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Executive Summary: This discussion summarizes core concepts related to securities regulation, equity and debt instruments, trading practices, customer accounts, investment risks, and related areas, based on excerpts from an SIE exam preparation book. It is intended as a study aid, highlighting key definitions, rules, and relationships within the securities industry.
I. Regulatory Overview (Chapter 2):
Federal, SRO, State, and Firm Regulation: The securities industry operates under a multi-layered regulatory framework involving federal agencies, Self-Regulatory Organizations (SROs) like FINRA and the MSRB, state-level ("blue-sky") regulations, and internal firm rules.
The importance of understanding the roles and responsibilities of these regulators is stressed.
II. Equity Securities (Chapter 3):
Common Stock: Represents ownership in a corporation, granting shareholders certain rights.
Rights of Common Shareholders: Include the right to vote on key corporate issues (election of directors, stock splits, mergers – but NOT on dividend decisions, which are made by the board), inspect company books, and receive dividends (if declared).
"The ability to vote is typically associated with common stockholders... It’s important to remember that shareholders vote on whether the corporation may execute a stock split, but NOT on whether the corporation should pay cash and/or stock dividends. Rather than allowing common stockholders to decide whether they deserve any form of distribution, all dividend decisions are made by the board of directors."
Different classes of stock may have different voting rights (Class A vs. Class B). Voting can be statutory (one vote per share, per issue) or cumulative (total shares * number of issues can be allocated as desired).
"With statutory voting, a shareholder is given one vote, per share owned, per voting issue...With cumulative voting, shareholders are able to multiply the number of shares that they own by the number of voting issues."
Stock Classifications: Blue-chip (large, stable companies), growth (high-growth potential), defensive (recession-resistant, e.g., utilities, consumer staples), income (high dividend payouts), and cyclical (performance tied to the economic cycle) stocks.
"Defensive stocks are associated with companies that are resistant to a recession, including sectors of necessary services (utilities), production of consumer staples (tobacco, pharmaceuticals, soft drinks, and candy), and essentials (food)."
American Depositary Receipts (ADRs): Facilitate trading of foreign stocks in the U.S. markets.
Rights and Warrants: Derivative securities that give the holder the right to purchase the issuer's common stock at a specified price.
Rights are short-term and offered to existing shareholders to maintain their proportional ownership.
"For example, Widget Inc. has 1,000,000 shares of outstanding stock and plans to issue an additional 1,000,000 shares to the public. An investor who currently owns 100,000 shares (10% of the outstanding stock) will receive 100,000 rights. These rights will allow her to purchase 100,000 shares at a favorable price and maintain her 10% ownership in the company."
Warrants are long-term and often issued as sweeteners with other securities.
"However, unlike stock rights that have a relatively short life, warrants have a maturity that’s often set years in the future. In fact, some warrants have a perpetual (endless) life."
Warrants have "intrinsic value" when the stock's market price exceeds the warrant's subscription price.
"If the stock’s market price rises above the warrant’s subscription price, then the warrant has intrinsic value. For example, if the warrant’s subscription price is $30 and the stock’s market price is $33, then the warrant has intrinsic value of $3."
Rule 144: Governs the resale of restricted and control stock.
Key terms: Authorized, Issued, Treasury, and Outstanding shares. Outstanding stock = Issued Stock - Treasury Stock.
III. Debt Instruments (Chapters 4 & 5):
Basic Bond Characteristics: Bonds are debt instruments where investors lend money to issuers in exchange for interest payments (coupon rate) and repayment of principal (par value) at maturity.
"A bond is a contract between an issuer and an investor... The par value of a bond (also referred to as the principal or face value) is the amount that the issuer agrees to pay the investor when the bond matures."
Bond Pricing: Prices are quoted as a percentage of par value (e.g., 100 = $1,000, 90 = $900, 110 = $1,100).
"A bond’s price is usually stated as a percentage of its par value. For example, a bond with a price of 100 is selling at 100% of its par value, or $1,000."
Accrued Interest: The interest earned between coupon payments, paid by the buyer to the seller in a secondary market transaction. Corporate and municipal bonds use a 30/360 day count, while U.S. government securities use actual days/365.
"This accrued interest is the amount of interest that the seller is entitled to receive (from the buyer) and the amount that the buyer is required to pay (to the seller) for a bond being sold in the secondary market."
Credit Risk: Measured by rating agencies like Moody's, S&P, and Fitch. Ratings range from AAA/Aaa (highest) to D (default). Lowered credit ratings can significantly decrease a bond's market price.
"Credit risk is more difficult to evaluate when the bonds are issued by a corporation or a municipality. Most investors rely on an organization that specializes in analyzing the credit of bond issues."
Treasury Securities: Issued by the U.S. government and considered the safest fixed-income investments.
Include T-bills (short-term, discount securities), T-notes (2-10 year maturity), T-bonds (over 10 year maturity), TIPS (inflation-protected), and STRIPS (separated coupon and principal payments).
"Treasury securities are considered the safest type of fixed-income investment and are suitable for the most conservative investors. Since the securities are backed by the full faith and credit of the U.S. government, they have virtually no credit risk."
Municipal Bonds: Issued by state and local governments. Interest is typically exempt from federal income tax and may be exempt from state and local taxes in the issuing state.
"For most investors, the primary advantage of municipal bonds is that the interest received is typically exempt from federal tax. "
General Obligation (GO) Bonds: Secured by the full faith, credit, and taxing power of the issuer. Require voter approval and are subject to debt ceilings.
"A general obligation bond is secured by the full faith, credit, and taxing power of the issuer. Therefore, only issuers that have the ability to levy and collect taxes may issue GO bonds...prior to issuing general obligation bonds, issuers must obtain voter approval."
Revenue Bonds: Fund specific projects and are repaid from the project's revenues.
"Revenue bonds are typically issued to fund a specific project or facility, such as a bridge or toll road. For revenue bonds, the cash flows that are generated by the specific project (e.g., tolls, usage fees) are used to repay bondholders."
Municipal Notes: Short-term debt instruments (TANs, RANs, BANs, GANs, CLNs) used for financing or cash flow management.
VRDOs: Variable Rate Demand Obligations - long term securities marketed as short term investments.
Corporate Bonds: Debt instruments issued by corporations.
Income Bonds: Pay interest only if the company has sufficient earnings.
"Income bonds are normally issued by companies in reorganization (bankruptcy). The issuer promises to repay the principal amount at maturity, but does NOT promise to pay interest unless it has sufficient earnings."
Eurodollar Bonds, Yankee Bonds, and Eurobonds: Different types of bonds issued and traded internationally.
"A Eurodollar bond is sold outside the US, but pays in US dollars... Yankee bonds are dollar-denominated bonds sold in the US by a foreign issuer... A Eurobond is sold in one country, but denominated in the currency of another."
Money-Market Securities: Short-term, highly liquid debt instruments (Commercial Paper, Banker's Acceptances, CDs, Repurchase Agreements, Federal Funds). Considered "cash equivalents."
"Money-market instruments are a separate asset class and referred to as cash equivalents. Since cash equivalents are investments of high quality and safety, they’re considered to be nearly the same as cash."
Taxation: Knowledge of the tax status (federal and state/local) of different bond types is essential.
IV. Investment Returns (Chapter 6):
Bond Yields:Nominal Yield: The coupon rate.
"A bond’s nominal yield is the same as its coupon rate."
Current Yield: Annual interest payment / current market price.
"Current yield essentially measures what a bond investor receives each year based on her (potential) purchase price."
Yield-to-Maturity (YTM): The total return an investor receives if holding the bond until maturity, considering interest payments and the difference between purchase price and par value.
"Yield-to-maturity takes into account everything that an investor receives on a bond from the time she purchases it until the bond ultimately matures."
Understanding the relationship between these yields is crucial, especially when bonds are trading at a premium or discount.
"Basis" is another term for YTM. Basis point = 1/100 of 1%.
Averages and Indexes: Benchmarks for measuring investment performance.
Dow Jones Averages: DJIA (30 stocks), Transportation Average, Utility Average.
S&P 500 Index: Broader market measure (500 stocks).
Wilshire Associates Equity Index: Broadest index, representing the dollar value of all stocks.
V. Packaged Products (Chapter 7):
Mutual Funds: Investment companies that pool money from multiple investors to purchase a portfolio of securities.
Breakpoints: Quantity discounts on mutual fund sales charges.
"Breakpoints affect the purchase price of mutual fund shares."
Letters of Intent (LOIs): Allow investors to qualify for breakpoints by committing to invest a certain amount over 13 months.
"A letter of intent qualifies an investor for a discount made available through breakpoints without initially depositing the entire amount required. The letter indicates the investor’s intention to deposit the required funds over the next 13 months."
Rights of Accumulation (ROAs): Allow investors to qualify for breakpoints based on the total value of their investments within a fund family.
"Rights of accumulation give investors the ability to receive cumulative quantity discounts when purchasing mutual fund shares."
Prohibited Sales Practices: Breakpoint sales (inducing purchases just below breakpoint levels), recommending B shares when A shares are more suitable, switching funds unnecessarily.
"RRs who induce clients to purchase shares at a level just below the dollar value at which a breakpoint is available are engaging in a prohibited practice that’s referred to as a breakpoint sale."
Exchange-Traded Notes (ETNs): Debt securities that track an underlying index or benchmark. Subject to issuer credit risk.
VI. Options (Chapter 10):
Core Concepts: Calls (right to buy), puts (right to sell), long (buy) positions, short (sell) positions.
Long Call: Right to buy; bullish strategy.
Short Call: Obligation to sell; bearish strategy.
Long Put: Right to sell; bearish strategy.
Short Put: Obligation to buy; bullish strategy.
Components of an Option Contract: Underlying security, expiration month, exercise (strike) price, option type (call or put), and premium.
"An equity option is a contract to buy or sell a specific number of shares of a particular stock at a fixed price over a certain period."
Hedging: Using options to protect existing stock positions.
Long Stock, Buy a Put: Protects downside risk.
Short Stock, Buy a Call: Protects upside risk.
"If an investor is long stock and fears that the stock will decline, buying a put on the stock creates a long hedge. If an investor is short stock and fears that the stock will rise, buying a call on the stock creates a short hedge."
VII. Offerings (Chapter 11):
Issuing General Obligation (GO) Bonds: Requires voter approval and adherence to debt ceiling limitations.
"The issuance of general obligation bonds usually requires voter approval...A GO issue is generally subject to debt limitations that are placed on the municipality by a voter referendum or by statutes."
New Issue Underwritings: Municipalities may use negotiated sales (selecting an underwriter) or competitive sales (bidding process) to select an underwriter. Municipal advisors may assist with the offering.
"With a negotiated sale, an issuer brings its issue to market by selecting the lead underwriter or senior manager that will sell the issue to the public... Rather than selecting its underwriter, an issuer may invite interested underwriters to compete against one another by submitting bids for the issue."
VIII. Orders and Trading Strategies (Chapter 12):
Broker-Dealer Capacities: Firms act as either brokers (agents, earning commissions) or dealers (principals, earning markups/markdowns).
"A broker is defined as any person that engages in the business of effecting agency transactions in securities for the account of others...A dealer is defined as any person that engages in the business of buying and selling securities for its own account."
Order Types: Market orders (executed immediately at the best available price), limit orders (executed at a specified price or better), stop orders (triggered when the stock reaches a specific price, then becomes a market order), and stop-limit orders (triggered at a stop price, becomes a limit order).
"A limit order may be executed only at the specified price or better. A buy limit order may only be executed at the limit price or lower, while a sell limit order may only be executed at the limit price or higher."
5% Policy: FINRA guideline for markups and markdowns, considering various factors.
"FINRA emphasizes that 5% is merely a guideline, it’s possible that certain circumstances will justify higher markups; while conversely, there are other times when even 5% is too much."
IX. Settlement and Corporate Actions (Chapter 13):
Stock Splits: Increase the number of outstanding shares and decrease the price proportionally. Reverse stock splits decrease the number of shares and increase the price. Not taxable events.
"In a forward stock split, the number of outstanding shares are increased and the price is decreased. However, in a reverse stock split, the company decreases its number of outstanding shares and increases the stock’s price proportionally."
X. Customer Accounts (Chapter 14):
Account Types: Cash, margin, options, discretionary, fee-based/commission-based, educational.
Account Registrations: Individual, joint, corporate/institutional, partnership, trust, custodial.
Trust Accounts: Trustee manages assets for the benefit of the beneficiary. Revocable trusts can be changed, while irrevocable trusts cannot.
"In a trust, one person (the trustee) is put in charge of managing the assets for the benefit of another (the beneficiary)... Revocable trusts...can be changed at any time...The downside of a revocable trust is that assets funded into the trust are considered the person’s personal assets for creditor and estate tax purposes."
Privacy Notices: Must be provided to consumers and customers regarding the disclosure of non-public personal information.
XI. Prohibited Activities (Chapter 16):
Regulation M: Prevents manipulation of new issue prices.
"Under Regulation M, the SEC restricts distribution participants (such as underwriters and issuers) from aggressively bidding for or making purchases in the secondary market of a stock that’s currently being offered in a distribution."
Time of Trade Disclosures (MSRB Rule G-47): Municipal securities dealers must disclose all material information at or prior to the trade.
"A municipal securities dealer is required to disclose to a client all material information that’s either known or reasonably accessible to the market."
Borrowing/Lending to Customers: Generally prohibited unless specific conditions are met.
XII. SRO Requirements for Associated Persons (Chapter 17):
Registration: Most associated persons must register with FINRA.
Qualification Exams: Series exams are required to engage in specific securities activities.
Statutory Disqualification: Prevents individuals with certain disciplinary histories from being employed by broker-dealers.
"A broker-dealer may be prohibited from employing an individual who is subject to statutory disqualification (often referred to as an SD person) in any capacity unless FINRA provides specific permission."
XIII. Economic Factors (Chapter 19):
Growth vs. Value Stocks: Growth stocks have high P/E ratios and low dividend payout ratios. Value stocks trade at a lower price relative to their fundamentals and are considered undervalued.
"From an analytical point of view, growth stocks have high price-to-earnings (P/E) ratios and low dividend payout ratios... A value stock is one that tends to trade at a lower price relative to the issuing company’s fundamentals."
Market Capitalization: Total value of a company's outstanding shares (outstanding shares x current price). Categories include large-cap, mid-cap, small-cap, micro-cap, and nano-cap.
"To calculate a company’s market capitalization, its total number of outstanding common shares is multiplied by its current price."
Monetary Policy: The Federal Reserve (FRB) controls the money supply to influence interest rates and economic activity.
"The Federal Reserve System implements monetary policy in the U.S. and primarily focuses on controlling inflation."
Yield Curves: Normal (upward sloping) during periods of easy money, inverted (downward sloping) during periods of tight money.
"During periods of easy money when interest rates are declining, yields on short-term debt securities will be lower than those on long-term debt securities...on the other hand, during periods of tight money, the yield curve may invert."
XIV. Investment Risks (Chapter 20):
Systematic (Non-Diversifiable) Risk: Affects all securities and cannot be eliminated through diversification. Examples include market risk, interest-rate risk, and inflation risk.
"Systematic risk is caused by factors that affect the prices of virtually all securities."
Beta: Measures the volatility of an asset or portfolio relative to the market.
"The amount of non-diversifiable risk associated with a particular portfolio or asset is measured as beta."
Duration: Measures the sensitivity of a bond's price to changes in interest rates.
"Duration measures the sensitivity of a bond or portfolio of bonds to a given change in interest rates."
Unsystematic (Diversifiable) Risk: Unique to specific securities and can be managed through diversification. Examples include business risk, regulatory risk, legislative risk, political risk, and liquidity risk.
"Unsystematic risk is based on circumstances that are unique to a specific security and may be managed by diversifying the assets in a portfolio."
Alpha: Measures risk specific to a particular company.
"Alpha measures the risk that’s specific to a particular company."
This briefing document provides a foundation for further study and review. Good luck with your exam!
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