MONEY MARKETS ..................................................................................................................68 Money Market Vs Capital Market.......................................................................................68 TREASURY BILL OR T-BILL ........................................................................................................69 COMMERCIAL PAPER ................................................................................................................69 BANKER’S ACCEPTANCE ...........................................................................................................70 CERTIFICATES OF DEPOSIT .......................................................................................................71 THE EURODOLLAR MARKET ......................................................................................................72 THE BOND MARKET ...............................................................................................................73 Creditor Vs Owner ...........................................................................................................73 Registration.......................................................................................................................73 Figuring a Bond’s Worth....................................................................................................74 VALUE..............................................................................................................................74 Analyzing Bond Yield.........................................................................................................75 BUYING AND TRADING BONDS ...................................................................................................77 How Trading Works ?........................................................................................................77 VALUABLE BOND MARKET TERMS ..............................................................................................77 CALL.................................................................................................................................77 DEFAULT .........................................................................................................................77 COLLATERAL...................................................................................................................78 High-Yield (Junk ) Bonds...................................................................................................78 U.S. GOVERNMENT SECURITIES ..........................................................................................79 TREASURY SECURITIES.............................................................................................................79 Treasury Bills ....................................................................................................................79 Treasury Notes .................................................................................................................79 Treasury Bonds.................................................................................................................79 Trading .............................................................................................................................80 AGENCY SECURITIES 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The Guide to Financial Industry Ginnie Maes (GNMA)........................................................................................................80 Fannie Maes (FNMA)........................................................................................................81 Freddie Macs (FHLMC).....................................................................................................81 Sallie Maes .......................................................................................................................81 Tennessee Valley Authority...............................................................................................81 MUTUAL FUNDS......................................................................................................................82 Paying out the profits ........................................................................................................83 MUTUAL FUND CHECKLIST .........................................................................................................84 Objective...........................................................................................................................84 Performance .....................................................................................................................84 Loads and fees .................................................................................................................84 The Net Asset Value .........................................................................................................85 PENSION FUNDS.....................................................................................................................86 DEFINED BENEFIT PLANS..........................................................................................................86 DEFINED CONTRIBUTION PLANS ................................................................................................86 MARKETS FOR DERIVATIVE SECURITIES............................................................................88 THE LANGUAGE OF OPTIONS .....................................................................................................88 FUTURES ................................................................................................................................90 SOURCES AND BIBLIOGRAPHY ..........................................................................................109

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Introduction

This guide aims at two public targets, the beginners and the professionals who need some memory refreshment. It is mainly a compilation of existing publications mentioned at the end than a new guide containing new information. This publication is not commercial and is published thanks to the many people who helped on the compilation of the information contained. I want this guide to be helpful, to be informative, self-explaining that will link the theory to the real world.

Frederic Goblet

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What is an Investment?

To invest is to acquire an asset with the expectation of growing value in the future. It is linked to the concept of ownership.

The Investment Process

The investment process can be split in three steps: TRADE AND THE POST-TRADE.

THE PRE-TRADE, THE

The pre-trade concerns the decision on what to buy in what quantity. The trade process is the actual agreement between the seller and the buyer regarding the price and the quantity. At this moment, the asset changes ownership. The post-trade concerns everything after the trade itself: the management of the trade.

Pre -Trade

Trade

Market Data News Portfolio Management Analytics

Order Routing Trade Management Trade Execution Cash Management Currency Management Securities Lending

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Post - Trade Transaction Confirmation Custody Performance & Analytics Portfolio Accounting

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The Guide to Financial Industry

The Market and The Institutions

"MARKET" in a very general way, refers to the availability of, and inter-relationships between, potential buyers and sellers of goods or services. The term "market" can be used in a variety of ways to refer to different physical locations or environments in the investment system for the purchase and sale of securities, commodities or currencies.

THE INVESTMENT BANKS

The Investment Bank

The INVESTMENT BANK is a financial specialist who acts as an intermediary in the selling of securities. Three basic functions are provided by the investment banker: 1. He assumes the risk of selling a new security issue at a satisfactory (profitable) price. This is called underwriting. Typically, the investment banking house, along with the underwriting syndicate, actually buys the new issue from the corporation that is raising funds. The syndicate (group of investment banking firms) then sells the issue to the investing public at a higher (hopefully) price than it paid for it. 2. He or she provides for the distribution of the securities to the investing public. 3. He or she advises firms our governments on different matters like merge and acquisitions, economic health, …

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THE INSTITUTIONAL INVESTORS An INSTITUTIONAL INVESTOR is an organization that invests its own assets or those it holds in trust for others. Typical institutional investors are investment companies (including mutual funds), pension systems, insurance companies, universities and banks.

THE CUSTODIAN

What is Custody ?

CUSTODY means “safekeeping of assets”. This refers to “keep” the assets in a “safe” place. They are two main reasons why banks are originally responsible for custody: First, you need a vault in order to immobilize the assets if physical, and secondly because it implies the exchange between cash and securities. Custody function involves to: n capture the trade n protect the investment, to gain ownership : settlement date n record the position n Keep track of the rights (income, corporate action, taxes,…)

The Custodian

A CUSTODIAN is an agent, usually a bank, which receives delivers, and safekeeps cash and securities for its clients. The custodian is also responsible for the maintenance of the securities while they are under custody. Prepared by Frederic Goblet 01/13/98

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RECEIPTS AND DELIVERIES Receipts and deliveries of securities and cash are done only upon instruction or authorization of the client or the client's authorized investment manager. These transactions usually involve a trade, that is, a purchase or sale of securities or cash. When a security is purchased, the security is received in and cash is delivered out. When the security is sold, the security is delivered out and cash is received in. Cash itself can be purchased and sold as an investment in the context of foreign exchange. SAFEKEEPING Securities under custody must be protected in a secure environment regardless of whether they are held physically or electronically. Securities held physically are generally kept in a vault at the custodian bank or in a SUBCUSTODIAN bank hired by the primary custodian. Securities held in Book Entry are recorded on the books of the DEPOSITORY as being in the account of the custodian. Once securities have been purchased and received into safekeeping, the custodian is responsible for the maintenance of these assets as it pertains to registration, income collection, and corporate actions. INCOME One major custodial responsibility is the timely crediting of income payments due to the client from investments held in the client's portfolio. Custodians need to be aware of any income event affecting securities under their care. This is often accomplished by contracting for the services of various Information agents, who provide, among other things, information regarding the terms of a securities issue, income schedule, or dividend announcements. CORPORATE ACTIONS A corporate action on a security can have a significant impact on the value of that security, and therefore on the value of the client's portfolio. Monitoring and accurately processing corporate actions on securities held under custody is one of the important responsibilities of a custodian. The custodian must be aware of any pending action, which could affect any security being held on behalf of any client; monitoring for corporate actions thus becomes a significant element of custodial functions. Most custodians have contracted with a variety of news services or information agents in Prepared by Frederic Goblet 01/13/98

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order to receive daily information regarding corporate events. Further information might be obtained from depositories, subcustodians, or even issuers. ACCOUNTING SERVICES The custodian may also provide accounting services to the client, although this service is not necessarily part of every custodial contract. This accounting can include pricing of securities in the portfolio on a daily, weekly, or monthly basis, keeping track of expense accruals and payments, capital purchases or contributions and disbursements, and calculating the NET ASSET VALUE of the portfolio (also known as fund pricing.)

THE SUBCUSTODIAN Rule: The securities stay in the local market. They remain in the country where they are issued. A SUBCUSTODIAN can be a bank located in any country, hired by a primary custodian that performs custodial functions in the local market in which it has expertise. The success of the custodian in servicing its clients depends greatly on the subcustodian's ability to function for the custodian in that particular market; therefore, a consistently high level of service quality must be provided.

Role of the Subcustodian

The role of the subcustodian generally includes: 1. Settling and vaulting securities, 2. Collecting income, 3. Sending information to the custodian regarding cash and security movements, cash balances, month-end securities positions, notification of corporate actions and upcoming income events, and reporting changes in the market environment and tax regulations.

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TRUSTEE A TRUSTEE is a person or entity who is legally responsible for another person or entity's investment, property or other assets. There are two types of Trustees in the financial industry, Trustees for Master Trust Accounts and those for Corporate Trust Accounts. Trustees for Master Trust Accounts A MASTER TRUST is a pool of trusts or a pool of assets involved in one trust agreement. A trustee for a master trust manages and oversees all assets for a trust client according to a trust agreement or plan document. Most often a trustee is hired to service PENSION PLANS. Many of the responsibilities of a trustee and a Custodian are similar, however, a trustee has more responsibilities and greater legal burden on behalf of the plan or trust. A trustee has a FIDUCIARY RESPONSIBILITY to act with discretion and diligence in the best interest of the client. These fiduciary responsibilities in general apply to a trustee who has the power to act on behalf of the client, to manage a plan, or who provides investment advice regarding the plan assets or administers a plan. In most cases, the trustee is liable for a loss which occurs as a result of its actions, unless the mistake was created by a third party or unless the contract includes a provision to indemnify the trustee from any loss or expense. Because agreements between the client and the trustee may vary, the responsibilities of the trustee can be different from one client to another. Some of the basic responsibilities of a trustee are recordkeeping, income collection, corporate action processing, and pricing, although there can be additional responsibilities according to the terms of the agreement. Trustees are also responsible for collecting Income and monitoring corporate actions on securities held in client portfolios. When a corporate action is announced, the trustee must notify the Investment Manager who will decide the suitable course of action on behalf of the client. This final decision is passed back to the trustee who will act accordingly.

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CORPORATE TRUSTEE A company issuing bonds in an amount greater than $5 million must hire a bank or trust company to administer its securities. The CORPORATE TRUSTEE acts as intermediary between the company issuing the bonds and the investors buying the bonds.

THE BROKER An INVESTMENT BROKER can be anyone who earns commissions or fees for executing investment transactions that transfer ownership from one party to another. All brokerage firms and all brokers acting as individuals must be a member of the exchange through which they trade, and must pay an annual membership fee to the exchange. Exchanges have strict codes of conduct, and can bar individuals or firms from membership due to fraudulent or unethical activity. Brokers can hold MEMBERSHIP in more than one exchange. Some brokers specialize in a particular security type or commodity, and would therefore be a member of that specialized exchange. Some of their functions include: transition management, directed brokerage, soft dollars agreements, commission recapture programs, electronic trading, …

THE SECURITY EXCHANGES A STOCK EXCHANGE is a private association that provides a physical location and clerical support for its members. Trading occurs AUCTIONSTYLE with investors exchanging bids and offers on the exchange’s listed securities. Organized security exchanges are tangible entities whose activities are governed by a set of bylaws. Security exchanges physically occupy space and financial instruments are traded on such premises.

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Exchanges do not buy or sell securities, nor do they set prices. TRADING is conducted on the exchange “FLOOR” where each SPECIALIST presides over the auctioning of shares for one or more of the listed companies. Sellers willing to take the lowest prices and buyers willing to pay the highest prices are given priority trade instructions. When a company first goes public (INITIAL PUBLIC OFFERING), the management decides how its shares will be traded among investors, either on a stock exchange, an auction market, or OVER-THE-COUNTER, a negotiated market. Major stock exchanges must comply with a strict set of reporting requirements established by the SECURITIES AND EXCHANGE COMMISSION (SEC). These exchanges are said to be registered. Organized security exchanges provide several benefits to both corporations and investors. They (l) provide a continuous market, (2) establish and publicize fair security prices, and (3) help businesses raise new financial capital. A corporation must take steps to have its securities listed on an exchange in order to directly receive the benefits noted above. Listing criteria differ from exchange to exchange. Three of the most well known United States exchanges are the NEW YORK STOCK EXCHANGE (NYSE), THE AMERICAN STOCK EXCHANGE (AMEX), AND THE NATIONAL ASSOCIATION OF SECURITIES DEALERS AUTOMATED QUOTATION SYSTEM (NASDAQ). Other national exchanges specialize in commodity and security options and futures trading. These include the CHICAGO BOARD OF TRADE, CHICAGO BOARD OF OPTIONS EXCHANGE, MID-AMERICA COMMODITY EXCHANGE, NEW YORK COFFEE, SUGAR AND COCOA EXCHANGE, NEW YORK COTTON EXCHANGE, NEW YORK FUTURES EXCHANGE, PACIFIC STOCK EXCHANGE AND THE PHILADELPHIA EXCHANGE.

The New York Stock Exchange

The NEW YORK STOCK EXCHANGE (NYSE), sometimes referred to as the "Exchange" or the "Big Board", was established in 1792 and is the oldest and largest securities exchange in the United States. Usually only large firms can meet the stringent eligibility requirements of the NYSE. These require that a firm have a minimum of one million publicly held shares, a Prepared by Frederic Goblet 01/13/98

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market value of publicly held shares of at least $10 million, total market value of $16 million, annual net income of over $2.5 million before federal income taxes, and 2,000 holders of 100 shares or more.

The American Stock Exchange

The AMERICAN STOCK EXCHANGE (AMEX) was originated in 1921.The AMEX could be considered a proving ground for the NYSE, as it trades securities from mainly small and medium size companies. A large number of companies that were once listed on the AMEX have moved to the NYSE. Another difference between these two exchanges is that the AMEX has an options market where the NYSE does not.

Regional Stock Exchanges

Regional stock exchanges are organized securities exchanges located outside of New York City and registered with the SEC. They do not exclusively list only regional or local securities, but list many issues that are also on the New York exchanges. NYSE and AMEX listings often also list on a regional exchange to receive broader market exposure. This dual listing practice of a security on one or more exchanges increases competition for the issue and boosts trading availability due to different time zones. Regional exchanges in the United States include the BOSTON, CINCINNATI, MIDWEST, PACIFIC, PHILADELPHIA STOCK EXCHANGES.

NASDAQ

NATIONAL ASSOCIATION OF SECURITIES DEALERS AUTOMATED QUOTATION SYSTEM (NASDAQ) is a computerized communication system that serves the dual function of providing security information to its members, and acting as an exchange for stocks. Ranking third in trading volume behind the New York Stock Exchange and the Tokyo Exchange, it features efficiency in trading, as it can locate the most up-to-date quotes regardless of where the market is in the U.S.

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The Chicago Board Options Exchange

The CHICAGO BOARD OPTIONS EXCHANGE (CBOE) revolutionized options trading by creating standardized, listed options in 1973. Before 1973, options were individually tailored and traded "over-the-counter" by a few put/call dealers. CBOE established a secondary market where options could be traded. The growth in the use of options propelled CBOE to become the world's largest options exchange, and the second largest securities exchange in the U.S. Today, CBOE captures the largest share of the U.S. options market by trading 700,000 option contracts daily accounting for over 47 percent of trading in equity options, over 95 percent of index options trading and over 65 percent of all options trading. Today, options are traded on five U.S. exchanges: the Chicago Board Options Exchange, the American Stock Exchange, the New York Stock Exchange, the Pacific Stock Exchange and the Philadelphia Stock Exchange. Although there are five U.S. exchanges that trade standardized options, options have become a global contagion trading on over 50 exchanges worldwide.

Country Specific Exchanges (National Exchanges)

Various countries throughout the world have national exchanges that provide trading arenas for that specific country. Some of these countries include: AUSTRALIA:

Australia Stock Exchange (ASX) is the nation-wide exchange.

AUSTRIA:

Vienna Stock Exchange is the national exchange; Telefonhandel is the OTC exchange.

BELGIUM:

Brussels is the main exchange, with branches in Antwerp and Liege.

CANADA:

Toronto and Montreal exchanges are linked together, with branches in Vancouver and Alberta.

DENMARK:

Copenhagen Stock Exchange.

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FRANCE:

Paris is the center of all equity trading in France.

GERMANY:

Frankfurt is the main exchange.

ITALY:

Milan is the main exchange, and there are several regional exchanges.

JAPAN:

Tokyo and Osaka are the main exchanges.

MEXICO:

Mexico City is the national exchange.

NETHERLANDS:

Amsterdam Stock Exchange is the national exchange.

NORWAY:

Oslo Stock Exchange (OSE) is the national exchange, with branches in Bergen and Trondheim.

SPAIN:

Madrid is the main exchange, with branches in Bilbao, Barcelona and Valencia.

SWEDEN:

Stockholm is the national exchange.

SWITZERLAND:

Zurich is the main exchange, with branches in Geneva and Basle.

UNITED KINGDOM: London Stock Exchange (LSE) is the main exchange for equity trading in the U.K. and the Republic of Ireland. Branches are in Manchester,Birmingham, Glasgow, Leeds and Belfast in the U.K., and Dublin in Ireland.

THE MARKET INDEXES A BENCHMARK is a standard; a set of information used for comparisons. Indexes are often used as benchmarks. A MARKET INDEX is a weighted average of the specific security prices, industrial production components, or market factors that make up the index.

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The DOW JONES INDUSTRIAL AVERAGE is composed of 30 stocks. The Dow accurately measures what it claims to measure : the performance of 30 key companies which are worth about 25% of the total value of all stocks listed on the NYSE. To the extent that those companies represent key sectors of the economy, their performance indicates how the economy is doing. However, other sectors of the economy perform differently. The NYSE COMPOSITE INDEX includes all stocks traded on the New York Stock Exchange . The NYSE also reports the activity in four sectors industrial, utility, transportation and financial - in separate indexes. The STANDARD & POOR’S 500 INDEX incorporates a broad base of 500 of some of the largest U.S. public corporations: 400 industrial, 40 utility, 40 financial and 20 transportation companies. The NASDAQ COMPOSITE INDEX was created to track the progress of more than 4000 stocks listed on the National Association of Securities Dealers Quotation System. The AMEX MARKET VALUE INDEX monitors the performance of over 800 companies listed on the American Stock Exchange. The RUSSELL 2000 represents the smallest two-thirds of the 3,000 largest U.S. companies, including a great many of the initial public offerings of the last few years. The WILSHIRE 5000, the broadest index, includes all stocks traded OTC and on exchanges, including the S&P 500.

WHAT IS A TRADE, HOW DOES IT WORK ? Stocks are generally traded in 100-share increments called Any number of share fewer than 100 is an ODD LOT.

ROUND LOTS.

When you buy or sell a security, the brokerage firm enters your order into its computer system for transmittal to its traders at the designated exchange or the firm’ OTC trading desk. For an exchange-listed security, the order is sent to the BROKERAGE FIRM’S FLOOR BROKER on the exchange

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or directly to a SPECIALIST in that particular stock, who maintains a post on the exchange floor, to be matched with an offsetting order. THE SPECIALISTS Brokers called "SPECIALISTS" play a critical role because they serve as the contact point between brokers with buy and sell orders in the NYSE's twoway auction market. Each stock listed on the NYSE is allocated to a specialist, a broker who trades only in specific stocks at a designated location. All buying and selling of a stock occurs at that location, called a trading post. Buyers and sellers - represented by the floor brokers - meet openly at the trading post to find the best price for a security. The people who gather around the specialist's post are referred to as the trading crowd. Bids to buy and offers to sell are made by open outcry to provide interested parties with an opportunity to participate, enhancing the competitive determination of prices. When the highest bid meets the lowest offer, a trade is executed. To a large degree the specialist is responsible for maintaining the market's fairness, competitiveness and efficiency. Specifically, the specialist performs four vital functions. One of the specialist's jobs is to execute orders for floor brokers in their assigned stocks. A floor broker may get an order from a customer who only wants to buy a stock at a price lower than the current market price - or sell it at a price higher than the current market price. In such cases, the broker may ask the specialist to hold the order and execute it if and when the price of the stock reaches the level specified by the customer. In this role the specialist acts as an agent for the broker. In a sense, specialists act as auctioneers for their assigned stocks. At the start of each trading day, the specialists establish a fair market price for each of their stocks. The specialists base that price on the supply and demand for the stock. Then, during the day, the specialists quote the current bids and offers in their stocks to other brokers. Investors may direct brokers to place stock orders contingent on a variety of conditions. The most common are : MARKET ORDER and LIMIT ORDER. MARKET ORDERS are executed immediately. A to buy or sell at a specified price or better.

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LIMIT ORDER

is an open order

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When your trade is executed, the brokerage firm sends you a confirm, a written confirmation that reports the trade date (date the order takes effect, you are the legal owner), the quantity, the description, and the price. When securities are purchased, payment must be made on or before the SETTLEMENT DATE. Settlement for stock generally occurs on the third business day following the trade date. Commissions and Markups. Transaction costs for buying and selling stock are based on the share price and number of shares traded during a single market session. Stock commissions are typically a fraction of 1 percent to 3 percent. The higher the stock price and the greater the number of shares traded, the lower the commission.

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The Customer

The Brokerage Firm Places orders to buy and sell

Initiates transaction Pass the order to a Floor Broker on the Stock Exchange

The Stock Exchange The Floor Broker

The Specialist

When the order reaches the floor of the exchange, the floor broker takes it to a specialist in that particular stock

The Order will be confronted with others and the specialist will match them

Buy = priority for the highest bid Sell = priority for the lowest offer

Securities Settlement

SECURITIES SETTLEMENT is the final point in the trading process at which securities are delivered and money is exchanged. Prepared by Frederic Goblet 01/13/98

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Delivery vs. Payment

DELIVERY VS. PAYMENT involves any settlement where securities are delivered and cash is received concurrently. DVP describes the seller's perspective.

Clearing House Funds vs. Same Day Funds

Depending upon how payment is made to settle a trade in the United States, use of clearing house funds or same day funds will determine the availability of cash associated with a trade. CLEARING HOUSE FUNDS are available to spend one day after actual settlement date. Almost all DTC trades settle in clearing house funds, the exception being commercial paper which settles in same day funds. SAME DAY FUNDS are available to spend on the same day as actual settlement date. Same day funds are sometimes referred to as Fed funds.

Free Delivery

FREE DELIVERY or Delivery Free of Payment involves security transfers where there is no corresponding cash movement. Securities transferred from a previous custodian or trustee to a newly hired custodian or trustee are examples of free delivery settlements.

Book Entry vs. Physical

BOOK ENTRY is an electronic system that records transfers of securities and/or cash between a buyer and a seller. Most DEPOSITORIES operate in a book entry environment. For securities that settle through book entry, physical certificates may or may not exist. If physical certificates do exist, however, a major advantage to book entry is that these certificates do not have to physically move in order to settle the trade. Another major advantage to book entry is that registration in the name of the new owner is usually effective immediately upon settlement. In the United States, book entry settlement locations include DTC, the Fed, and PTC. Prepared by Frederic Goblet 01/13/98

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In contrast, PHYSICAL SETTLEMENT requires that paper certificates change hands. Disadvantages to physical settlement include the increased risk that certificates could become lost, the time delay associated with reregistration because new certificates must be issued, and the time required to make physical delivery itself. Physical certificates are generally held in a vault by the appropriate bank or broker.

Trade Date

TRADE DATE refers to the date upon which a buyer and seller agree to the terms of a security purchase or sale, including the price, the amount of shares, and the date, location, and method of exchanging the cash and the securities. By agreeing to the trade, both buyer and seller have entered into a mutually binding contract regarding the exchange of securities and cash.

Contractual Settlement Date

CONTRACTUAL SETTLEMENT DATE is the date upon which a trade is expected to settle, according to the terms of the trade agreement.

Actual Settlement Date

ACTUAL SETTLEMENT DATE refers to the date upon which the trade actually settles. Actual settlement can occur on or after contractual settlement date. Although the contractual settlement date is agreed to on trade date, a trade may not settle until sometime later, due to an error or problem with delivery of the security.

Failed Trades

A FAILED TRADE occurs when a trade does not settle on contractual settlement date due to either inaccurate delivery or non-delivery of the security by the seller. Trades which are open after contractual settlement date are said to be "failing", as they have "failed to settle" on time. Failed trades can cause subsequent problems with income collection and corporate actions, as the new owner is unable to register the security until Prepared by Frederic Goblet 01/13/98

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settlement has occurred. A failed buy can also cause problems if the purchaser wishes to sell the security but is unable to make delivery on the sell since the purchase has not yet settled.

DK (Don't Know)

In some cases, the receiving party does not accept an attempted delivery of securities for settlement. This may occur when there is a mismatch in the information connected with the delivery, such as the name of the security, the amount of shares or par, the price, the contractual settlement date, the broker, etc. It may also occur if the receiving party has no instructions regarding the trade whatsoever. The receiving party refuses to accept delivery, saying that they "DON'T KNOW" this trade as delivered. The expression "DK" is short for "don't know", thus, the receiver is said to "DK" the trade. Errors which could cause a mismatch in information may have occurred in either the buyer's or seller's instructions to their respective agents. Both parties usually reconfirm their information and changes are made as necessary in order to effect good delivery.

Market Conventions

Depending upon the type of security traded and the market in which the trade occurs, the period between Trade Date and Contractual Settlement Date will vary. The scheduled contractual settlement date is usually denoted as TRADE DATE + (number of days), or TD + (number of days), or T + (number of days). The following describes examples of settlement variations within different markets as of this writing. United States In the United States, LONG TERM DEBT and EQUITY SECURITIES are scheduled for Trade Date + 5 settlement. Settlement dates for COMMERCIAL SHORT TERM DEBT (MONEY MARKET INSTRUMENTS) can be negotiated at the time of the trade, but due to the nature of these investments, most are traded to settle either on Trade Date or Trade Date + 1.

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SHORT TERM TREASURY securities on the secondary market are generally traded for settlement on T + 1. Some trades can be negotiated for same day settlement, however the interest rate agreed to may be lower than if the trade is made for next day settlement. Treasury securities bought at Monday Treasury auctions (primary market purchases) usually settle on T + 3. Canada The Canadian Depository for Securities (CDS) settles trades executed on the Toronto and Montreal Exchanges through their Securities Settlement Service (SSS). Although owned by the depository, SSS is used to settle both depository and non-depository trades. SSS operates both a book entry system and a physical settlement system. Depository eligible securities settle by book entry through the Book Based System (BBS). Depository ineligible securities with valid CUSIP numbers are settled physically through the Certificate Based System (CBS). Ineligible securities without valid CUSIP numbers cannot be settled through SSS, and must settle physically, at the office of the buyer's broker or custodian. Denmark All settlements in Denmark occur on T + 3. Italy Formal settlement practices in Italy apply only to trades executed on one of the official stock exchanges. Whether a trade is contracted to settle on the forward or cash market determines how quickly it will settle. Trades executed on the FORWARD MARKET have a settlement period of up to T + 45. Trades made during the last two weeks of a month and the first two weeks of the following month settle during the last half of that second month. Trades executed on the CASH MARKET settle T + 3. The transaction costs for cash market trades are slightly higher, as the costs reflect the settlement of those trades within a shorter period of time. Korea In Korea, equities and convertible bonds settle on T + 2. Trading and settlement activity take place on Saturdays, since Saturday is a working day in Korea.

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Sri Lanka All settlements in Sri Lanka occur on T + 7. United Kingdom In the United Kingdom, trades are processed for settlement every fourteen days. The fourteen day schedule is maintained unless the scheduled settlement date falls on a holiday, then the whole cycle is moved forward to be begun again on the next open business day. Thus, settlements may occur on Mondays for a while, then be pushed forward to Tuesdays, etc. An attempt is made to settle failed trades within the next few days. Trades are always settled through physical delivery.

THE INVESTMENT MANAGERS An INVESTMENT MANAGER, (also known as an Investment Advisor), is an individual or agency designated to make investment decisions for a Client Company or entity that has beneficial ownership of assets. Clients may be pension funds, mutual funds, or other types of investment funds. Often, the investment manager is an outside agent or agency hired by the client company. Companies may also use internal investment managers. Investment managers operate in accordance with the client's investment strategy. In many instances, investment managers specialize in managing a specific investment type, such as equities or fixed income securities. Responsibilities include making trade decisions, executing trades with brokers, and providing trade details to the custodian or trustee bank. Investment managers are also responsible for making decisions on voluntary corporate actions and managing cash, both as an investment asset and to ensure that sufficient cash is available to cover pending purchases. An investment manager has power to purchase and sell any plan asset, and has FIDUCIARY responsibility to act with discretion and diligence in the best interest of the client.

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THE DEPOSITORIES AND CLEARANCE SYSTEMS Today, many debt securities are in electronic book-entry form. Ownership is transferred via computer rather than via actual transfer of paper certificates, reducing the possibility of loss, theft, or mutilation of the certificates. In the future, more and more securities certificates will be in this electronic form. A DEPOSITORY is an institution that provides central VAULTING of certificates, and where security ownership is transferred and recorded. A security must be accepted by a given depository as "depository eligible" before the depository will begin to service it; once this has occurred however, an attempt is usually made to keep all physical certificates underlying that security centrally vaulted in the depository, regardless of ownership. Today there are numerous depositories around the world and in addition to the standard service of maintaining ownership records, each performs services unique to their requirements and technology. Many depositories collect income, maintain a linkage between cash and security movements, provide recordkeeping of securities held, and provide reporting to all participants in the depository to facilitate income and corporate action information flow. Depositories act as TRANSFER AGENT and PAYING AGENT, as well. The term "clearance system" is often used interchangeably with the term "depository", as both generally provide some form of recordkeeping service that facilitates the accuracy of trade information.

Book Entry

The transfer of ownership records at a central location without physical reregistration taking place is known as BOOK ENTRY. Almost all depositories use book entry systems. Reports are generated reflecting current ownership and transfer activity for each security held. Book entry systems can be used whether or not certificates physically exist to represent the underlying securities.

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Immobilization

When securities are represented by physical certificates, the depository provides a central vaulting location where the certificates are held regardless of changes in ownership. This is known as IMMOBILIZATION since the certificates do not move upon trading. Advantages of immobilization include decreased risk of error, decreased risk of loss, and decreased cost, since certificates do not have to be handled physically to effect the delivery and re-registration process. Usually, certificates held in a depository are registered in the name of that depository.

Dematerialization

In some cases, security certificates may not exist physically. A depository simply records changes in ownership of the security. This certificate-free environment is called DEMATERIALIZATION, also referred to as "scripless".

Depository Trust Company (DTC)

DTC, located in New York City, is a member owned depository and not a profit driven company. With a main purpose of providing timely and accurate securities settlements, fees are kept to a minimum and any profits generated are distributed to participants in DTC. Established in 1968, DTC is the largest safekeeper of corporate stocks and bonds in the U.S. Not all securities are "DTC eligible", or can be traded using DTC as the depository, however, most U.S. equities and corporate bonds are eligible. A security which is DTC eligible does not have to be traded or held in DTC. An owner has the option of withdrawing the certificates from DTC and holding them physically. To participate in DTC, an institution applies for DTC membership, and upon approval, is assigned a participant number. Payments on trades in DTC are usually in "same day funds", meaning that cash movement occurs on the day of actual settlement.

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Participant Trust Company (PTC)

PTC purchased the Mortgaged-Backed Securities Clearing Corporation (MBSCC), a depository for Government National Mortgage Association (GNMA) securities, in 1989. This depository, renamed the Participant Trust Company (PTC), is chartered by the state of New York and is registered with the Securities and Exchange Commission as a clearing agency. PTC is a central depository where mortgaged-backed securities are exchanged and vaulted. PTC is member owned. In PTC, cash payment is in same day funds.

Federal Reserve Bank (+ see Regulators)

The FEDERAL RESERVE BANK provides a book entry system for settlements of securities issued by the United States Treasury, including Treasury Bills, Notes and Bonds, along with the related re-purchase agreements and certain mortgage and loan issues. Only members of the Federal Reserve Bank, which are generally commercial banks, may be direct participants in this depository. Since brokers, therefore, cannot be participants, a broker must affiliate with a member bank in order to settle transactions. Cash for delivery or receipt of settled trades is in same day funds.

EUROCLEAR

International depositories were developed in order to deal with the growing number of trades that crossed country borders and were not being adequately handled. EUROCLEAR is a major international depository, located in Brussels, formed to provide exchange and clearance services for internationally traded securities. Euroclear was initiated in principle in 1965 and formally created in 1968 with Morgan Guarantee Trust as founder. Euroclear is owned by the Euroclear Clearance System Public Limited Company, whose shareholders are over one hundred banks, brokers and investment institutions worldwide. As of this writing, Euroclear handles securities issued from over 121 countries worldwide. Euroclear has an "electronic bridge", a direct link, to the Cedel depository to facilitate settlements between the two. Prepared by Frederic Goblet 01/13/98

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Cedel

CEDEL (CENTRALE DE LIVRAISON DE VALEURS MOBILIERES) is the second major depository, along with Euroclear, for international trading. Located in Luxembourg, Cedel was created in 1971 and is owned by various banks. Cedel works with Euroclear to facilitate transaction flows. An example of the cooperation between these two depositories which results in efficiency for participants, is that Cedel performs pre-matching of trades with Euroclear daily to ensure timely delivery and receipt. Benefits of Cedel's working relationship with Euroclear include fewer physical settlements that result in lower fees charged to participants and same day cash proceeds.

PRIMARY MARKET Securities are first offered for sale in a primary market. For example, the sale of a new bond issue, preferred stock issue, or common stock issue takes place in the PRIMARY MARKET. These transactions increase the total stock of financial assets in existence in the economy.

SECONDARY MARKET Trading in currently existing securities takes place in the SECONDARY MARKET. The total stock of financial assets is unaffected by such transactions.

THE OVER-THE- COUNTER MARKET OVER-THE-COUNTER MARKETS include all security markets except the organized exchanges. The money market is a prominent example. Most corporate bonds are traded over-the-counter. Most Stocks and Bonds are not traded on exchanges but in the over-thecounter market. The OTC market is not a place but rather a method of negotiated trading which, unlike exchanges, has no central location. It is composed of numerous dealers called market makers. Acting as Prepared by Frederic Goblet 01/13/98

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wholesalers and principals, these dealers “make a market” in the shares of one or more companies as they trade for their customers and their own accounts.

THE REGULATORS The various securities markets, procedures of issuance, marketing, and subsequent trading of securities, must adhere to certain rules and standards in order to proceed in a reasonable and orderly fashion. In the U.S., the main regulatory agencies include the Securities and Exchange Commission (SEC), and the Federal Reserve Board (Fed). The SECURITIES AND EXCHANGE COMMISSION (SEC) regulates all organized securities exchanges to protect investors from unfair practices and to maintain orderly markets. SEC regulations include three major Acts governing the trading of securities on organized exchanges. The SECURITIES ACT OF 1933 pertains to newly issued securities, the SECURITIES EXCHANGE ACT OF 1934 deals with trading in securities markets, and the SECURITIES ACT AMENDMENT OF 1975 centers on the national securities markets. In fact, the SEC established many of the regulations cited in the U.S. Regulations and Acts module. There are also specific regulators for specific markets, such as the COMMODITIES FUTURES TRADING COMMISSION which regulates activities in commodities futures markets.

THE CENTRAL BANK OF THE U.S.A.: THE FEDERAL RESERVE SYSTEM THE FEDERAL RESERVE SYSTEM is the guardian of the nation’s money banker, regulator, controller, and watchdog all rolled into one. Like other countries, the U.S. has a national bank. However, the Federal Reserve (the Fed) is not one bank; it’s twelve separate ones governed by a

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seven- member Board of Governors. Congress established it in 1913 to stabilize the country’s chaotic financial system.

How the Fed works

Technically a corporation owned by banks, the Fed works more like a government agency than a business. Under the direction of its Chairman, it sets economic policy, supervises banking operations, and has become a major factor in shaping the economy. The Fed has several tools by which it influences, indirectly and to a greater or lesser extent, the amount of money in the economy and the general level of interest rates. These tools are reserve requirements, open market operations, open market repurchase agreements and the discount rate. These instruments represent the key ways that the Fed interacts with commercials banks in the process of creating money.

Member Banks

About half of all the banks in the country are members of the Federal Reserve System. All national Banks must belong, and state-chartered banks are eligible if they meet the financial standards the Fed has established.

The Federal Reserve’s many Roles

The Fed plays many roles as part of its responsibility to keep the economy healthy. The Fed handles the day-to-day banking business of the U.S. government. It gets deposits of corporate taxes for unemployment, withholding and income, and also of federal excise taxes on liquor, tobacco, gasoline and regulated services like phone systems. It also authorizes payment of government bills like Social Security and Medicare as well as interest payments on Treasury bills, notes and bonds. Moreover, the Fed manages the currencies replacement, the gold matters and is also a clearing house for checks.

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THE FED AS A REGULATOR By buying and selling government securities, the Fed tries to balance the money in circulation. When the economy is stable, the demand for goods and services is constant, and so are prices. Achieving that stability supports the Fed’s goals of keeping the economy healthy and maintaining the value of the dollar. THE FED AS A LENDER If a bank needs to borrow money, it can turn to a Federal Reserve Bank. The interest the Fed charges banks is called the DISCOUNT RATE. Bankers do not like to borrow from the Fed since it may suggest they have problems. In addition, they can borrow more cheaply from other banks. THE FED AS AN AUDITOR The Fed monitors the business affairs and audits the records of all the banks in its system. Its particular concerns are compliance with banking rules and the quality of loans.

THE G30, THE GROUP OF THIRTY The GROUP OF THIRTY (commonly known as G30) is a private, international group of top economists and bankers who meet for the purposes of exploring and discussing issues of international finance and global economics. Although the group has no legislative power, it is highly respected, and its recommendations are taken into serious consideration when relevant national or market policies and practices throughout the world are being revised or formulated. In 1989, the G30 issued a set of NINE RECOMMENDATIONS for improving international securities settlements, corporate actions processing, and income processing. The purpose was to reduce risk and improve efficiency in national and world markets. The nine G30 recommendations, as published in 1989, are: 1) By 1990, all comparisons of trades between direct market participants should be accomplished by T+1. Prepared by Frederic Goblet 01/13/98

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2) Indirect market participants should, by 1992, be members of a trade comparison system that achieves positive affirmation of trade details. 3) Each country should have a fully developed central securities depository organized to encourage the broadest possible industry participation by 1992. 4) Each country should determine whether a trade netting system would help reduce risk and improve efficiency. If a netting system is appropriate, it should be in place by 1992. 5) Delivery vs. Payment (DVP) should be used for settling all securities transactions. A DVP system should be in place by 1992. 6) Payments associated with the settlement of securities transactions should be consistent across all instruments and markets by adopting the same day funds convention. 7) All markets should adopt a "rolling settlement" system. Final settlement should occur on T+3 by 1992. As an interim target, final settlement should occur by T+5 by 1990, except where it hinders the achievement of T+3 by 1992. 8) Securities lending and borrowing should be encouraged as a way to expedite the settlement of securities transactions. Regulatory barriers to securities lending should be removed by 1990. 9) Each country should adopt the ISO standard for securities messages and the ISIN numbering system by 1992.

S.W.I.F.T. SOCIETY FOR WORLDWIDE INTERBANK FINANCIAL TELECOMMUNICATIONS S.W.I.F.T. is an acronym for SOCIETY FOR WORLDWIDE INTERBANK FINANCIAL TELECOMMUNICATIONS. S.W.I.F.T. is not a payment system, rather it is a system of electronic communication. S.W.I.F.T. is a nonprofit organization that facilitates the exchange of payment instructions or advises of payment between financial institutions around the world. S.W.I.F.T. messages can be sent both internationally and domestically. A

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S.W.I.F.T. message can also be used to convey trading and settlement messages, corporate action notices, and general messages, among others. S.W.I.F.T. was organized in 1973 to provide a more efficient communications method than telegraph wire (also known as TELEX) or mail. Participants to the S.W.I.F.T. network include broker-dealers, securities firms, Investment Management Institutions, recognized exchanges, central depositories and clearing institutions, registrars and transfer agents, and custodian banks. The advantages of S.W.I.F.T. in a global environment are that it provides common rules, standards and communication methods across a variety of users. S.W.I.F.T. is considered one of the most secure and efficient networks for the delivery of funds transfer instructions. S.W.I.F.T. protects against unauthorized access, loss or incorrect delivery of messages, transmission errors, loss of confidentiality and fraudulent changes to messages.

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Types of Investment There are four basic types of investments: 1. LAND (real estate) 2. COMMODITIES 3. SECURITIES (debt/equity) 4. CASH (“fake asset”)

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Investment Strategies Various INVESTMENT STRATEGIES allow all types of investors the opportunity to maximize returns on their investments according to their individual needs. Before developing an investment strategy, investors must consider the objectives and constraints influencing their investment choices. Objectives are what the investor wishes to accomplish by investing. For example, objectives can be to generate a steady and secure income flow, to maintain liquidity, to have a specified amount of money available at a particular time in the future, to increase the initial capital by a substantial amount, etc… Not all objectives are mutually exclusive, but different objectives require different types of investments and strategies. Constraints provide the framework of limitations within which the stated objectives will be pursued. Constraints can be liquidity requirements, tax considerations, legal and regulatory requirements, or circumstances of the investor.

RISK-RETURN TRADE-OFF

The RISK-RETURN TRADE-OFF is a subjective principle of investment strategy. Before a strategy can be developed, the amount of risk an investor is willing to take must be considered. Generally, the highest risk investments will offer the highest potential returns, as well as the highest potential for losses.

DIVERSIFICATION

DIVERSIFICATION reduces an investor's exposure to risk by spreading a variety of investment choices among different asset categories. Diversification works on the theory of "not putting all of your eggs in one basket"; by choosing investments in different markets or industries, or Prepared by Frederic Goblet 01/13/98

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mixing equity and debt, the investor is protected from a negative impact in one category. For diversification to be effective, the chosen investments should not fluctuate in a similar fashion, such that external market conditions would cause the investments to rise or fall in value at the same time. Diversification implies that if one asset or investment category performs poorly, the entire portfolio will not be affected.

ASSET ALLOCATION

Everyone invests for the same basic reason: to make their assets work as hard as they can to meet a set of financial objectives. But those objectives are different for each of us, and they define how we invest. The relationship between your needs, resources, goals and tolerance for risk will pinpoint the asset allocation strategy--the method by which you divide your assets among stocks, bonds and cash--that's best for you. The different strategies are based on several factors, and differ in how they balance risk and reward. In general, higher growth means a greater emphasis on stocks--and a higher level of risk. Identifying your investment objectives will help you decide which investment strategy is right for you. ASSET ALLOCATION is related to diversification, and refers to the question of what percentage of a portfolio should be invested in any asset category in order to maximize returns within the risk parameters desired. Determining an optimal asset mix of any combination of investments, including short term debt, stocks, bonds, real estate, options, futures, venture capital and derivatives, enhances the investor's ability to achieve desired returns. • You need a CAPITAL PRESERVATION strategy. This strategy is based on the following asset allocation: Stocks: 10% Bonds: 55% Cash: 35%

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This division of assets is designed to maintain capital. Most of your money will be in bonds and cash, with a small portion seeking equity growth to offset the effects of inflation. Overall returns may be lower than normal in order to minimize the risk of principal loss. • You need a CURRENT INCOME strategy. This strategy is based on the following asset allocation: Stocks: 30% Bonds: 60% Cash: 10% While moderate risk is assumed from fluctuating interest rates, this strategy provides the greatest level of income. • You need an INCOME AND GROWTH strategy. This strategy is based on the following asset allocation: Stocks: 40% Bonds: 50% Cash: 10% This strategy seeks a balance between bonds for income and stocks for growth of principal and dividends. Dividends and interest income comprise a large part of the invested assets' total return. Some risk is assumed in order to achieve growth. • You need a LONG-TERM GROWTH strategy. This strategy is based on the following asset allocation: Stocks: 70%

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Bonds: 25% Cash: 5% In order to accumulate wealth over a 3-5 year period, this strategy places greater emphasis on stocks. An investor would need to be willing to accept some price volatility to achieve growth. Equities are dominant, particularly leading companies in strategically favored industries. There is limited turnover, and dividend reinvestment and dollar cost averaging are stressed to achieve the growth objective. • You need an AGGRESSIVE GROWTH strategy. This strategy is based on the following asset allocation: Stocks: 80% Bonds: 10% Cash: 10% The primary investment objective of this strategy is to achieve aboveaverage capital growth over a 3 - 5 year period. Income is of no concern. The investor is willing to make few changes in this larger-than-normal commitment to stocks in strategically favored industries.

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The Concept of Risk (β β ,…) and Return

What is Risk ?

RISK can be defined as the possible variation in cash flow about an expected cash flow. Conventionally, we measure the EXPECTED CASH FLOW as follows:

EX = X1 P1 + X2 P2 + . . . + X n Pn where Xi is the cash flow in the ith state of the economy and Pi is the probability of the ith state of the economy. Similarly, the EXPECTED RATE OF RETURN is given by:

Σ R i Pi i=1 n

ER =

where Ri is the rate of return in the ith state of the economy and pi is the probability of ith state of the economy.

The Types of Risk

MARKET RISK

An asset may lose market value because of economic and other swings in the overall market or conditions affecting the asset itself.

CREDIT RISK

The borrower may fail to repay principal

INFLATION RISK

The currency in which an asset is based may lose purchasing power

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LIQUIDITY RISK

An asset may lose market value because it is difficult to sell.

INTEREST-RATE RISK The market value of a fixed-income investment moves opposite to market interest rates. REINVESTMENT RISK When reinvesting a bond’s principal and interest proceeds, you might not get as high a rate because market interest rates have declined. CURRENCY RISK

An asset denominated in foreign currency may lose value when the home base strengthens.

How to measure risk ?

Market risk refers to the fluctuation of an investment’s price volatility or potential loss in market value at the time you need to liquidate. Wall Street has found a way to actually measure the risk of certain investments in terms of price volatility. ALPHA. With this measure, you can gauge how much better an investment or portfolio performs, given its risk. Alpha is the return over and above the market average, as measured by the S&P 500 Index. An Alpha of ‘0’ means you are being adequately compensated for risk taken; a higher number reflects better than expected performance. BETA. With this measure, you can gauge a security’s price volatility relative to the overall market. Theoretically, a portfolio or security with a beta of 1.00 moves in line with S&P 500 index. A Beta higher than 1.00 denotes greater price volatility than the overall market. Statistically, risk may be measured by the standard deviation of the random cash flow. The STANDARD DEVIATION is denoted by σ and is calculated as follows:

σ=

n

Σ i =1

R i – ER 2 Pi

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where n is the number of states of the economy, Ri is the return in the ith state and Pi is the probability of the ith state of the economy. The attractiveness of a security cannot be determined by standard deviation alone. The risk and return of a security has to be compared with the alternatives available for investment. Total Risk or variability of returns can be divided into: The variability of returns unique to the security : Commonly referred to as Firm Specific Risk or Unique Risk or Diversifiable Risk or Unsystematic Risk. The risk related to market movements : Also referred to as MARKET RISK or Non-diversifiable Risk or Systematic Risk. By diversifying, the investor can eliminate the “unique” security risk. The systematic risk, however, cannot be diversified.

Measuring Systematic Risk

SYSTEMATIC RISK affects all securities. To measure systematic risk, we measure the tendency of a stock to move relative to the market. The plot of firm excess returns versus market excess returns is called the CHARACTERISTIC LINE, i.e., ER - Rf = β (ERm - Rf) The measure of a stock’s systematic risk or market risk is commonly called BETA. BETA is also the slope of the Characteristic line. The BETA of stock A is calculated as follows:

βa =

Cov (Ra , Rm ) Var R m

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where Ra is the return on stock A and Rm is the return on the market portfolio and where

n

Var Rm =

Σ

Rmi – ERm 2 p i

i= 1

n

Cov R a, Rm =

Σ

Rai – ERa Rmi – ERm pi

i =1

The beta of a portfolio is the weighted average of the individual securities betas. The beta of the market is one.

The Required Rate of Return

The required rate of return equals the risk free rate plus a return to compensate for the additional risk. The REQUIRED RATE OF RETURN can be expressed as : R = Rf + RP, where R is the investor’s required rate of return, Rf is the risk-free rate, and RP is the risk premium.

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The Balance Sheet and the Income Statement

THE BALANCE SHEET The BALANCE SHEET represents a statement of the financial position of the firm on a given date, its asset holdings, liabilities, and owner supplied equity. This statement is considered the most important financial statement for judging the economic well being of the firm. The balance sheet consists of two basic components: (1) assets and (2) liabilities plus owner's equity.

Assets

On the ASSET side of the balance sheet, we usually find two categories. a) CURRENT ASSETS are those assets that are expected to be realized in cash, sold, or consumed either in 1 year or within the operating cycle of the firm, whichever is longer. b) FIXED OR NONCURRENT ASSETS contain all those resources that are not expected to be converted into cash within the operating cycle of the firm. Security investments, plant, equipment, and land are the most common fixed assets.

Liabilities

LIABILITIES represent the outstanding claims held against a firm's assets and are reported at their stated or face value. There are two basic categories of liabilities. a) CURRENT LIABILITIES represent obligations that are reasonably expected to be liquidated within 1 year. b) LONG-TERM OR NONCURRENT LIABILITIES include permanent obligations of the firm that are not reasonably expected to be liquidated within the Prepared by Frederic Goblet 01/13/98

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normal operating cycle of the firms but are payable at some later date. Noncurrent liabilities are often referred to as long-term liabilities.

Owner's equity

OWNER'S EQUITY represents the book value of the owner's interest in the assets of the firm. Owner's equity is comprised of capital stock (par value of common stock plus paid in capital) and retained earnings (undistributed earnings).

THE INCOME STATEMENT The INCOME STATEMENT represents an attempt to measure the net results of a firm's operations over a specified time interval. Some of the more important components of the income statement are discussed below: 1. SALES represent the total sales of products or services net of returns and allowances attributable to the period. 2. COST OF GOODS SOLD is simply the cost of the product sold or service provided. There are two widely used methods for computing cost of goods sold. The First In First Out (FIFO) method assigns to cost of goods sold the prices the firms paid on the oldest item in inventory. The Last In First Out (LIFO) method assigns cost to items sold based on the cost of the most recently purchased inventory item. The method selected can have an important effect on net earnings for a period in which prices have risen or fallen significantly. 3. GROSS PROFIT represents the amount by which sales exceed cost of goods sold. 4. SELLING EXPENSE includes all those expenses incurred in the process of making the period's sales. 5. GENERAL AND ADMINISTRATIVE EXPENSES include all those operating expenses not directly attributed to the cost of merchandise sold or selling expenses. These expenses usually include administrative

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salaries, utilities, depreciation.

non-income-related

taxes,

insurance,

and

Depreciation is not a cash expense; it represents an attempt to allocate the cost of the firm's plant and equipment against the periods in which those assets are being used. The purpose of depreciation is to allow firms to help defray the cost of asset allocation by deducting the cost for tax purposes. 6. NET OPERATING INCOME reflects the net results of a firm's operations before considering financing costs and income taxes. 7. NET INCOME AFTER income taxes.

TAXES

represents net earning for the period after

8. RETAINED EARNINGS for the period represent any earnings that remain after all dividends have been paid to stockholders. This amount is often added to the existing retained earnings figure on the balance sheet.

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The Time Value of Money

THE NET PRESENT VALUE NPV = Present value of expected future cash flows

- Cost

NPV measures the value created by a financial decision. Positive NPV increases wealth. A zero NPV decision earns the “fair” rate of return. A positive NPV decision earns more than the fair rate of return.

REQUIRED RATE OF RETURN The REQUIRED RATE OF RETURN is the return that exactly reflects the risk of the expected future cash flows. A person requires the return from an investment before she/he is willing to make the investment.

EXPECTED RATE OF RETURN It is the return that an investor expects to earn from the investment. If it is equal to the required rate of return, the investment has a zero NPV. If it is greater than the required rate of return, the investment has a positive NPV.

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If it is less than the required rate of return, the investment has a negative NPV.

PRESENT VALUE FORMULA Let PV = Present Value FVn

= Future Value at time n

r = interest rate (or discount rate) per period.  1   PV = FVn  n  (1 + r ) 

FUTURE VALUE FORMULA Let PV = Present Value FVn

= Future Value at time n

r = interest rate (or discount rate) per period. FVn = PV (1 + r )

n

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The Stock Market EQUITY SECURITIES represent the ownership of a corporation. For example, if an investor purchased 50 shares out of 1000 outstanding XYZ shares, this investor owns 50/1000 of the XYZ Corporation. A privately owned company goes public by selling all or parts of its ownership to investors to raise capital. By purchasing common stock, you actually own a part of the company’s assets and stand to participate in its profitability. SHAREHOLDERS or STOCKHOLDERS have the right to vote for the Board of Directors and on corporate matters. Over the years, studies have shown that successful stock investing is a matter of time rather than a matter of timing. That's because stock prices can move up and down dramatically on a day-to-day basis but, over the long-term, build wealth better than any other investment vehicle. From the investment point of view, there are two main reasons why investors are interested in investing in equity securities: dividend payments and the growth of the stock's market value. A DIVIDEND represents that portion of the net earnings of the corporation, which is distributed to stockholders. A combination of the current earnings and financial status of the company plus potential investors' perceptions of the company's future earnings and financial status determine the Market Value of a company's shares. Thus, as a company grows and becomes more successful, the value of the shares increases.

GOING PUBLIC The first time companies issue stock, is called GOING PUBLIC. After that, they can raise additional money, or capital, by selling additional stock.

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To take a company public, which means making it possible for investors to buy the stock, the management makes an INITIAL PUBLIC OFFERING (IPO). The company goes to INVESTMENT BANKERS who agree to UNDERWRITE the stock offering - that is, to buy all the public shares at a set price and resell them to the general public, hopefully at a profit. The company has to prepare a PROSPECTUS, a legal document containing a detailed analysis of the company’s financial history, its products, its management’s background and experience.

THE PRICE

The Price

Whether a company’s stock is listed on a stock exchange or traded overthe-counter, two prices are always quoted the bid and the offer. If selling shares, you are interested in the bid, the highest price offered by a buyer. If buying shares, you want to know the offer, the lowest price at which one or more shareholders have agreed to sell. Prices are still quoted in points and fractional points (1/8, ¼, 3/8, ½, 5/8,…)

The Spread

The difference between the bid price and the offer is the SPREAD. The spread varies usually between 1/8 and $1. A larger spread may indicate greater risk to market makers or low trading activity.

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The Ticker

Every public company has a TICKER SYMBOL or a stock symbol by which it is easily identified.

Reading the Newspaper

52-weeks Hi Lo Stock 677/8 501/2 Disney

Sym Div Yld% PE Vol 100s Hi Lo Close Net Chg DIS $.44 .6 26 32001 691/8 673/4 685/8 +7/8

52 Weeks Hi/Lo

The highest and lowest prices paid for Disney's stock during the past year. The numbers are expressed in points, but represent dollar amounts. In this case, 677/8 is the same as $67.875. Knowing the highs and lows for the past 52 weeks can help an investor evaluate a stock's current price.

Stock

The name of the company.

Sym

The stock's trading symbol. To avoid confusion and to simplify the order process, every stock that is traded on an exchange or in the OTC market is assigned a symbol. Some newspapers do not provide the stock's trading symbol, but instead provide an abbreviation of the company's name.

Div

Short for dividend. For each share of stock owned, a Disney shareholder should receive 44 cents from the company's annual profits. Payment is usually made on a quarterly basis. Not all companies pay dividends all the time. The company's Board of Directors decides whether a dividend will be paid and its amount.

Yld%

The yield, or rate of return, on a stockholder's investment. It is figured by dividing the annual dividend by the current price of the stock. Disney stockholders earn .6 percent of today's stock price from dividends.

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Investors who want income from their stock look for a high yield. PE

Short for price/earnings ratio. The price of a share of stock divided by the company's earnings per share for the last year. Investors use the P/E ratio to decide if a stock is over or under priced.

Vol 100s

The total amount of stock traded during the previous day. On that day, 3,200,100 shares of Disney stock changed hands. The number does not include odd lots or sales of less than 100 shares.

Hi and Lo

The highest price paid for Disney stock during the previous day was $69.125 (or 691/8). The lowest was $67.75 (or 673/4).

Close

The last price paid for Disney at the end of the previous day was $68.625 (or 685/8).

Net Chg

The last price on the previous day, $68.625 (or 685/8), was 87.5 cents (or 7/8 of a dollar) more than the last price on the preceding day. Brokers call this "closing up 7/8 ."

THE SUPPLY AND DEMAND There is an old saying on Wall Street that a stock is worth what somebody is willing to pay for it. Moreover, that is true - the price of a stock is determined by buyers. As they gain new information, investors decide whether they are willing to pay more for a stock or less. Their changing perceptions continually push stock prices up or down. Simply put, the price of a stock - or for any product or service, for that matter - is determined by supply and demand. The supply of stocks is based on the number of shares a company has issued, or sold to the public. People wanting to buy those shares from the people who already own them create the demand for stocks. If people think they will make money on a stock, they will want to buy it.

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But here's the catch: supply is limited, and not everyone who wants to own a company's stock can. The more people desire to own a stock, the more they will be willing to pay for it. High demand for a stock pushes up its price. Similarly, as the value of a stock increases, owners are more reluctant to sell it. The rise continues until prospective buyers decide the price has gone too high. Then, fewer people are willing to buy the stock at the high price. Stockowners who are anxious to sell must lower the price at which they are willing to sell. The stock's price falls until investors believe the stock is again worth the price at which owners are willing to sell. THE COMPANY FINANCIAL HEALTH The laws of supply and demand explain why stock prices fluctuate. How do investors and analysts arrive at their decisions as to whether a stock is worth buying or selling at a given price? Above all, they examine the financial health of the company offering the stock. Investors are not likely to put a high value on stock in a company that is going to lose money. They look for a business with a history of making strong profits and consistently paying healthy dividends. While history is important, investors also analyze a company's future prospects. A company with a poor profit history might have a promising future, and one with a good history might be on the way down. Therefore, careful investors also review how a company fares against its competition and whether it's being run by experienced, responsible people who keep up with current trends. If a company is viewed by potential investors as increasing efficiency or producing new, innovative products, its stock is likely to rise in price. Alternatively, trouble on the horizon - damaging lawsuits, threats of a strike, more intense competition, or more stringent regulation - can depress the value of a company's stock. When a major oil company announced that it was filing for bankruptcy, for instance, the value of its stock dropped 11 percent. A report that someone or some company is trying to buy a certain business usually pumps up that business's stock prices. That is because the purchaser has to buy a majority of the stock to gain control of the company. To do so, the suitor must persuade stockholders to sell their stock by offering an attractive price or their shares.

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Sentiment may also count. For example, when the owners of the Boston Celtics basketball team offered shares of stock in 1986, analysts suggested that the stock was overvalued. But investors - most of them Celtic fans had a high regard for the team and were willing to pay the price to be associated with it. AN INDUSTRY’S FINANCIAL HEALTH Another important factor to consider is the health of a company's whole industry. A company's stock prices may go up or down depending on whether investors think its industry is about to expand (grow bigger) or contract (grow smaller). For example, a company may be doing well financially, but if its industry is declining, investors might question the company's ability to keep growing. In that case, the company's stock price may fall. Many industries expand and contract in cycles. For example, home building declines when interest rates rise. ECONOMIC TREND In addition to events surrounding a specific industry or company, analysts carefully watch what they call economic indicators - general trends that signal changes in the economy. An essential indicator is the change in the rate of economic growth as measured by the Gross National Product (GNP). GNP measures the total production of goods and services in our economy. If it is rising, then shortterm business prospects are improving. Another important indicator is the inflation rate. Inflation occurs when prices are rising rapidly. During an inflationary period, a company's costs may rise faster than it can increase its prices; so its profits shrink. In addition, the inflation rate has a major influence on another important indicator, interest rates. Rising interest rates mean that the government, businesses and consumers must pay more to borrow money. Therefore, the government's budget deficit increases, businesses may delay their plans for new projects, and consumers don't spend as much. That can set the stage for a recession - a period of slow economic growth.

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Analysts also monitor the U.S. budget deficit - the gap between the money the Federal Government takes in and the money it spends. When the deficit grows, the Government has to increase its borrowing of money that would otherwise be available to businesses to expand and consumers to spend. Many other indicators signal changes in the economy. Among them are stock prices, unemployment rates (the percentage of U.S. workers who cannot find jobs), and changes in the value of the dollar (the amount of foreign currencies that can be purchased for each U.S. dollar). These indicators are more than just numbers. They point to changes in the way ordinary people spend their money - and, in turn, how the economy is likely to perform. If unemployment rates are falling, or if people are getting good values for their money, they are probably going to feel optimistic about the economy. They are more likely to spend money, benefiting companies and stock prices. WORLD AND NATIONAL EVENTS Nothing alters people's attitudes toward saving and investing more than their perceptions of a major news event. For example, when a nation has declared war, stock prices may go up. That's because a country at war needs armaments, supplies for troops, spare parts, and huge amounts of fuel. Therefore, companies gear up to produce and sell more goods. News of other events can push stock prices down. If fighting between Iran and Iraq, for example, flares up in the Persian Gulf, U.S. stock prices may drop. That's because fighting may decrease the supply of oil coming from that region. Consequently, oil may become more expensive and the cost of all U.S. goods that rely on oil or petroleum products may increase. People are reluctant to invest unless they feel confident about the future of the economy. If investors are not sure how a major event will affect the nation's economy, they are likely to hesitate about investing in securities. For example, if investors are uncertain of a new president's attitude toward business, stock prices may drop while investors await developments.

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HOW TO VALUE A STOCK? The price of a stock is not by itself any indication of value by itself. Stocks are analyzed based on a multitude of criteria, including Price/Earnings ratio and dividends.

EARNINGS PER SHARES (EPS) The portion of a company’s profit paid on each share of common stock. It is calculated after paying taxes and preferred shareholders and bondholders

PRICE/EARNINGS RATIO A company’s stock price is greatly influenced by its earnings growth. The P/E is calculated by dividing the stock price by the company’s annual earnings per share. SHARE PRICE ÷ EARNINGS PER SHARE = P/E Company earnings are anticipated and estimated, therefore you can see how a stock’s P/E reflects investors’ feelings about the company’s future prospects. The higher the P/E, the more earnings growth investors are expecting. Stocks with a higher P/E, usually over 20, are considered riskier than stocks with lower growth.

THE STOCK PRICE PRICE = EPS (ANNUAL)

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X

P/E

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DIVIDENDS The total return of a stock investment includes dividends paid by the company in addition to share-price gains. Newer companies generally reinvest profits, but as they mature, nearly all large public companies pay cash dividends to share-holders out of their earnings. A company’s Board of Directors decides if a dividend is to be paid and how much. Dividends generally increase in line with company profits. The percentage of a company’s retained earnings paid as dividends is the PAYOUT RATIO. The typical payout ratio is 25 to 50 percent of company earnings. Dividends are paid quarterly to shareholders, designated owners of record. To qualify, shares must have been purchased before the exdividend date, approximately three weeks before the dividend is paid. Dividends may also be paid in shares of stock when its Board of Directors feel that the money can be best used to expand the business or develop new products. As you might expect, when many corporations increase their dividends, it is considered positive for the stock market. Indeed, dividend yields are an indicator of corporate growth and profitability as well as investment value. Stocks that pay dividends regularly are known as INCOME STOCK, while those that pay little or no dividend while reinvesting their profit are known as GROWTH STOCKS.

The Dividend Yield

The Dividend Yield is the percentage of purchase price you get back through dividends each year. For example, if you buy a stock for $100 a share and receive $4 per share, the stock has a dividend yield of 4%. However, if you get $4 per share on stock you buy for $50 a share, your yield would be 8%.

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STOCK SPLIT If a company determines that it stock price is too high to interest investors, it may split the shares to lower the price. Although a split changes the number of outstanding shares, it has no effect on shareholder equity, and dividends are adjusted accordingly. Sometimes the announcement of a split increases the stock’s market value, but often is has no effect at all. A STOCK SPLIT may be a distribution of any whole or fractional number of shares for each share held. A reverse split decreases the number of outstanding shares. A company may reverse split its stock when the price is too low for its stock to be used as collateral for borrowing money or is too costly to trade.

VALUABLE STOCK MARKET TERMS

Common Stock

Most often corporations offer equity ownership in the form of COMMON STOCK. Many corporations issue just one class of common stock to raise capital; however, there can be different classes of common stock issued by the same corporation in the market, such as Class A and Class B stocks. Terms of each class issued by the corporation are detailed in the prospectus. Each common stockholder is entitled to dividend payments, and the right to vote their shares at annual meetings. In some cases, shareholders have the opportunity to purchase newly issued shares at below market price before they are offered to the public.

Preferred stock

PREFERRED STOCK is sometimes called a hybrid security because it has some characteristics of both equity and debt securities. It is like common stock in that it earns dividends, and has no maturity date. It is as if debt in Prepared by Frederic Goblet 01/13/98

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that the amount of each dividend paid to the preferred stockholders is predetermined. This is different from the dividend payments on common stock for which the dividend rate may fluctuate depending on the performance of the corporation. For example, an investor owns 1000 preferred shares of XYZ Corporation and the company declares a 10% dividend rate annually. This investor will receive a dividend of $100 annually, or $25 quarterly. This income calculation is very similar to debt instruments, where investors are paid according to a stated interest rate. One other difference between preferred and common stock is that the preferred stockholder has little or no voice in the management of the corporation. They reduce the investor’s risk but limit reward. There are five distinct types of preferred stock. These are cumulative preferred, participating preferred, convertible preferred, prior preferred, and callable preferred stocks. In case of liquidation of the corporation, the debt holders and preferred stockholders are ranked ahead of common stockholders for claims on both the assets and income of the corporation.

The Right to Vote

Owning a stock gives you the right to vote on important company issues and policies. Most shareholders vote by PROXY, an absentee ballot they receive before the annual meeting. On the other hand, they have the option of attending the meeting and voting in person.

Book Value

Theoretical historical value (not market value) of a company’s assets after all debts are paid.

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Debt /Equity Ratio

A measure of a company’s financial solvency. Debt is the total cash a company owes creditors; equity is the dollar value assigned to shareholder ownership. The relationship between the two is an indicator of a company’s financial condition.

Tender Offer

Offer from a company or group to purchase several of a company’s shares. The bidding entity sends a document to the shareholders outlining the terms of the offer. Shareholders are not obliged to tender (sell) their shares, but generally it is in their interest to do so, since the offered price might be the highest price at which the stock will trade in the near future or perhaps ever again.

Insider Trading

Illegal trading in securities based on confidential information to which only insiders (such as a company’s accountants, lawyers, and employees) are privy. Industry computers detect heightened trading activity in certain stocks, which allows suspicious trades to be traced and investigated for insider-trading abuse.

Warrant

The right to purchase a certain number of a company’s shares at a fixed price prior to a specified future date. Companies that plan to issue stock or raise cash by selling shares held in reserve issue warrants.

Program Trading

Some of the big investors speed up the process of buying and selling stocks by using program trading techniques that involve placing large

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orders by computer. The programs are sometimes triggered automatically, when prices hit predetermined levels. Such sudden buying or selling can cause abrupt price changes or even dramatic shifts in the entire market. The stock market crash of 1987 occurred, at least in part, because of program trading triggered by falling prices. To prevent potentially catastrophic program trades, trading now shuts down in a major sell-off to let things cool down.

Rule of 72

Quick calculation to determine how long it takes to double an investment at a given interest rate. Divide 72 by the rate of interest earned to get the number of years it takes money to double. For example, if an investment earns 8% annually, it takes 9 years to double.

Capitalization

In order to fully appreciate market price in a comparative sense, one must take into account the capitalization of the companies in question. This is defined as the amount derived by multiplying the current market price by the number of outstanding shares. CAPITALIZATION =

MARKET PRICE PER SHARE

X SHARES OUTSTANDING

Arbitrage

ARBITRAGE is the method whereby investors buy a security in one market and simultaneously sells it in another market, when legally able to do so. Arbitrage techniques differ from market to market but traditionally they have been confined to two or more markets which happen to trade the same security, for instance the NYSE and Pacific Stock Exchanges. The process is very rapid and is based upon even the smallest of price differentials.

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Blue Chips

Blue Chips is a term borrowed from poker, where the blue chips are the most valuable, and refers to the stocks of the largest, most consistently profitable corporations.

Bull Market Vs Bear Market

A bull market is a period during which stock prices are generally rising. A bear market is a period which stock prices are generally falling. Each of these is fueled by investors' perceptions of where the economy and the market are going. If investors believe they are in the midst of a bull market, or one seems likely, they will feel confident that prices are going up. Their own confidence helps to keep stock prices rising. During a bear market investors believe stock prices will fall. They hesitate to invest in stocks, and their own concerns help keep stock prices down. A bull or bear market can last anywhere from several months to several years.

SHORT SELLING The most common form of stock investing is buying long. When you “LONG A STOCK”(meaning you owe the stock), the most you can lose is amount of cash you invested. However, if an investor believes that price of a company’s shares will decline, he may speculate by selling Prepared by Frederic Goblet 01/13/98

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stocks short. SELLING A STOCK SHORT involves selling borrowed shares with the expectation that the price will fall, providing the opportunity to buy them back cheaper - sell high, buy low - The short seller’s profit is the difference between the buy and sell prices, less commissions. You borrow shares from your broker, sell them and get the money. Then you wait, expecting the price of the stock to drop. If it does, you buy the shares at the lower price and repay the broker to settle the loan (plus some interest and commission). Buying shares back is called COVERING THE SHORT POSITION.

BUYING WARRANTS Warrants are a way to wager on future prices. Warrants guarantee, for a small fee, the opportunity to buy stock at a fixed price during a specific period. Investors buy them if they think a stock’s price is going up. For example, you might pay $1 a share for the right to buy XCo. Stock at $10 within 5 years. If the price goes up to $14 and you EXERCISE (use) your warrant, you save $3 every share. You can then sell the shares at a higher price to make a profit. Companies sell warrants if they plan to raise money by issuing new stock or selling stocks they hold in reserve.

BUYING ON MARGIN Investors who want to buy stock but do not want to pay the full price can LEVERAGE their purchase by buying on margin. They set up a MARGIN ACCOUNT with a broker, sign a margin agreement, and maintain a minimum balance. Then they can borrow 50% of the price of the stock and use the combined funds to make the purchase. Investors who buy on margin pay interest on the loan portion of their purchase but do not have to repay the loan itself until they sell the stock.

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Despite its advantages, buying on margin can be very risky. For example, the price of the stock you buy could drop so much that selling it would not raise enough cash to repay the loan to your broker. To protect themselves in cases like this, brokers issue a MARGIN CALL if the value of your investment falls below 75% of its original value. That means you have to put additional money into your margin account.

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The Fixed Income Securities The Money Market Vs The Capital Market * Investor gets par value at maturity * Investor gets interest payment at specific intervals

The Individual as a Lender Investors willing to lend money

Municipal Bonds Corporate Bonds U.S. Treasury Bonds

States, cities, counties and towns issue bonds * to pay for public projects: schools, highways, stadiums,... * to supplement their operating budgets

Corporations use bonds * to raise capital to pay for expansion, modernization * to cover operating expenses * to financnce corporate take-overs or other changes in management structure

The U.S. Treasury floats debt issues * to pay for a wide range of government activities * to pay off national debt

Bond Matures

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Money Markets

Money Market Vs Capital Market

LONG TERM DEBT refers to debt that has a maturity of one year or longer. This type of debt is traded on what is called the CAPITAL MARKET while SHORT TERM DEBT refers to debt that has a maturity of less than one year. This type of debt is traded on what is called the MONEY MARKET, as the liquidity of these instruments makes them almost as fluid as money. A company or government would issue short term debt in order to cover temporary shortfalls in cash flows. An investor would buy short-term debt to earn interest on excess cash. The second type of capital available to companies -debt- is divided into many classifications. Debt is the most widely used method of raising capital and the capitalization of the major money and bond markets exceeds that of the stock markets many times over. The major classifications are quite simple: debt is broken down into two short- and long-term instruments. Short-term debt is traded on the money markets while the long-term debt trades on the bond markets. As debt markets, the primary function of the money markets is to redistribute funds from those economic units in society possessing a surplus to those in deficit. Since most of these markets are institutional in nature, surplus households do not normally lend directly to deficit borrowers but do so through financial intermediaries. The intermediaries in the money markets are financial institutions and banks whose very business it is to perform this function. Behind this maze of operations which occurs in daily in money markets, one basic economic distinction has to be made. This has to do with the difference between the PRIMARY AND THE SECONDARY MARKETS. As with equities, only a primary market operation actually raises money for the borrower. If the original investor decides not to hold the instrument until maturity and sells it in the secondary market, the borrower is no longer affected since it already has its money. Then the buying and selling of these instruments become a matter of importance only for investors.

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Most money market instruments are sold on what is known as a DISCOUNT basis; that is, they are sold at a price lower than par and pay back principal at redemption. The example employed here will use a Treasury bill of oneyear maturity returning 10%. The price the investor will pay will be 90% of par, or in bond market terms, simply 90. At redemption, 100% will be paid back. The Federal Government, state and local governments, and corporate entities issue American money market instruments.

TREASURY BILL OR T-BILL TREASURY BILLS are issued so that the central government can finance its short-term cash needs, and are auctioned at regular intervals. They normally come in a variety of term structures, with 3 months, 6 months and 1 year being the most common. They are the lowest money market yields available because the government is considered the highest quality credit risk in the country. Since a large and ready secondary market exists for Treasury Bills, their prices will vary during their outstanding lives. If interest rate conditions change, the price of the bill will also change reflecting this.

COMMERCIAL PAPER COMMERCIAL PAPER, a type of promissory note, is issued by large corporations, and generally not secured by any collateral. CP is used to finance short term cash needs of a corporation. The issuer promises to pay the buyer of the paper a set amount on a future date. When issued, CP usually has a maturity date of 1 to 3 months. Large investors who have excellent credit ratings may sometimes be able to negotiate favorable terms with issuers, such as arranging short term CP for as little as 3 days.

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Traditionally, CP was issued at a discount (known as DISCOUNT PAPER) but it is increasingly being issued at par. CP may be issued as either STRAIGHT PAPER having a fixed rate, or FLOATING RATE PAPER having interest rates that vary periodically. CP may be resold on the secondary market to other investors. As such, an issue of CP may have many owners over its lifetime. CP issued by companies with excellent credit is called "PRIME CP". Prime CP can either be sold directly to the public, called DIRECTLY PLACED PAPER, or through a dealer. The latter type of paper is called DEALER PAPER and generally carries a longer maturity term than directly placed paper. Types of CP include Financial Paper, Industrial Paper, Line of Credit Paper, and Eurocommercial Paper. FINANCIAL PAPER is CP that is issued by a financial company such as General Motors Acceptance Corporation (GMAC). INDUSTRIAL PAPER is CP issued by a non-financial firm such as a public utility. LINE OF CREDIT (LOC) PAPER is a note issued by smaller or less marketable firms and is accepted by a Letter of Credit from a bank, which guarantees that payment will be made to the investor who accepts this LOC. Smaller firms and cross-border firms may opt to use LOC Paper as they do not have to disclose financial data to the public upon registering, but only furnish this information to the bank. LOC paper is sold at a discount. EUROCOMMERCIAL PAPER is CP issued, at either par or at a discount, by European corporations. It is denominated in U.S. dollars but payable through foreign banks or foreign branches of U.S. banks.

BANKER’S ACCEPTANCE A business that owes money to a second party may go to a bank and arrange for that bank to pay the money that is owed directly to the second party. The bank agrees to pay on behalf of the business and charges a stated interest rate for the loan. The business agrees to repay full principal Prepared by Frederic Goblet 01/13/98

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and interest at the end of the term of the loan. This arrangement is known as a BANKER'S ACCEPTANCE (BA). Businesses usually enter into this type of arrangement in order to finance the purchase of goods from other countries. Before the loan is repaid, the bank can sell the BA on the secondary market to an investor. This investor now is due to receive the repayment of the loan from the business. The bank guarantees payment on the BA; if the business does not pay the loan, the investor has the legal right to collect the money from the bank that originated the BA. BAs are issued at a discount.

CERTIFICATES OF DEPOSIT As the name indicates, CDs are a type of security that acknowledges a certain deposit of money in a bank with terms to pay the depositor a specific interest rate plus the principal amount deposited, at a specific future date (MATURITY DATE). CDs are issued in negotiable form (may be resold) or non-negotiable form (may not be resold). If negotiable, the depositor that receives the CD from the bank may choose to either hold the CD until it matures, or sell the CD on the secondary market. If the CD is sold, the buyer now has claim to the principal and interest that is due at maturity. CDs can be sold repeatedly but the originating bank may not purchase the CD that it issued. Banks that have excellent financial standing are called "prime banks" and the CDs that they issue are referred to as "prime CDs". This is because the bank has a recognized ability to honor the maturity payments. Prime CDs have a minimum denomination of $1 million. Most CDs are denominated in the currency of the country in which they are issued. Eurodollar CDs, however, represent U.S. dollars that are deposited in foreign banks or foreign branches in U.S. banks. U.S. dollar denominated CDs, issued by foreign banks through foreign branches in the U.S. market, are called Yankee CDs.

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THE EURODOLLAR MARKET After WW2, the US dollar demand increased in international transactions, replacing sterling as the premier reserve currency. In the 1960s, the U.S. began to run large balance of payments deficits. This meant that many dollars were being held in the hands of non-American citizens and corporations. This created a large pool of offshore dollars, ultimately nicknamed “EURODOLLARS”. This term denotes dollars held in banks outside the US, primarily in Europe and also in other offshore banking centers. Eurodollars have their own market rate quoted by the major banks in London holding and trading eurodollars. The rate is quoted on a term basis, in addition to overnight money. The usual term structures are 1, 3, 6, 9 and 12 months, and 3 and 5 years. Rates for these terms are quoted on a spread basis, called the interbank rate. A quote of 11-11 ¼ % means that a bank will take a deposit at 11% and loan (to a prime customer) at 11 ¼ %. It is from the offer side of this spread that the eurodollar rates derives its name, LIBOR; the London, Inter-Bank Offered Rate.

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The Bond Market In order to raise capital, a firm may issue DEBT SECURITIES. Issuing debt securities is, in effect, taking out a loan, with the buyers of the security being the lenders. The issuer of a debt security is therefore obligated to pay the buyers of the security INTEREST according to a predetermined schedule, and to return the investment PRINCIPAL to the investor at a specified future date, known as MATURITY DATE.

Creditor Vs Owner

Debt has one general advantage over equity which again serves to underscore the basic differences between these two forms of financing. Bond holders are CREDITORS of the issuer, not OWNERS. This means that creditors are senior to equity holders in the capital structure of a company. In the event that bankruptcy arises, bond holders must be paid before the equity holders are compensated. This holds true for the payment of interest as well as the payment of principal. For the company, on the other hand, this also means it will be able to raise the money it requires without adding new shareholders to the rolls. Bondholders are, for the most part, a silent majority whose interests are more muted and less politically and organizationally significant than the interests of actual owners of a company.

Registration

All new security issues must be registered with the Securities and Exchange Commission (SEC). REGISTRATION involves the filing of financial statements regarding the firm and other related information. A firm wishing to issue debt must qualify by possessing adequate financial status within established guidelines. Issuing debt places constraints on the firm; because the firm has an obligation to repay creditors, it must maintain the ability to meet these commitments. A debt security is usually registered in the name of the owner. The registered holder's name will appear on the debt certificate and on the Prepared by Frederic Goblet 01/13/98

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books of the paying agent. Registered holders receive the interest payments and any applicable corporate action notifications.

Figuring a Bond’s worth

The Value of a bond is determined by the interest it pays and by what’s happening in the economy. An interest rate of a bond never changes, although other interest rates do. If the bond is paying more interest than is available elsewhere, investors will be willing to pay more to own it. If the bond is paying less, the reverse is true. When interest rates drop, the value of existing bonds usually goes up. If the bond investors buy at par, and holds the bond to maturity, INFLATION (or the shrinking value of the currency) is the worst enemy. Generally, when inflation is up, interest rates go up. Conversely, when inflation is low, so are interest rates. It’s the change in interest rates that causes bond prices to move up or down. For example: If Xcorp. Floats a new issue of bonds offering 6% interest. You buy some bonds at the full price (par value) of $1000 a bond. Three years later, interest rates are up. If new bonds costing $1000 are paying 8% interest, no buyer will pay you $1000 for a bond paying 6%. To sell your bond, you will have to offer it at a DISCOUNT. Consider the reverse situation, if the interest rates reach only 5% interest rate, you’ll be able to sell your 6% bonds for more than you paid: the PREMIUM - since buyers will agree to pay more to get a higher interest rate.

VALUE

The major factors that dictate bond prices and yields are credit quality of the issuer, market interest rates, length of the bond’s maturity, and supply and demand. "PAR" is the term used for the principal value, or the face value of a debt instrument, and is the amount that will be paid to the holder at maturity. Debt can be sold at, below, or above par value.

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A security can be issued at a DISCOUNT (below par) when the interest is scheduled to be paid only at maturity. Full par value is paid to the holder at maturity; thus, the difference between the purchase price and the maturity value represents the income earned on the security. This type of arrangement is common with money market instruments, which have shortterm maturities. A zero-coupon bond is an example of a long-term debt security issued at a discount. Securities can also sell at a discount from the current accrued value if market interest rates have increased since the security was issued. A security with a stated rate below market value is less attractive to investors; a discounted price will help to equalize the value of the security in the marketplace. Securities selling at a PREMIUM carry a price higher than the current accrued value of the par. This can happen if market interest rates have fallen since the security was issued, making the security with the relatively higher rate more attractive to investors. LONG TERM DEBT refers to debt that has a maturity of one year or longer. This type of debt is traded on what is called the CAPITAL MARKET, as a company or government would issue long term debt to raise capital to cover expenditures, which are expected to have a long-range payback. Long term debt instruments may pay interest on a monthly, quarterly, semiannual, or annual basis, or at some other interval as stated in the prospectus. Many types of long term debt securities exist with different interest and maturity terms. There are also several other ways in which security types differ. Descriptions of some of the most commonly traded long term security types follow. They are three major groups of bond issuers in the United States: corporations, the U.S. Government and municipalities (state and local governments).

Analyzing Bond Yield

YIELD is the return on an investment, calculated as a percentage of the amount invested. Nevertheless, it is not that simple because the ultimate Prepared by Frederic Goblet 01/13/98

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proceeds to be returned as principal may be more or less than your original investment. COUPON RATE is the fixed-dollar amount the issuer contracts to pay bondholders until the bond matures, expressed as a percentage of the face value of the bond. The CURRENT market price.

YIELD

is the coupon rate on a bond divided by its current

Coupon rate (in money terms) Market price Bond prices are calculated as a percentage of par and then translated in money terms. This percentage is usually calculated on a bond of $1000 face or nominal, value. Thus, a bond paying 9% per annum, selling at $98, has its current yield calculated in the following manner: $90 = 9.18% $980 Current yield is limited because it ignores the fundamental nature of bond risk: time.

YIELD TO MATURITY is a bond’s annualized total return if held to maturity. discount or premium coupon +/years to maturity market price + redemption price 2

= YTM

Yield to maturity is therefore the true yield on a bond, reflecting both current and future return. YIELD TO CALL is a bond’s total annualized yield if it is called on its earliest call date.

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BUYING AND TRADING BONDS Investors can buy bonds from brokers, banks, or directly from certain issuers. Newly issued bonds and those trading in the secondary market are available from stockbrokers and from some banks. Treasuries, though, are sold at issue directly to investors without any intermediary - or any commission. The Federal Reserve Banks handles transactions in new Treasury issues bonds, bills and notes.

How Trading Works?

Most already-issued bonds are traded over-the-counter (OTC). Bond dealers across the country are connected via electronic display terminals. A broker buying a bond uses a terminal to find out which dealer is currently offering the best price and calls the dealer to negotiate.

VALUABLE BOND MARKET TERMS

CALL

In some instances, an issuer of long term debt may wish to repay all of the outstanding principal on a debt security prior to the scheduled maturity date, thereby retiring the debt. This is known as a CALL. Calls can be made on the entire issue, or on only a portion of the issue. The right of the issuer to do this will be clearly stated in the security's prospectus.

DEFAULT

Sometimes a debt issuer DEFAULTS on an obligation by failing to pay the scheduled interest or maturity proceeds. In these cases, the owners of a Prepared by Frederic Goblet 01/13/98

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firm's debt securities are among the first in line with a claim to any liquidation of the assets of the company. Shareholders, as owners, are last in line.

COLLATERAL

COLLATERAL is an asset, owned or controlled by a borrower, which is pledged to a lender in exchange for a loan. The value of the collateral is generally equivalent to that of the loan. The lender is given ownership or liquidation rights to the collateral in case of default by the borrower, thereby giving the lender some protection against loss. Usually, some type of collateral is required in order to take out a loan, as a guarantee that the loan will be repaid. Debt securities are often backed by collateral pledged by the issuer. This collateral could consist of other securities, real estate, or some other asset that has a value comparable to that of the loan. When a security is collateralized, it is referred to as "secured". A security that does not have collateral behind it is "unsecured".

High-Yield (Junk) Bonds

A JUNK BOND is a bond with a credit rating of BB or lower. CREDIT RATING services assign lower rating to less credit-worthy issuers whose so-called junk bonds must pay higher returns to investors for assuming greater risk.

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U.S. Government Securities The two major categories of government securities are TREASURY and AGENCY.

TREASURY SECURITIES TREASURY SECURITIES, or Treasuries are debt obligations of the U.S. government, issued and guaranteed by the U.S. Department of the Treasury to finance government expenditures and its budget deficits.

Treasury Bills

T-BILLS are issued for 3, 6, 9 months or 1 year. They are available in multiples of $1,000, but the minimum investment is ten bills. T-Bills resemble zero coupon bonds because they are bought at a discount from their face value, and no regular payments are made to holders. The interest you earn is the difference between the purchase price and the $1,000 paid out at maturity.

Treasury Notes

T-NOTES are issued in increments of $1,000 for terms longer than 1 year but fewer than 10 years. Unlike T-bills, T-notes contain coupons and pay interest semiannually. The minimum purchase is $5,000 on maturities of fewer than 5 years and $1,000 on maturities of 5 years or more.

Treasury Bonds

T-BONDS are issued in increments of $1,000 for terms longer than 10 years, and pay interest semiannually. The minimum purchase through the brokerage firm is $1,000. The 30-year long bond is a widely quoted yield benchmark for long-term interest rate in the United States. Prepared by Frederic Goblet 01/13/98

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Trading

PRIMARY MARKET Treasury securities are initially offered through the Federal Reserve System in about 100 auctions held each year. This process involves no more than 39 authorized primary dealers, mostly large brokerage firms and commercial banks, who bid for blocks of securities to resell their customers for profit. SECONDARY MARKET Most investors buy Treasury securities from brokers so they can know the yield prior to purchase and can sell them any time.

AGENCY SECURITIES AGENCY SECURITIES are debt obligations of certain federally owned or sponsored government agencies. Most are repackaged mortgages on homes owned by U.S. citizens. All agency securities are assumed to be rated AAA.

Ginnie Maes (GNMA)

GINNIE MAES are MORTGAGE bonds issued by the Government National Mortgage Association (GNMA), an organization that buys FHA and VA home mortgages from banks and auctions them to financial institutions. The institutions package the mortgages into “pools” to create securities to market to investors. The government guarantees both principal and interest whether or not homeowners meet their mortgage obligations. Ginnie Mae interest is paid monthly and is subject to federal, state, and local taxation. Ginnie Maes are the most popular agency securities because they are very liquid, formally backed by the full faith and credit of the U.S. government, and pay higher yields than Treasury securities.

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Fannie Maes (FNMA)

FANNIES MAE are mortgage bonds issued by the Federal National Mortgage Association (FNMA), a federally sponsored, quasi-private corporate that provides funds to the mortgage market by purchasing convential mortgage loans from banks and other lenders. Like Ginnie Maes, these loans are packaged into pools by financial institutions and sold to investors. They lack official government backing, but they are considered a moral obligation of the U.S. government. Interest is paid monthly.

Freddie Macs (FHLMC)

FREDDIE MACS are securities issued by the Federal Home Loan Mortgage Corporation (FHLMC), a federally sponsored corporation that loans money to member institutions so they may supply conventional mortgage loans at competitive rates. FHLMC issues both coupon bonds and monthly on the mortgage securities.

Sallie Maes

SALLIE MAES are packaged student loans purchased from financial institutions.

Tennessee Valley Authority

TVA is a federally owned corporate agency that was established to develop the resources of the Tennessee Valley region into one of the largest electric utility systems in the country.

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Mutual Funds An OPEN-END investment company--usually known as a mutual fund--is a company with a portfolio of securities managed in accordance with stated investment objectives and policies that will buy back shares from investors whenever the investor wishes to sell. The redemption price depends upon the value of the company's portfolio at that time (the "net asset value"). There is no secondary trading market for the shares of such companies. CLOSED-END FUNDS resemble stocks in the way they are traded. While these funds do invest in a variety of securities, they raise money only once, offer only a fixed number of shares, and are traded on an exchange (hence the name EXCHANGE-TRADED funds) or over-the-counter. The market price of a closed-end fund fluctuates in response to investor demand as well as to changes in the value of its holdings. MUTUAL FUNDS are investment vehicles that purchase a variety of securities. They're a few different types: Stock mutual funds own a variety of stocks. Bond mutual funds own a variety of bonds. Money market funds own a diverse group of short-term debt instruments, making them highly stable, if conservative investments. Unit investment trusts own a group of stocks or bonds whose identity is preselected and known by the investor before purchase. Mutual funds are usually managed by investment specialists who decide what type and quantity of securities the fund will own, and when to buy and sell those securities. By purchasing shares of a mutual fund, an investor buys a portion of all the securities in the fund, rather than actual shares of those securities. For instance, if you own one of the million shares issued by a certain mutual fund, your share is worth approximately 1/1,000,000 of the total value of the securities that the fund owns. And the price of your share will Prepared by Frederic Goblet 01/13/98

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fluctuate in a fairly direct relationship with the price of the securities owned by the fund. This example is simplified, and does not take into account certain costs of buying or selling shares, or annual fees of owning the fund. Some funds specialize in small, aggressive foreign stocks, while others might buy conservative government bonds; there are funds available for virtually any type of investor. Advantages of investing in mutual funds: • The benefit of professional investment management • Protection from the price fluctuations of individual stocks or bonds There are several ways that investors are charged for buying, selling or just owning mutual funds--the mutual fund checklist might will help you understand some of the more common terms. But be sure to read the prospectus that every fund must issue before making any purchase.

Paying out the profits

A mutual fund makes money in two ways : by earning dividends or interest on its investments and by selling investments that have increased in price. The fund pays out, or distributes, its profits (minus fees and expenses) to its own investors. INCOME DISTRIBUTIONS are from the money the fund earns on its investments. CAPITAL GAIN DISTRIBUTIONS are the profits from selling investments. Different funds pay their distributions on different schedules from once a day to once a year. Many funds offer investors the option of reinvesting all or part of their distribution in the fund. Fund investors pay taxes on the distribution they receive from the fund, whether the money is reinvested or paid out in cash.

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MUTUAL FUND CHECKLIST The prospectus provides a detailed roadmap of a fund - covering everything from its objectives and fees to its portfolio holdings and manager. These are some of the terms you may come across in reading about mutual funds:

Objective

Every fund has its own objective: aggressive growth, income, preservation of capital, etc. Choose carefully before investing, and make sure the fund is appropriate for your goals. The discussion of asset allocation will help you decide what strategy is right for you. The three-letter abbreviation following the fund name in the newspaper describes its investment objective.

Performance

A fund's total return is the actual increase or decrease in the value of its investments, including appreciation and dividends or interest paid. Research a fund's performance over a 1, 5 and 10 year period, and compare it with others of its kind. Moreover, remember an old maxim: past performance is no guarantee of future results!

Loads and fees

A LOAD, either front- or back-end, is a commission paid by the investor for mutual funds purchased through a full-service brokerage firm. In this instance, a financial consultant provides advice regarding which funds best suit an investor's needs and investment objectives. A front-end load is deducted when shares are purchased; a back-end load is deducted when you sell your shares, and may be contingent upon selling within a certain period. Prepared by Frederic Goblet 01/13/98

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In a NO-LOAD fund, an investor buys shares directly from the mutual fund company. While these funds carry no sales charges (and a maximum 0.25% 12b-1 fee--see below), they do charge the management fees and administrative fees found in load funds. Finally, be sure that the company through which you invest offers a wide range of funds, and the flexibility to switch your investment from one fund to another as your needs or overall economic conditions change. Fees charged by a fund are described in the prospectus. MANAGEMENT FEES are annual charges to administer the fund. All funds charge this fee, though the amount varies from a fraction of one percent to over two percent. DISTRIBUTION FEES (12B-1 FEES) cover marketing and advertising expenses, and sometimes are used to pay bonuses to employees. About half the all the funds charge them. REDEMPTION FEES are assessed when shares are sold to discourage frequent in and out trading. In contrast, a DEFERRED SALE LOAD, a kind of exit fee, often applies only during a specific period and then disappears. REINVESTMENT FEES are similar to loads; they are charged when distributions are reinvested in a fund. EXCHANGE FEES can apply when money is shifted from one fund to another within the same mutual fund company.

The Net Asset Value

The fund’s NAV is the dollar value of one share of stock in the fund, the price a fund pays per share when you sell. It is figured by totaling the value of all the fund’s holdings and dividing by the number of shares.

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Pension Funds A PENSION FUND is a fund created to pay the pension benefits of retired employees of a corporation or other organization. Actuaries are employed to calculate the amount the company needs to contribute regularly in order to meet their present payout requirements, and to generate cash to meet future obligations. Collectively, pension funds are a strong force in the market due to the large dollar amounts invested in these funds and the volume of trading. There are two classifications of pension funds, Defined Benefit Plans and Defined Contribution Plans.

DEFINED BENEFIT PLANS Defined benefit plans are the largest group of pension funds and are known simply as pension funds. They are subject to THE EMPLOYEE RETIREMENT INCOME SECURITY ACT (ERISA) and are not taxed. In a defined benefit plan the employer is usually the sole contributor to this retirement fund hence the word "benefit" in the name. The employer funds the plan based on projected benefits to be paid, and the employee receives a predetermined amount upon retirement, typically based on a formula of the employee's length of service and salary. The contributions are invested according to the employer's investment strategies, and any profits or losses resulting from the investments belong to the employer. The employee does not assume the investment risk as in a defined contribution plan but does not share in the gains either.

DEFINED CONTRIBUTION PLANS Defined contribution plans are more commonly termed 401(K) or savings plans. The plans are subject to the Employee Retirement Income Security Act (ERISA) and are not taxed. Prepared by Frederic Goblet 01/13/98

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In contrast to a defined benefit plan, regular contributions are made to a defined contribution plan by the employee with a preset matching amount up to a certain percentage made by the employer. The employee decides how to allocate these contributions between the available investment options offered by the employer such as various stock, bond and money market funds. The employee contributions are pre-tax dollars. The employee bears all the investment risk and although the money is slated for retirement, there are specific hardship withdrawals that may be made prior to retirement based on Internal Revenue Service regulations. Employers tend to favor defined contribution plans over defined benefit plans since employee participation is voluntary and therefore the employer is less liable. Employees favor defined contribution plans because the amount of contributions and investment allocations are flexible, and withdrawals are allowed for specific reasons before retirement.

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Markets for Derivative Securities

THE LANGUAGE OF OPTIONS Option are the RIGHT to buy or sell a specific item for a preset price during a specified period of time. OPTION buyers have rights. Option sellers have obligations. An options contract gives the option purchaser the right to buy (for a CALL OPTION) or sell (for a PUT OPTION) the underlying security at a pre-specified price by a certain date. Sellers of options, on the other hand, are obligated to buy (for a put option) or sell (for a call option) the UNDERLYING SECURITY (or cash for index options) if the option is exercised by an option holder, but keeps the premium paid by the purchaser for the option. Unlike other investments where the risks may have no limit, options offer a known risk to buyers. An option buyer absolutely cannot lose more than the price of the option, the premium. Because the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the conditions for profitable exercise or sale of the contract are not met by the expiration date. An uncovered option seller, on the other hand, faces unlimited risk, because it obligates the seller to either buy (puts) or sell (calls) the underlying security at the market price. Like stock, options can be sold or bought after the initial transaction. If an option buyer or seller changes his investment strategy, the investor can sell or buy the option contract any time prior to the expiration date. Option Purchaser's Rights Buy Call:

right to buy

Option Seller's Obligations Sell Call:

underlying security Buy Put:

right to sell underlying security

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obligation to sell underlying security

Sell Put:

obligation to buy underlying security

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Options are sold as CONTRACTS. An equity options contract generally represents 100 shares of the underlying common stock, and is settled with the delivery of the underlying stock. Index options, however, represent the underlying companies, and are settled in cash. The number of shares covered, the expiration date and the strike price or exercise price are all standardized. The price of the option or the premium is the primary variable, and generally is dependent on the option's exercise price relative to the price of the underlying security, the time until expiration, stock and stock index volatility, dividends and interest rates. There are two types of options contracts: CALLS and PUTS. Call options contracts allow the purchaser to buy the underlying security, while the seller of a call is obligated to sell the underlying security. Put options contracts allow the purchaser to sell the underlying security, while the seller of a put is obligated to buy the underlying security. The strike price or exercise price is the price at which the holder can buy the stock (for call options) or sell the stock (for put options). Each options contract specifies an expiration date in addition to the strike price. The expiration date is the last day an options contract can be exercised. Most options expire on the Saturday after the third Friday of each expiration month. There are two types of exercise styles: American and European. These terms refer to when the options are exercisable and have nothing to do with the geographic location of the markets in which the options are traded. American-style options may be exercised by the holder on any business day up to the expiration date. European-style options may be exercised only on the last business day before expiration. Call options are referred to as "IN THE MONEY" when the strike price is below the market price of the underlying security. Call options are "OUT OF THE MONEY" when the strike price is above the market price. For put options, the reverse is true. A put option is "in the money" when the market price of the underlying security is below the strike price. On the other hand, put options are "out of the money" when the market price of the underlying is above the strike price of the option. Options are "AT THE MONEY" when the market price equals the strike price, a situation which rarely occurs. Therefore, these options are sometimes referred to as "NEAR THE MONEY".

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FUTURES Futures contracts are financial assets just like stocks and bonds, but with some important differences. These differences are what make futures such an appealing investment for traders. Many tend to think that futures are complicated to understand and consequently, miss many opportunities by not trading them. It helps to remember a simple but true formula that applies to futures trading as surely as it does to trading in stocks, bonds, real estate, and even old comic books and hockey cards. Money is made if you "buy low and sell high". With futures, you can sell before you buy, so our simple rule can also read: Money is made if you "sell high and buy back low". Keeping this rule in mind puts you on your first step to becoming a successful trader.commodity futures broker, futures trader, commodities futures trading, financial and commodity futures markets, paper trading, full service broker assisted accounts.

What is a Futures Contract?

A standard textbook definition reads something like this: A commodity futures contract is a firm commitment to deliver or receive a specific quantity and quality a commodity during a designated month at a price determined by open auction on a futures exchange. This sounds more complicated than it actually is. Let's take an example. Suppose you, being hungry and health conscious, go to a grocery store to buy bananas. You select some bananas, take them to the cashier (express lane, of course), and pay for them. The bananas are now yours. This is a simple transaction which you have probably done many times before. The exchange of money in return for goods, in this case, bananas, occurs now, in the present. A futures transaction is just like this with one difference, the exchange of money for goods is deferred until some time in the future. This is why futures contracts are regarded as deferred delivery contracts. To continue with the example, buying banana futures would work something like this: You go to the grocery store, select the bananas that you want, and tell the cashier, "I'll buy these bananas tomorrow at the price they are marked at now." The cashier agrees to sell you the bananas tomorrow. When you return the following day, you pay for the bananas (at yesterday's price) and then take them home. Of course, the futures market doesn't quite work exactly like this, but the idea is the same.commodity futures broker, futures trader, commodities futures trading, financial and Prepared by Frederic Goblet 01/13/98

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commodity futures markets, paper trading, full service broker assisted accounts.

Buying a Futures is Like Buying on Lay-Away

Have you ever bought clothes, appliances, or furniture on lay-away? Buying on lay-away is just like buying a futures contract. You agree to buy merchandise at a particular price sometime in the future, say, in two weeks when your paycheck comes in. The store agrees to sell the merchandise to you at that price, and holds it for you for two weeks. You probably have to put down a small amount of money to guarantee the transaction. In two weeks, you return with the full balance owing and the merchandise is yours. (This is when the exchange of goods and money takes place.) If the price of the item went up during the two week period, do you pay the higher price? NO. The price you pay was decided when you put the item on layaway and is fixed over the holding period. Let's take a closer look at the similarities of buying on lay-away and buying a futures contract. With a futures contract, the underlying merchandise is known, just like onlayaway. For example, you can by a futures contract on gold, lumber, pork bellies, swiss francs, and many other items. The underlying item or commodity is described specifically in the contract specifications which, in turn, are determined by the futures exchange on which it trades. Like layaway, the price of a futures transaction is agreed upon initially between the buyer and seller, and remains fixed over the holding period, or length of the contract. The small amount of money that you need to deposit for layaway is also required for buyers and sellers of a futures contract and is called margin. Finally, the full price of the commodity must be paid only upon contract expiration at which point you take delivery, if you bought futures, or make delivery, if you sold futures, of the underlying commodity. (Don't worry. You don't have to make or take delivery if you don't want to. You can instead offset or square your position.) However, while you can transact on lay-away at almost any department store, transactions in futures can only be done on futures exchanges. These exchanges are located primarily in Chicago and New York.commodity futures broker, futures trader, commodities futures trading, financial and commodity futures markets, paper trading, full service broker assisted accounts.

Understanding a Futures Price

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contract expires. Similarly, when you sell a futures contract, the price represents the price at which you are committed to selling the underlying commodity when the futures contract expires. (Not all futures contracts require physical delivery upon expiration, some are simply settled by cash.) For example, if you buy a COMEX December gold futures at $380 per ounce, then you have the obligation to buy 100 ounces of gold at a price of $380 per ounce in December when the futures expires. (COMEX, which stands for the Commodities Exchange in New York, is the futures exchange on which gold futures trade. COMEX has set the quantity of gold underlying the contract at 100 ounces.) The price of gold futures constantly fluctuates in response to several factors such as supply and demand, interest rates, and prices of other precious metals. However, no matter what the price of gold does after you buy the futures, you will be able to buy gold at the price of $380 per ounce - you have locked in this purchase price. Futures prices are often different than cash prices for the same commodity. You may find in some cases that futures prices are consistently above cash prices, in which case the futures are said to be trading at a forward premium, or you may find that futures prices are consistently below cash prices, in which case the futures are said to be trading at a forward discount. Whether a futures price is at a forward premium or discount depends upon cost-of-carry considerations, and these may change over time. Consequently, a futures price can move, for example, from a forward discount to a forward premium. This can happen for commodity futures in which there is a shortage of immediate supply of the underlying commodity.commodity futures broker, futures trader, commodities futures trading, financial and commodity futures markets, paper trading, full service broker assisted accounts.

Futures as an Investment

When you buy a futures, you lock in a purchase price for the underlying commodity. Similarly, when you sell a futures, you lock in a selling price of the underlying commodity. How, then, do you make money trading futures? Well, futures prices move around all of the time, that is, they are volatile. Prices of agricultural commodities, for example, may rise in response to unfavorable weather conditions, increased demand by importers, or spread of plant diseases, and fall in response to abundant supplies or a shift in consumer preference. If prices go up after you buy a futures contract, then you earn profit since the futures contract has increased in value. For example, if you buy one gold futures at $340 per ounce and two weeks later, the price of gold futures is trading at $350 per ounce, then your futures contract is now worth $10 per ounce more than when you bought it. Prepared by Frederic Goblet 01/13/98

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One futures contract represents 100 ounces of gold, so the total profit on your gold futures position is $1,000. That's the thrill. Be careful, though. Gold prices could have fallen instead, in which case you would have suffered a loss. As a trader, your challenge is to anticipate price movements correctly and make the appropriate trade. If you expect prices to rise, you will buy futures and if you expect prices to decline, you will sell futures. If your expectations turn out to be correct, then you will make money. If not, you will lose money. Realistically, it is virtually impossible to be right all of the time. In fact, many traders are wrong more often than right. BUT, they can still be successful traders.

Offsetting Contracts

As a trader looking to profit from movements in futures prices, you do not want to actually buy or sell bushels of oats, or bars of gold, or whatever is the underlying commodity of the contract. So, you will not hold a futures contract to its expiration. In practice, only a small percentage of futures contracts traded are actually held to delivery. Instead, you will close or square your futures position by enterring an equal but opposite trade - for example, buying if you previously sold or selling if you previously bought. By offsetting a futures contract, the trader cancels any obligation he has to make or take delivery of the underlying commodity. The difference between the price of the futures contract when the trade was initiated and the price when it is offset is the net gain or loss on the trade. Offsetting must be done prior to contract expiration,and these differ depending upon the futures in question. Expiration dates for many futures contracts can be found in Futures and Options Contract Specifications in Step 4: The Trader's Handbook.commodity futures broker, futures trader, commodities futures trading, financial and commodity futures markets, paper trading, full service broker assisted accounts.

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Sources and Bibliography

State Street, Boston n Global Investor Services Group - International Jacques Philippe Marson, Executive Vice President n Global Pricing Services in Global Financial Technology Services n State Street Brokerage, Thomas J. Bryant, Senior Trader Boston Stock Exchange, Boston n William G. Morton Jr, Chairman and Chief Executive Officer n William I. Lee, III, Senior Vice President Customer Service and Communication n K. and S. Inc., Specialists Boston Stock Exchange Kenneth M. King, President n Ward, Conary and Murphy Inc., Member Boston Stock Exchange N. Withney Conary n and especially Kathleen M. Radulki, Sales Associate, who organized my agenda at the Exchange on the Floor

Books n The Wall Street Journal Guide to understanding money & investing n Financial Industry Topics for Custody Services , State Street Bank

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n Invest without stress, Anne Farrelly n Foundations of financial markets and institutions, Fabozzi, Modigliani, Ferri n A Guide to the Financial Markets, Charles R. Geisst n The Super Traders, Secrets & Successes of Wall Street’s Best & Brightest, Alan Rubenfeld n Reuters Glossary

Internet Resources http://www.statestreet.com http://www.quote.com http://www.ml.com http://www.finweb.com/ http://www.networth.galt.com http://nt-mis-pri01.ssb.com/finind.htm http://www.nyse.com/ http://www.reuters.com http://www.bloomberg.com/welcome.ht ml http://www.utexas.edu/world/lecture/ http://www.dowjones.com http://www.telerate.com/ http://emea.telerate.com/ http://www.amex.com http://www.nasdaq.com/ http://www.euro.net/innovation/Finance _Base/Fin_encyc.html http://www.stockroom.org/ http://www.telesph.com http://www.ejv.com/ http://www.stocksmart.com/

http://www.investorsedge.com/ http://www.etrade.com/ Prepared by Frederic Goblet 01/13/98

State Street cotations bancaires merryl lynch investor guide finance info finance info liens avec les banques`(intranet) New York Stock Exchange reuters bloomberg Site des cours financiers (syllabus) dowjones dow jones telerate, prices telerate europe american stock exchange nasdaq Financial Encyclopedia graphical representation of key financial indicies and market sectors telesphere, price provider Bridge Price provider beyond the news, and provides the understanding with which Investors can secure their future prosperity. prices, portfolio analysis first electronic trading service available page 95

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http://www.wallstreetcity.com/ http://www.dbc.com/ http://www.pcfn.com/

http://www.brill.com/expert.html http://www.secapl.com/secapl/quoteser ver/mw.html http://www.muller.com/muni.html http://www.jjkenny.com/ http://www.bourse.be http://www.bourse-de-paris.fr http://www.sec.gov/consumer/weisktc.h tm http://www.sec.gov/index.html

on the web online financial services for individual and professional investors. consumer-oriented financial information. news, investment databases, research, on-line trading, and realtime market quotes using Telesphere's Global Ticker A World Wide Web guide to mutual fund resources. market watch, indexes every 3 minutes Muller price vendor J.J.Kenny price vendor Belgium stock exchange Bourse de Paris What Every Investor Should Know

http://www.whitehouse.gov/ http://www.whitehouse.gov/fsbr/esbr.ht ml

The U.S. Securities and Exchange Commission white house Economic Statistics Briefing Room (ESBR)

http://stats.bls.gov/cpihome.htm

Consumer Price Index

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