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BU111 Final Review.docx

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Leanne Hagarty

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Business Final Review - Financial institutions facilitate flow of money - Four distinct legal areas /”pillars”: - Chartered banks - Alternate banks - Life insurance companies - Investment dealers - Lines between pillars have been blurred due to deregulation - Individuals, governments and businesses have a surplus of money, and our financial system has ways to tap into that surplus, and put it into the hands of other individuals, governments, and businesses that need it. Pillar #1 – Chartered Banks - Privately owned, publicly traded, profit seeking - Regulated (not owned) by the government - Largest and most important institution - Concentrated and highly regulated industry  Five largest account for 90% of total bank assets  Bank Act limits foreign-controlled banks to <8% of total domestic bank assets - Serve individuals, business, and others (government organizations) - Major source of short-term loans for business • Secured (Collateral) vs. Unsecured loans (No collateral) - Secured loans require collateral such as house, car, bonds, stocks, etc. - Expand money supply through deposit expansion - Unsecured will have higher interest rates. - Chartered banks also expand money supply through deposit expansion - One source of revenue for banks is paying you next to nothing for your deposits, but loaning your money to others for higher interest rates. Changes in Banking: - Deregulation - Changes in consumer demands - Competition from foreign banks Bank of Canada: - Canada’s central bank - Manages economy and regulates aspects of chartered bank operations. - Manages money supply (picture in text book) • Tools: – Open Market operations • Buy or sell govt securities – Bank Rate • Lower or raise the bank rate Pillars #2 – Alternate banks - Trust companies & credit unions Pillar #3 – Specialized lending/saving intermediaries - Insurance companies, venture capital firms, pension funds. - Venture capital firms will approve some loans to businesses that aren’t fully established but are growing (well established banks won’t likely approve these loans) - Will be harsh with the terms because they are taking a risk on the business. Pillar #4 – Investment Dealers - Facilitate trade of stocks, bonds and other products in Securities Markets. - Primary Markets • Investment bankers/dealers • Advise, underwrite, distribute - Secondary Markets • Toronto Stock Exchange and other exchanges International Banking & Finance - Governments and corporations frequently borrow in foreign markets International Bank Structure: - Aims for stability - World Bank provides limited services, funds national improvements. - International Monetary Fund: • Promotes stability of exchange rates • Provides short-term loans to members • Encourages member cooperation • Promotes system for international payments * The bank of Canada has a lot of power over our banking system (chartered banks) Investment Factors Types of Investments: BONDS - Represents debt for issuing corporation or government Characteristics: - Legal, binding agreement - Fixed rate of return (often paid semi-annually)  no matter what happens in the economy. - Fixed term – principal repaid at maturity - Repaid to current owner (may have been traded) - Priority over stockholders Types: Secured – more from governments (more trustable), they can just raise taxes to help pay Unsecured – corporations Bearer Bond (Less practical) – doesn’t keep track of who owns the bond, doesn’t keep track of trades, if they are stolen, thief will get the money, if it burns, you lose it Up to the bearer to claim the interest. Registered Bond – keeps track and is sent out to current owner at the end of its life Common Features: Callable – gives issuer flexibility (allows them to pay that bond out earlier than maturity date) - Pays out debt (less interest to pay in the future) Serial – staggering a series of redemption dates - Instead of having to pay out a large sum of money all on one maturity date Convertible – never works on Government (countries don’t issue stocks) - Gives bond holder the option to convert their bond to common stocks (not usually for preferred stocks) What impacts Bond Value? 1) What impacts the coupon rate at bond issue? • Prevailing interest rates • Credit rating of issuer • Features & Time to Maturity 2) What impacts bond price when traded? • Coupon rate & prevailing rates of interest (relationship) • Changes in credit rating • Inflation • Economic/Market Risk Why are the coupon rates different for different bonds? - Bondholders want higher interest rates for a longer bond period for putting their - - Money away for a long time - Prevailing interest rates in the economy. - Risk premium (some countries and companies are riskier than others) - If there are beneficial features for the bondholder, these will compensate for issuing the bond with a lower interest rate - Bond prices should fall if inflation is on the rise (vice versa) What impacts bond values? - If you lower the value of the lower interest rate bond. More people will buy it. (Ex: New 8% bond with old 5% bond. 5% bond price will go down to make it more attractive) Concept of Yield: - Percentage return on any investment - Helps us to compare investments Yield = what you made/what you paid = Interest + Capital Gain or Loss/what you paid For a bond, Interest = coupon rate x face value Capital gain = face value – purchase price * Always use a face value of $1,000 for bonds! Bond Pricing (Three scenarios to consider): 1) You pay less than face value for the bond  priced “At a Discount” - Coupon rate is less than expected yield 2) You pay more than face value for the bond  priced “At a Premium” - Coupon rate is more than the expected yield 3) You pay face value for the bond  priced “At Par” - Coupon rate is equal to expected yield * Bond prices vary inversely with interest rates Scenario 1: Pay at a “Discount” - This scenario happens when the coupon rate is less than the expected yield. - Example: You are buying a 2008 bond with a 3% coupon and today’s expected bond yields are 5% Notice: With a Yield expectation that is greater than the coupon rate, you would need a capital gain to attain the Yield, which means you pay less than face value for the bond. Scenario 2: Pay at “a Premium” - This scenario happens when the coupon rate is more than the expected yield. - Example: You are buying a 2004 bond with a 7% coupon and today’s expected bond yields are 5% Notice: With a Yield expectation that is less than the coupon rate, you would be willing to pay more than face value (a premium) for the bond; in other words you would take a capital loss.  The seller should demand more money as the coupon rate is higher.  The buyer would buy it even if it means incurring a capital loss. (Up to a certain point) Scenario #3: Pay “At Par” - This scenario happens when the coupon rate is equal to the expected yield. - Example: You are buying a 2006 bond with a 5% coupon and today’s expected bond yields are 5% Notice: Since your Yield expectation is met by the coupon rate, you would have no capital gain, which means you pay face value for the bond. Bond Pricing Summary  Bond prices vary inversely with interest rates  Interest rates increase  Bond prices fall  Interest rates decrease  Bond prices rise Reading Bond Quotations  Bonds issued at $1,000 face value and redeemed at $1,000 face value at maturity Types of Investments: STOCKS - Represents equity/capital for issuing company Characteristics: - Voting rights - No fixed term - Variable return - Discretionary payment (dividends) - Risk Types: Put bonds in another column to compare - Preferred = “hybrid investment”  kind of like a common stock, kind of like a bond - Preferred treatment over common stock holders - Common shareholder takes most risk, so they get voting rights and choice who’s on BOD - Preferred don’t get voting rights (unless things aren’t going well) - More established, older companies will pay common stock dividends - Preferred stocks have planned dividends  won’t for sure happen (debt payments take priority) just in the plan Right – Other features  company is offering an additional block of shares (secondary public offering). They do this to expand more. - If they did this, common stock owner would own less % of company - Allow existing common shareholders to buy a certain amount of shares in order to maintain their % ownership (ex. 20% of a company) Redemption – make the company buy back your preferred stocks. There are certain times you can do this. Convertibility – covert your preferred shares to common shares. What Impacts Stock Price? - Demand and supply of stock due to negative or positive perceptions/facts - Primary factors: • Earnings - above or below expectations, rumours • General market conditions - bull vs. bear markets, economy, interest (especially preferred) • Speculation - bought or sold on belief price will soon move - PRICE OF A SECURITY IS A COLLECTIVE EXPRESSION OF ALL OPINIONS OF THOSE WHO ARE BUYING AND SELLING Undervalued issue - offers higher return than stocks of similar risk Less supply, much demand = increased price More supply, less demand = decreased price COMPARE AND CONTRAST BONDS AND STOCKS (Exam Question) - Riskier (no way of knowing that we will get all of our capital back) - Bond  ongoing return (interest payment) - Stocks  only might give some return (less likely) - Stocks  may or may not give out dividends, but if company has a bad year, they don’t legally have to pay out dividends. Leverage: - Engaging in a transaction whose value is greater than the actual dollars you have available - Creates potential to make a larger return or loss than indicated by the investment you have made Examples: - Buying on margin - Selling short 1) Buying on margin - Put up only part of purchase price - Broker lends remainder (with interest) - Usually no more than half *Min. requirements set and enforced by Securities Commission - crash of ‘29 - 10% Rules: - Must qualify for margin account - Must sign ‘hypothecation’ agreement (Margin Account Agreement Form) - pledging of securities as collateral for a loan - Must pay interest on loan - The investors % equity (margin) in the margined stock must always be > the minimum margin requirement Example: Margin Call • 1 month into the transaction the price of XYZ drops to $40 CMV = $40 x 200 shares = $8,000 • CMV - loan >/= % margin req’t CMV $8000 - $2700 = 66.25% $8000 • Therefore, receive a ‘margin call’ from broker for amount ‘x’ that will bring % equity back up to minimum requirement (increase equity by reducing loan) Two ways to calculate margin call: • Broker is only willing to lend 30% of market value • CMV = $8,000 x .3 = $2,400 max. loan • Current loan $2,700 • Therefore reduce loan by $300 (margin call) OR • (CMV – loan) + margin call >/= margin req’t CMV ($8,000-$2,700) + ‘x’) / $8,000 = 70% $5,300 + ‘x’ = $5,600 ‘x’ = $300 • The amount of the margin call is used to reduce the debt to the broker $2,700 owed - $300 call = $2,400 owing (after 1 month) Impact on Interest • Margin call 1 month into transaction • Sell stocks after total of 3 months Interest = $2,700 x 10% x 1/12 = $22.50 + $2,400 x 10% x 2/12 = 40.00 $62.50 2) Selling Short - Buy low, sell high = sell high, buy low - Sell shares you don’t own - borrow from broker Rules: - Short deposit must be 150% CMV at all times - Agreement may be terminated by either party at any time - forced to cover / “buy-in” - Short sale price governed by ‘last sale’ rule - Dividends declared are the responsibility of the seller Short Selling Summary: What is maximum profit you can make? - Price of short What is maximum loss? - Anything goes; price can rise infinitely Risks: - Unlimited losses - Forced to cover short at disadvantageous price - Dividends may be declared that you must cover - Short calls • Notice similarities and differences between margin buying and short selling – Both face calls Money today is worth less in the future because of risk, inflation, etc. - Sometimes worth more in case of deflation Annuity: multiple but equal payments over equal periods of time - O
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