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Types of Marketable Securities

Marketable Securities are investments (or are derived from such investments) in companies, government entities and/or market indices. Marketable securities are generally "liquid" in that they can usually be sold (converted to cash) with relative ease on a securities exchange or market.

The most common types of Marketable Securities are:

  1. Equity Securities
  2. Bonds – Fixed Income Securities
  3. Option Securities
  4. Mutual Funds
  5. Unit Investment Trusts
  6. Commodities
  7. Derivatives

Equity Securities

Equity securities – or stock – represent an ownership interest in a company. The owner of an equity security, the shareholder, is a pro-rata owner of the issuing company.

Equity securities generally pay shareholders periodic dividends. Dividends are pro-rata payments to the shareholders, paid from the company’s earnings. Essentially, dividends help the company distribute its earnings to its owners.

Dividend payments must be declared by the company’s Board of Directors.

Key Features of Equity Securities

Par Value

For accounting purposes, equity securities are assigned a Par Value at the time of issuance. The Par Value of a security, which is expressed as an amount per share, has no impact on the issue price or market value of the stock.

Traded on an Exchange or Market

Equity securities are generally traded on either one of the listed stock exchanges or on the NASDAQ Over-the-Counter market. The market value of equity shares is influence by prevailing economic conditions such as the company’s performance (ie. earnings) supply and demand and interest rates.

Limited Liability

Shareholders of equity securities enjoy limited liability from the consequences of the actions or deeds of the corporation and/or its corporate officials and employees. The shareholder’s liability is generally limited to the original amount of the investment plus the Par Value of the shares owned.

Therefore, in the event of a liquidation or lawsuit, the personal assets of a firm’s equity investors are not available to the firm’s creditors and cannot be claimed as part of a legal settlement.

In addition to the original investment amount, shareholders are liable for the Par Value of the shares owned. Therefore, it is in the best interest of the equity investor that the Par Value be set as low as possible at the time that the shares are issued.

Classes of Equity Securities

Different classes of equity securities exist:

  • Common Stock
  • Preferred Stock

The primary differences between Preferred Shares and Common Shares are:

  1. The dividend rate on Preferred Shares is usually fixed
  2. Owners of Preferred Shares receive dividends ahead of common shareholders
  3. In the event of a liquidation, Preferred Shareholders have a prior claim to assets over common stock owners

The dividend rate on Preferred shares is usually fixed. This rate is generally expressed as either:

  1. an annual dollar amount per share - $2.50 per share
  2. an annual percentage of the Par Value of the stock – 5% per share

Voting vs. Non-Voting Stock

Because equity securities represent an ownership stake in the company, shareholders generally have a voice in certain corporate decisions. Shareholders are often permitted to vote on important corporate matters at the annual shareholder’s meeting. Generally, shareholders are entitled to one vote for each share of stock owned.

In some cases, however, equity securities are issued solely to raise capital – and it is not the intention of the Board of Directors to convey voting rights to the shareholders. In this case, Non-Voting stock is issued. Shareholders of Non-Voting stock are still entitled to dividend payments from earnings, but are not empowered to vote on corporate affairs at the annual meeting.

Restricted Stock

In certain cases, shareholders receive their shares as part of a special distribution or incentive plan. Often, the terms of these distributions or plans prohibit the sale of these securities for a set period of time. To prevent the holder from selling these securities prior to the proscribed date, Restricted Securities are issued.

Restricted securities contain a printed legend on the face of the stock certificate that prohibits the sale of the shares until the restriction period is ended. The legend is generally printed in red so that it stands out, and prevents the Stock Transfer Agent from transferring the shares out of the customer’s name, thereby preventing the securities from being sold before the end of the restriction period.

Once the restriction period is ended and the restriction is lifted, it is permissible for the shareholder to sell the shares.

Convertible Bonds

Convertible Bonds are fixed income securities that are readily convertible into shares of the issuing company’s stock on or after a pre-determined date. This means that holders of Convertible Bonds will eventually receive equity securities as a result of their investment.

As such, Convertible Bonds are treated as equity securities for accounting and tax purposes and are therefore mentioned in this section.

American Depository Receipt’s – ADR’s

An American Depository Receipt is an investment security created by a US Bank or custodian. The US Bank holds the stock certificates of a foreign entity – which are traded on a foreign exchange or market – in its vault. The bank or custodian issues a domestic ADR equity security that is collateralized by the foreign securities held, and is traded on a US exchange or market.

ADR securities are created to alleviate the difficulties involved in transferring securities from one country to another and in converting currencies in the buy and sell process, making it easier for US investors to invest in foreign securities.

To the investor, an ADR represents a ‘receipt of ownership’ of the foreign securities that are held on deposit at the American Depository. The ADR securities are traded in US currency and are readily transferable from one investor to the next.

For example, assume that MAJOR US BANK acts as custodian for INTL Co., a foreign security which trades on a foreign exchange. MAJOR BANK holds 300,000 shares of INTL Co. common stock in its vault. MAJOR issues 300,000 shares of INTL ADR – a domestic security that trades on a US stock exchange. Each domestic ADR represents one share of the foreign stock – INTL Co.

The one-for-one relationship in the preceding example between the foreign securities held and the ADR’s issued is not a requirement. ADR securities are often issued to represent multiple shares of the foreign security.

For example, MAJOR might have instead issued only 30,000 shares of INTL ADR, each ADR share representing 100 shares of the foreign INTL stock.

Bonds – Fixed Income Securities

To raise required funding, Corporations and Government entities borrow money from individual and institutional investors by issuing bonds or debt securities. Issuers of debt securities offer to pay a certain rate of interest for the use of the investor’s money over a specified period of time.

Holders of debt securities are creditors of the issuing entity. Debt holders do not have an ownership interest in the issuing entity and do not receive dividends from earnings.

Because the rate of interest is determined or ‘Fixed’ at the time the debt securities are issued, debt securities are also referred to as Fixed Income securities.

Similar to equity investments, fixed income securities are generally traded on established exchanges or markets, and many enjoy strong liquidity. In addition, bond holders also benefit from limited liability. An investor in debt securities has only the original amount invested at risk.

Key Fixed Income Terms

Par Value

The Par Value of a debt security is the Principal amount that will be paid back to the investor when the bond matures – or the maturity value. The Par Value is also referred to as the Principal or Face Amount.

The price of fixed income securities is expressed as a percentage of its Par Value. The price of a bond trading at Par Value is $100.

Maturity Date

The Maturity Date is the date upon which the issuer of debt securities agrees to repay the loan from the debt investor. The amount paid is the Principal or Face Amount.

Coupon Interest

The annual rate of interest the issuer agrees to pay its debt security investors is called the coupon rate or coupon. The bond coupon rate is expressed as a percentage of the bond’s Par Value and is fixed for the life of the bond.

For example, a bond with a $1,000 Par Value and a 7% annual coupon rate will pay a total of $70 in annual interest.

It is interesting to note that the annual interest rate acquired the name ‘Coupon Rate’ due to the fact that most fixed income securities were originally issued with detachable interest coupons. When the interest payment came due, investors were required to ‘clip’ the coupon off the bond and present it to the issuer for payment. Although the vast majority of modern fixed income securities are no longer issued with detachable coupons, the term ‘Coupon Bond’ is still widely used.

Discount

Bonds trading at prices below Par Value – less than $100.

Premium

Bonds trading at prices above Par Value – greater than $100.

Yield-to-Maturity – YTM

The Yield-to-Maturity is the actual rate of return a debt security investor will earn if that investor holds the securities until it matures. The YTM is a factor of the bond’s actual coupon payment – which is fixed – and the market price of the bond.

Because the coupon rate is fixed, each interest payment received by the investor is the same percentage of the bond’s Par Value – regardless of how much the investor actually paid for the bonds. When bonds trade at Par – the YTM and the Coupon Rate are the same. For bonds trading at a discount the YTM is higher than the coupon rate. Finally, the YTM is less than the coupon rate for bonds trading at a premium.

For example, assume a 5% coupon bond with a Par Value of $1,000. The investor receives a fixed amount of $50 (5% of $1,000) each year. If the investor paid $1,000 for the bond (Par Value) and receives interest payments of $50 (5% of $1,000) each year, the rate of return is equal to the coupon rate - 5%.

Investors that pay Par Value for the bond earn a rate of 5% until maturity. Investors who pay only $900 for the same bond also receive $50 (5% of $1,000). Because 5% of $900 is only $45 and the investor receives $50 each year, the investor earns more than 5% on the $900 investment and therefore has a higher yield to maturity.

Conversely, investors who pay $1,100 for the same bond earn a lower rate of return because the $50 per year received by the investor is less than $55, which is 5% of $1,100.

Bond Pricing

The market value of debt securities fluctuates as interest rates rise and fall. As prevailing interest rates increase, bond prices decline. Similarly, as interest rates fall, bond prices rise.

Fixed Income securities trade at Par, at a discount or at a premium. Bonds trade at Par - $100 – when the prevailing general interest rate in the economy is the same as the coupon rate of the bond. Bonds trade at a discount, or below Par, when general interest rates are above the fixed coupon rate. Bonds trade at a premium, or above Par, when general interest rates are below the stated coupon.

For example, the value of a 5% coupon bond is Par or $100 when the prevailing general interest rate is also 5%. If interest rates rise to 6% - that is, debt issuers are willing to pay a 6% coupon on new bond issues of similar risk – a bond paying only 5% becomes less attractive to investors. Because the prevailing interest rate for new debt is 6% - investors will only buy existing bonds that have a yield to maturity of 6%. To increase the YTM of a 5% bond the price must be adjusted below Par.

If general interest rates instead fall to 4%, the 5% coupon bond becomes more attractive to investors. The market price of the bond will adjust until the Yield-to-Maturity is equal to the 4% general interest rate. To decrease the YTM of a 5% bond the price must be adjusted above Par.

Bond Rating Agencies

Bond Rating Agencies assist bond investors in the analysis of risk. The two most influential bond rating agencies are:

  • Standard and Poor’s
  • Moody’s

These agencies perform financial analysis of debt issuers. The bond issues are then rated as to the issuer’s ability to make the obligated interest and principal payments. The greater the issuer’s risk of default the lower the bond rating.

Based on the bond’s rating, the issue is classified as either Investment Grade or High Yield. Investment Grade debt securities are rated AAA, AA, A or BBB. Because issuers of Investment Grade debt securities are less likely to default, the coupon rate is generally lower – less risk equals less reward.

High Yield or Junk Bonds are rated BB or lower. ‘High Yield’ implies a higher coupon rate. This higher rate compensates the bond investor for accepting a higher risk of default.

Common Fixed Income Securities include:

  • Corporate Bonds
  • Municipal Bonds
  • US Treasury Securities
  • Mortgage-Back Securities
  • Zero-Coupon Bonds
  • Commercial Paper
  • Certificates of Deposit

Corporate Bonds

A Corporate Bond is a Fixed Income debt security issued by a corporation to raise capital. Corporate Bond investors assume the risk that the company might not be able to satisfy its obligations to pay interest and ultimately to repay the debt. The degree of risk depends on the strength of the particular company and the length of time before the bonds mature. The longer the time until maturity, the greater the risk of default.

Municipal Bonds

Municipal Bonds (Muni’s) are debt securities issued by local, city and state governments to raise capital for special projects and operations. Municipal Bonds are generally less risky because they are backed by the taxing authority of the issuing municipality.

The Municipal Securities Rulemaking Board – MSRB – oversees both the issuance and trading of Municipal Bond securities.

The investment advantage of Municipal Bonds is that the interest payments received are exempt from federal income tax. Further, if the investor lives in the same city or state as the bond issuer, the interest payments are exempt from state and/or local taxes as well.

Because Municipal Bonds are subject to less risk – coupon rates are generally lower than those of other debt securities.

United States Treasury Securities

US Treasury Securities are debt securities issued by the Government of the United States. Treasury Securities offer investors substantially less risk because the scheduled interest and principal payments are guaranteed by the US Government. As such, the interest rates paid on Treasury Securities are low relative to the rates on debt securities of other issuers.

There are three general classes of US Treasury Securities:

  1. Treasury Bonds
  2. Treasury Notes
  3. Treasury Bills

Treasury Bonds are US Treasury debt securities with a maturity of 10 – 30 years from the date of issuance.

Treasury Notes are US Treasury debt securities with a maturity of 1 – 10 years from the date of issuance.

Treasury Bills or T-Bills are US Treasury debt securities with a maturity of less than 1 year from the date of issuance.

Treasury Auctions

US Treasury Securities are issued to the public in periodic auctions. Only brokerage firms that are designated as ‘Primary Dealers’ of US Treasuries are eligible to participate in the periodic auctions. This designation is obtained from the Federal Reserve Bank.

During the auction, Primary Dealers submit bids to the Treasury for both the Principal or dollar amount of Treasury Securities they wish to acquire in the auction, and the coupon rate or ‘level’ that is desired.

Prior to the auction, the Treasury establishes an optimal level or coupon for the issue. This level is not disclosed to the Primary Dealers participating in the auction. Dealers submitting bids that are better than (below) the pre-determined level are allotted securities first. Any remaining bonds in the auction are assigned to the remaining dealers on a pro-rated basis at the level pre-determined by the Treasury.

Mortgage-Back Securities – CMO’s

Mortgage-Back Securities are marketable debt securities that are backed by pools of Government Insured Mortgages. The vast majority of Mortgage-Back Securities are issued by:

  1. The Government National Mortgage Association – GNMA or ‘Ginnie Mae’
  2. The Federal National Mortgage Association – FNMA or ‘Fannie Mae’
  3. The Federal Home Loan Mortgage Corporation – FHLMC or ‘Freddie Mac’

Mortgage-Back Securities match bond market investors with perspective homeowners in need of home mortgages. The GNMA, FNMA and FHLMC create marketable securities from groups (pools) of government insured or guaranteed mortgages. Simply stated, these government organizations issue debt securities to both individual and institutional investors. The money received for these securities is used to create mortgages for perspective homebuyers.

Mortgage-Back Securities are very safe investments because:

  • Payments of principal and interest are guaranteed by both the respective issuing agency and the US Government
  • They are traded in active secondary markets and are therefore very liquid.

Pass Through

Investors in Mortgage-Back Securities receive monthly payments of principal and interest from the pooled mortgages. These payments are referred to as a ‘Pass Through’, because the payments pass from the homeowner to the investor – through the issuing agency.

Collateralized Mortgage Obligations – CMO’s

CMO’s are debt securities that are collateralized by Mortgage-Back Securities – such as Ginnie Mae’s, Fannie Mae’s and Freddie Mac’s. CMO’s are generally issued by FNMA and FHLMC, but are created by private issuers as well.

The distinctive feature of a CMO is that it is a multi-class bond. Different maturity classes or "Tranches" of investors receive principal and interest payments at varying rates and times in the security’s life cycle.

Zero Coupon Bonds

Zero Coupon Bonds are stripped of coupons. Therefore, Zero Coupon Bonds do not make regular interest payments. Instead, Zero Coupon Bonds are issued at a ‘Deep Discount’. At maturity, the Par or Principal value is paid to the investor. The difference between the discounted amount paid by the investor at the time of the investment and the Par Value received by the investor upon maturity represents the interest paid.

Zero Coupon Bonds are issued by the US Treasury, Municipalities and Corporations alike, and most enjoy relatively liquid secondary markets.

Commercial Paper (CP)

Commercial Paper is a very short-term debt instrument issued by banks, corporations and other borrowers. Commercial Paper enables issuers to obtain short term financing at below market interest rates.

Typical maturities for Commercial Paper range from 2 – 270 days. Most CP is issued at a discount – although some are interest bearing.

Certificates of Deposit (CD)

A Certificate of Deposit is an interest paying debt instrument issued by banks. CD maturities range from a few weeks to several years. Interest rates on CD’s are determined by prevailing market rates and competitive forces.

Option Securities

Option securities give an investor the right to buy or sell securities at a specified price on or before a specified date. One option contract gives the holder the right to buy or sell 100 shares of the underlying security. Option holders will only exercise this right if market conditions are favorable. Option holders are never obligated to exercise the option to buy or sell securities.

Option investors make money in one of three ways:

  1. The option writer receives a premium from the option holder at the time the contract is originated
  2. If market conditions become favorable to the option holder, the market value of the option contract increases – the option holder can sell these options to other investors for a gain
  3. With favorable market conditions, the option holder may choose to exercise their right or option to buy or sell securities – thereby making a profit on the exchange of the underlying security

Option expiration occurs on the 3rd weekend of each month – Expiration Weekend. On Option Expiration Weekend, all options that are "In-the-Money" are exercised on behalf of the option holders. Options that are not exercised expire at this time.

Expired option contracts are worthless. In the event an option contract expires, the option holder loses, and the option writer keeps, the premium paid for the option contract.

Call Option

A Call Option gives the holder the right to buy securities at a specified price by a specified date.

Put Option

A Put Option gives the holder the right to sell securities at a specified price by a specified date.

Strike Price

The strike price is the agreed upon price at which option holders have the right to buy or sell the underlying security. For example, an investor might purchase the following option contract.

1 Call XYZ Co. 200

This option gives the holder the right to buy 100 shares of XYZ Co. stock from the option writer at a price of $200 per share.

Expiration Date

Option securities give the holder the right to buy or sell an underlying security at a specified price during a specified period of time. Option contracts that are not exercised expire. The expiration date signifies the last date the option holder can exercise this right.

For example, an investor might purchase the following option contract.

1 Call XYZ Co. June 00 200

This option gives the holder the right to buy 100 shares of XYZ Co. stock from the option writer at a price of $200 per share. The option will expire in June 2000.

Option expiration occurs on the 3rd weekend of each month – Expiration Weekend. Therefore, the above contract would expire on the third weekend of June 2000.

Option Holder

The investor who buys an option contract. The option holder is ‘long’ the option. The option holder has the right to exercise the option contract. For each option holder there is an option writer.

Option Writer

The investor who sells an option contract. The option writer is ‘short’ the option. For each option writer there is an option holder. The option writer is assigned when the option holder exercises the option contract.

Premium

The amount paid to the option writer for the right to buy or sell securities.

In-the-Money

Option securities are "In-the-Money" when market conditions (specifically, the price of the underlying security) are favorable for the option holder.

Out-of-the-Money

Option securities are "Out-of-the-Money" when market conditions (specifically, the price of the underlying security) are unfavorable for the option holder.

Exercise

When economic conditions are favorable for the option holder – the investor might exercise the right to buy (calls) or sell (puts) shares of the underlying security from or to the option writer at the specified strike price.

Assignment

An option writer is assigned when the option holder exercises their right to buy or sell securities. When assigned, the option writer must sell (calls) or buy (puts) shares of the underlying security to or from the option holder at the specified price.

Leap Option

A Leap Option is a long-term option with an expiration date of greater than 1 year.

When investors buy or sell option securities they are speculating that the market price of the underlying security will move either up or down. Investors who believe that the market price of the underlying security will increase above the option strike price will buy call options.

For example, assume our investor, Slick Sam, buys 1 call option for XYZ Co. stock, with a strike price of $50 per share and an April expiration in the current year. If the market value of XYZ Co. stock rises to $75 per share the option contract is ‘In-the-Money’. The contract is In-the-Money because it is favorable for Sam to exercise his right to buy the shares from the option writer.

Upon exercise, Sam buys 100 shares of XYZ @ $50 per share:

Quantity

100

Strike Price

x 50

Principal Amount

$ 5,000

The actual market value of the shares is $7,500:

Quantity

100

Market Price

x 75

Market Value

$ 7,500

Thus our investor, Sam, has a $2,500 profit:

Market Value

$ 7,500

Principal

$ 5,000

Profit

$ 2,500

Had the market price of XYZ Co. instead decreased to $25 per share the option contract would be ‘Out-of-the-Money’. The investor would not exercise this contract because it is cheaper to acquire the shares in the open market at $25 per share.

Investors who expect the market price of the underlying security to decrease below the option strike price will buy put options.

For example, assume Sam buys 1 XYZ Co. Put option at a strike price of $50, and the market value of XYZ Co. shares drops to $25 per share. The put option is "In-the-Money’ because the market price of XYZ Co. is below the $50 per share strike price.

If Slick exercises the put option, he will sell 100 shares of XYZ Co. stock to the option writer at the agreed upon $50 per share.

Quantity

100

Strike Price

x 50

Principal

$ 5,000

The new market value of the shares is:

Quantity

100

Market Price

x 25

Market Value

$ 2,500

Therefore, Slick has a profit of $2,500:

Principal

$ 5,000

Market Value

$ 2,500

Profit

$ 2,500

Had the market price of XYZ Co. shares instead increased to $75 per share, the put option would be ‘Out-of-the-Money’. The investor would not have exercised the put because he would have made more money selling the shares in the open market at $75 per share.

Option Risk

The amount put at risk by an option investor depends on whether the investor bought the option (option holder) or sold the option (option writer).

The most an option holder can lose is the premium paid for the option contract. If the option expires before it is exercised, the option holder loses only the amount of the initial investment – the premium.

The option writer, on the other hand, is subject to unlimited liability, because there are no limits on the amount a stock price can move.

Non-Equity Options (NEO)

A Non-Equity Option is a form of option security that is tied to the movement of a market index rather than a particular equity security. Typical NEO’s are linked to popular stock market indices such as the S&P 500, S&P 100 or the Dow 100. As the value of the stock index rises and falls, so too does the value of the linked Non-Equity Option.

If the investor believes that a particular stock index will increase, the investor will purchase a call NEO option. If the investor believes that the value of that index will fall, the investor will purchase a put NEO option.

Most of the principals discussed for Equity Options, such as Strike Price, Expiration Date, Premium, In-the-Money, Out-of-the-Money etc., also apply to Non-Equity Options.

The major difference between Equity and Non-Equity Options is that NEO securities settle in cash. NEO’s settle with cash because there is no underlying security to be bought or sold. Upon exercise, the NEO option holder receives, from the NEO option writer, an amount of cash equal to the difference between the strike price of the NEO and the actual level of the market index.

Holders of Non-Equity call options receive cash when the value of the market index exceeds the strike price of the NEO option. Holders of Non-Equity put options receive cash when the value of the market index falls below the strike price of the NEO option.

Remember that one equity option contract gives the holder the right to buy or sell 100 shares of the underlying security. Similarly, one Non-Equity Option contract represents 100 times the difference between the strike price and the market index. That is, the option holder will receive $100 for each dollar or point difference between the index and the strike price of the NEO option.

This is best explained with an example.

Assume that the value of the S&P 100 market index is currently $1,000. Let’s also assume that our investor believes the value of the S&P 100 index is going to increase to $1,100, so he buys a NEO call option with a strike price of $1050.

Now let’s assume that the value of the S&P 100 Index does in fact rise to $1,100 and Slick exercises his NEO option. Slick will receive a cash amount of $5,000 from the option writer, which is calculated as follows:

Index Market Value

$1,100

NEO Strike Price

- $ 1,050

Change in Index

$ 50

Option Multiplier

x 100

Profit

$ 5,000

Mutual Funds

A Mutual Fund is an investment fund that raises money from investors – shareholders – and invests in stocks, bonds, options, commodities and other marketable securities. Mutual funds offer investors instant diversification, for a small management fee (generally less than 1% of net assets), through access to a large, professionally managed, portfolio of investments.

Mutual Funds enable investors to select an acceptable level of investment risk – which is determined by the type of fund selected by the investor. Risk – in Mutual Fund investments – refers to the degree of stability of the investor’s principal - the amount invested.

The type of fund is determined by the type of marketable securities (and the degree of risk associated with each) held by the fund. The most common types of Mutual Funds are:

  • Stock Funds
  • Bond Funds
  • Stock and Bond Funds
  • Cash Investment Funds

It is important to note that even though a particular fund belongs to one of these categories, fund managers often have the flexibility or latitude to invest fund assets in other types of investments to take advantage of certain market conditions or to hedge the fund’s risk against loss.

The degree of this flexibility is detailed in the fund’s prospectus. A Prospectus is a formal written offer to sell securities. It contains pertinent facts about the offered securities that an investor needs to make an informed investment decision.

It is very important that Mutual Fund investors review the information contained in the fund’s prospectus when evaluating a fund’s risk.

As the names suggest, Stock Funds primarily invest in equity securities, Bond Funds invest in debt securities, and so on and so forth. However, within each broad class of fund types exist smaller, more specialized classes.

Stock Funds

Stock Funds, by nature, involve a higher degree of investment risk due to the volatility of stock prices. The level of risk depends on the type of stocks traded by a particular stock fund. The main types of stock funds are:

  • Growth Funds
  • Income Funds
  • Blue Chip Funds
  • Large Cap Funds
  • Mid Cap Funds
  • Small Cap Funds
  • Sector Funds
  • International Funds
  • Index Funds

Dividend payments made by the issuers of equity securities to a particular fund are passed to the fund’s shareholders as Dividend Income Distributions. Gains on the disposition of fund assets are similarly passed along to the fund shareholders as Long Term or Short Term Capital Gains Distributions. The designation of Long Term or Short Term is dependent on the length of time a particular asset was held by the fund before being sold.

Growth Funds invest primarily in equity securities that the fund manager believes will appreciate in value over time. These equities generally do not pay large dividends because most of the company’s profits are reinvested into the company to provide for expansion and growth. Growth Funds are generally high risk funds due to the high volatility in the prices of the equity securities.

Income Funds invest primarily in low growth equity securities that pay large and frequent dividends. Income stock funds are generally less risky than growth stock funds because the stock prices of income generating equities are generally more stable.

Blue Chip Funds invest in the equity securities of well established national and worldwide companies, with long histories of sustained growth and dividend payments. Blue Chip Funds are subject to moderate investment risk.

Large Cap Funds invest primarily in the equity securities of companies with a market capitalization of over $5 billion dollars. Market capitalization is a calculation of a company’s value based on the market price of the company’s issued and outstanding shares.

Mid Cap Funds invest primarily in the equity securities of companies with a market capitalization of between $1 billion and $5 billion dollars.

Small Cap Funds invest primarily in the equity securities of companies with a market capitalization of less than $1 billion dollars. Small Cap Funds are aggressive growth funds and are subject to high market risk.

Sector Funds invest primarily in the equity securities of companies that make up a particular economic sector, or companies related to that sector – such as Technology or Financial or Bio-Tech sectors. Sector funds carry risk similar to that of the particular sector in which the fund’s assets are invested.

International Equity Funds invest in foreign securities – securities traded on foreign exchanges or markets. Global Funds may hold securities of various foreign markets, or might concentrate on one particular market, region or country.

Index Funds attempt to mirror popular stock indices such as the Standard and Poors (S&P) 500, the Dow Jones Industrial Composite, the NASDAQ Composite or other similar stock indices, by investing in the same securities that are tracked by the underlying index. Because Index Funds buy and hold the securities comprising the index, these funds generate less brokerage commission expense and as such, generally charge investors lower management fees.

Bond Funds

A Bond Fund – or Income Fund – primarily invests in fixed income debt securities of varying maturities and risk. Common types of bond funds are:

  • Corporate Bond Funds
  • Municipal Bond Funds
  • Government Security Bond Funds

Income payments made by the issuers of bonds held by a particular fund, are passed to the shareholders as Interest Income Distributions. Gains on the disposition of fund assets are similarly passed to the fund shareholders as Long Term or Short Term Capital Gains Distributions. The designation of Long Term or Short Term is dependent on the length of time a particular asset was held by the fund before being sold.

Corporate Bond Funds invest primarily in fixed income securities issued by corporations. The risk associated with the corporate bond fund is a variable of the maturity or length of time before the bonds mature (short term = less risk) and the investment grade (based on the S&P or Moody’s rating) of the debt issues held by the fund.

A High Yield Corporate Bond Fund invests primarily in fixed income securities issued by companies with S&P or Moody’s ratings of BB or lower.

Municipal Bond Funds invest primarily in debt securities issued by local, city and state governments. Municipal Bond interest payments received by the shareholders are exempt from Federal Taxation. Shareholders of Municipal Bond Funds might enjoy additional tax benefits depending on the shareholder’s state of residence and the specific bond issues held by the fund.

Government Security Bond Funds invest primarily in debt securities, of varying maturities, issued by the US Government or US Government Agencies (such as GNMA, FNMA etc.). Government Bond Funds are very safe investments due to the fact that the scheduled interest and principal payments are guaranteed by the US Government. Additionally, the interest payments received by the fund shareholders are exempt from Federal Income Tax.

Stock and Bond Funds

Stock and Bond Funds invest in a combination of Equity and Fixed Income Securities, and are often referred to as Balanced Funds. The investment objectives and associated risks are a factor of the specific equity and debt issues held by the fund.

A popular type of Balanced Fund is the Growth and Income Fund. The growth objective of the fund is achieved by appreciation in the value of the equity securities held by the fund, while the income stream is received from the debt securities held.

Cash Investment Funds

Cash Investment Funds invest primarily in short term debt securities – generally those with maturities of 90 days or less – issued by governments, corporations, banks or other financial institutions such as CD’s, Commercial Paper, Notes etc. Cash investment securities are also referred to as Money Market Funds or Cash Reserves.

Although not guaranteed by the fund, the investor’s principal is generally very safe in a money market fund due to the nature of the short-term cash investments held by the fund. As such, Money Market investors generally receive lower interest rates.

Key Mutual Fund Terms and Definitions

  • Net Asset Value – NAV
  • Load vs. No-Load
  • Open vs. Closed Funds
  • Dollar Cost Averaging

Net Asset Value – NAV

The Net Asset Value of a Mutual Fund is the total market value of the funds assets divided by the number of shares outstanding. NAV is calculated at the close of business each day using the closing market value of the individual assets held by the fund.

Load vs. No-Load

In addition to management fees, certain mutual funds charge investors a sales charge or ‘load’, which is expressed as a percentage of the investment.

Front End Loads are sales loads charged at the time of the investment, or ‘up-front’, as a percentage of the amount invested.

Back End Loads, or Contingent Deferred Sales Charges, are charged when the investor sells their fund shares, and are expressed as a percentage of the sale proceeds. Back End Loads are generally reduced or eliminated once the investor holds the fund shares for a pre-determined length of time.

Funds that do not charge a sales load are commonly referred to as No Load Funds.

Open Funds vs. Closed Funds

Mutual Funds are either Open or Closed. Open End mutual funds are open to new investors. That is, the fund accepts new capital. Purchases and sales of Open Ended fund shares are transacted directly with the mutual fund company. The price per share for both buy and sell trades, is derived from the fund’s NAV and is calculated at the close of trading each day. All investors receive the same share price for all orders on a given day – no matter what time of day the order to buy or sell was entered.

Closed End mutual funds, on the other hand, are not open to new investors. Shares of Closed End Funds are generally listed and traded on a stock exchange or market. Investors wishing to purchase shares of a closed fund must do so on the open market from another investor. The market price of closed end fund shares is subject to prevailing market factors and conditions – ie. Supply and Demand, interest rates etc. – and generally fluctuates throughout the trading day.

Dollar Cost Averaging

Dollar Cost Averaging is a common Mutual Fund investment strategy through which investors accumulate fund shares by investing a fixed amount of dollars at regular intervals – for example $250 each month. The investor buys more shares when the share price is lower and less shares when the share price is higher. The average price paid is generally lower than it would have been had a fixed quantity of shares - 100 shares each month - been purchased at regular intervals. Additionally, through Dollar Cost Averaging, investors are protected against the risk of losing a sum of money invested all at once immediately before a market decline.

Unit Investment Trust – UIT

A Unit Investment Trust is an investment security with features similar to both mutual funds and fixed income securities. Similar to a mutual fund, a Unit Trust is created from a fixed pool or portfolio of income generating securities, such as Corporate, Municipal or Government Bonds, Mortgage-Back Securities or Preferred Stock. Shares or ‘Units’ of the trust are sold to investors, who receive a pro-rated portion of interest and principal from the investment. Similar to fixed income securities, Units are generally sold in principal amounts of $1,000 or greater, and make regular interest and principal payments.

Commodities

Commodities are bulk goods such as grains, metals and foods that are traded on a commodity exchange. Selling goods in a commodities market protects the seller from potential downward price movements or trends, by enabling the seller to ‘lock-in’ a price today for commodities to be delivered at a future date.

Similarly, commodity trading also protects buyers of goods. Buyers of commodities are able to hedge against the risk of potential upward price movements by locking in a desired price today for delivery of goods at a specified future date.

Commodities are generally traded on an organized commodity exchange. The major commodity exchanges are:

  • AMEX Commodity Exchange
  • Commodity Exchange Inc. – COMEX
  • New York Coffee, Sugar and Cocoa Exchange
  • New York Cotton Exchange
  • New York Futures Exchange
  • New York Mercantile Exchange
  • Chicago Board of Trade
  • Chicago Mercantile Exchange
  • Chicago Rice and Cotton Exchange
  • International Monetary Market
  • Midamerican Commodity Exchange
  • Kansas City Board of Trade
  • Minneapolis Grain Exchange

Important Commodity Terms

  • Spot Commodity
  • Spot Market
  • Spot Price
  • Futures Contract
  • Futures Market

Spot Commodity

A Spot Commodity is a commodity traded with the expectation that it (the goods) will be actually delivered to the buyer.

Spot Market

The Spot Market is a commodity market in which goods sold for cash and delivered immediately.

Spot Price

The Spot Price – or Cash Price – is the current delivery price of a commodity trade in the Spot Market.

Futures Contract

A Futures Contract or Futures Option, is an agreement to buy or sell a specified amount of a commodity at a specified price on a specified date. In contrast to Option Securities which expire, the buyer of a futures contract is obligated to purchase the underlying commodity, and the seller is obligated to sell it.

Futures Market

The commodity exchange where Futures Contracts are traded.

Derivatives

Derivatives are complex financial instruments whose value is based on – or ‘derived’ – from another security.





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