Csc Summary i

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CSC Summary

CH 1 CAPITAL MARKET

Capital is mobile, sensitive to environment and scarce.

Focus on indirect investment, savers buy securities issued by govies and corpries, who use these funds for

directInvestments such as buildings, equipment, machinery, etc.

Factors influencing capital flow:

Political environment, economic trends, GDP, fiscal policy, monetary policy, ROI expected, risks, labour

Source of capital: ONLY SAVINGS (can be from individuals, governments, corporations retained earnings)

Retail Canadian investors had over $500b in personal savings at end of 2007 at chartered banks aloneOther wealth sources include investments at trusts, credit unions, dealers (home equity, cash, insurance, etc.)

Foreign investment in Canada concentrated in manufacturing, petroleum, natgas, mining, etc.)

Government

Annually, Minister of Finance presents govt budget to Parliament Provincial and municipal govies issue debt themselves and through Crown Corporations Municipalities responsible for streets, sewers, water supplies, police, protection, transportation, electricity Instalment debentures might be issued by municipalities to spread cost over several years

Bonds backed by specific assets, debentures only backed by general credit of issuer and no specific pledge

Investment Fund company that manages investments for clients

Open end (mutual) fund: sells shares or units to investors, and invests this capital into securities

FINANCIAL MARKETS

Securities are needed as means of transferring capital. Well-organized market has low transaction costs,high efficiency, high liquidity and effective regulation. Investment advisors facilitate meeting of buyers &

sellers.

Auction markets are single central markets through which buyer and seller orders are channeled and matched.They compete against each other.Stock exchange is this market place to trade shares, rights, warrants, futures,

options, installlment receipts, ETFs, income trusts and convertible debentures.

1) Toronto Stock Exchange: senior equities, debt instrments, income trusts, ETFs2) TSX Venture Exchange: junior equities, few debentures3) Canada National S tock Exchange (CNS X): securities of emerging companies4) ICE Futures Exchange : agricultural futures and options5) Montreal Exchange (Bourse de Montreal): derivatives, financial equity futures and options

Liquidity meansfrequent sales, narrow bid-ask spreads andsmall price fluctuations from sale to sale

De aler markets consist of dealer networks trading with each other, buy and sell to end consumers. Bonds anddebentures trade through these OTC / unlisted markets

1) Dealers enter bid ask quotations, have inventory of securities to trade2) Charges commissions for this service3) Derivatives are also traded, this market dominated by large financial institutions4) No regular market hours, no trading floor, open 24 hours a day, complex products5) No requirement to report unlisted trades (Exception: Ontario)6) Ontario Securities Commiss ion ( OSC) requires reporting through Canada Unlisted Board Inc. 7) CUB is automated system after reorganization of equity markets, Internet-based system for dealers to

report compled trades in unlisted securities


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CSC Summary

Quotation and Trade Reporting Systems (QTRS) are recognized stock markets operating similar toexchanges and provide facilities to userts to post quotations and report trades (bid and ask postings).

Market doe s NOT match orders, they are negotiated and trades are reported Traditional model for

NASDAQ

Alternative Trading Sy stems ( ATS) are privately owned computer networks, also referred to as PETS that

match orders for securities outside exchanges. Profits made through commissions. Much slower than in the

USExamples locally: Bloomberg Tradebook Canada, OMEGA ATS, Chi-X, Alpha Trading SystemCould threaten stability due to less transparency, technological glitches, cross-border trading, regulated

CanDeal member of IIROC, joint venture between CDNs 6 largest dealers ATS and INVESTMENT

DEALER

It allows investors access to federal bond bid offer prices and yields from 6 bank-owned dealers

CBID member of IIROC and ATS, operates RETAIL and INSTITUTIONAL markets: accessible by

registered dealers, investors, govies, pension funds (Debt Instruments mostly 1st electronic fixed-

income dealer)

CanPX joint venture of IIROC and IIAC (association Canada) providing real-time bid offer prices (bonds, T-bills,provincial and corporate bonds)

Priv ate Equity can be stocks, bonds, debentures. Good example is venture or risk capital. Leveraged Buyout,

Growth Capital, Turnaround, Early & Late S tage Ve ntures and Distressed Debt

Stock exchange ownerships: are divided into not-for-profit and for-profit membership

ALL CDN EXCHANGES set up as FOR-PROFIT memberships Members are known as participating organizations orapproved participants Admin and policy setting are responsibilities of each exchanges BOD: 1 permanent exchange official,

experienced senior executives from member firms, 2-6 highly qualified governors,

Provi ncial s ecurities acts allow exchanges to exercise considerable self-regulation Define acceptable standards of behaviour, trading rules, listing and reporting requirements for companies

Financing of Exchanges:

Transaction fees, listing fees, sustaining fees (corporations to keep listing in good standing) Sale of historical trading, market information

Largest Stock Exchanges in the World:

NYSE, Tokyo SE Group, NASDAQ, NYSE Euronext, London SE, Shanghai SE, Hong Kong Exchange,

TMX Group, BME Spanish Exchanges, BM&F BOVESPA (Brazil)

CDN Stock Exchanges:

1) Securities trading started in Canada in 18322) 1999 Canadas 4 major exchanges did some restructuring to ensure strong global market competitiveness3) TSX became Canadas senior-equities market, gave up derivatives trading and juniors4) Alberta, Winnipeg and Vancouver stock exchanges merged to the CDN Venture Exchange (CDNX)5) Montreal Exchange exclusive for financial futures and options6) CDNX became subsidiary of the TSX, which abbreviated from TSE to TSX7) CDNX renamed the TSX Venture Exchange, purpose8) TSX Markets Inc. is the arm of TSX that sells market information and trading services9) Investment Industry Regulatory Organization (IIROC) regulates trading, dealers must be member


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CSC Summary

CH 2 THE CANADIAN SECURITIES INDUS TRY

Provinces have power to create & enforce their own laws

Sel f-Reg ulatory Organizations (S ROs) establish and enforce industry regulations to protect investors

Trades are settled through organizations like Clearing & Depository Services Inc.Canadian Inve stor Protec tion Fund (CIPF) provide insurance against insolvency of dealer members

INVESTORS BROKERS & DEALERS USERS OF CAPITAL

SROs MARKETS CLEARING & SETTLEMENT

CSI Education CIPF PROVINCIAL REGULATOR

In 2009, 200 members of the IIROC

RBC employed over 70,000 people, assets = $654 billion

Intermediaries: organizations that facilitates trading between financial instruments (transfer of capital)

Most banks own a number of subsidiaries (dealers, trust companies, insurance subsidiaries)

Investment Deale rs (brokerage firms or securities houses):

1) Transfer capital from savers to users (underwriting and distribution of new securities) 2) Maintain secondary markets in which outstanding securities can be traded

Why have chartered banks grown in number and size?

Higher international activity, creation of more banks, foreign-owned Schedule II and III banks Purchase of trust companies by banks Changes in Bank Act permitting banks to competeA) Integrated Firms B) Institutional Firms C) Retail Firms

Generate about 70% of industry revenues

Most underwrite debt and corporate equity issues

Research, portfolio management , M&A advice, tax counselling, loans, safekeeping securitiesOperational structure: market share, number and location of employees, business mix, specialization

Smaller dealers (investment boutiques): stock & bonds trading, reserach, insitutional trading, unlisted stock

trading, arbitrage, portfolio management, underwriting of junior companies, mutual funds, tax-shelter

Wealth Management: focuses on retail and institutional clientsGlobal Capital Markets: trading, investment banking, institutional sales

Management: chairman, president, vp, directors, etc. The following departments exist inside a securities firm

A) Sales Department: very geographically dispersedi) Institutional deal with major traders at large financial institutionsii) Works with trading department to create trading volumeiii)Located at head and major branch officesiv)Retail sales is smaller (investment advisors)v) IAs must be ofleg al age, passed CSC, Conduct Practices Handbook, 90 -day training

programvi)IAs must have passed the Wealth Management Essentials Course (30 months after

registration)vii)Have to advise clients on financial goals, processing orders, investment decisions follow guidelines


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CSC Summary

B) Underwriting / Financing Department: individual companies, governments interested in raising capitali) Type of security, price, interest, dividend rates, protective provisions

C) Trading Department: works with underwriting and salesi) Divided into bonds, stocks, specialized productsii) Bonds typically traded out of inventories (govies, provies, municipals, corporate)iii)Stocks (common and preferred) typically trade on exchanges (buy/sell orders, phone calls)iv) Speciali zed instruments mutual funds, commodities, futures, contracts, etc.

D) Research Department: economist, fundamental, technical analystsi) Study industries, economic & markettrends, research coverageii) Institutional and retail (IAs make personal proposals)iii)Help underwriting and corporate finance in special studies (institutional)

E) Administration Department:i) Operations: recording and accounting of all tradesii) Credit & Compliance: focus on clients accounts (transactions)iii)Financial: payroll, budgeting, financial statements, controls)

How are securities firms financed?

Originally by founders capital, retained earnings and loans. Very highly leveraged, usually most of theirrevenues from commissions. Returns for financial shigh during bull markets. Firms are typically vulnerable to

business swings, bond and stock market fluctuations, securities price and interest rates.

Deale r, Principal & A gency Functions

Principal securities firm owns securities as part of its inventory (transaction with investors)

Agent facilitate active and liquid secondary markets for transfer of securities (commissions)Underwriting purchase from government body / company NEW ISSUE of securities, anticipate making a

profit when selling securities to investors. Risk that prices may fall. Dealer advises issuer on market conditions

Principal Trading secondary markets market making. Routinely conducted on OTC markets. Dealersknowledge of secondary market conditions help them advise clients of how to issue new offerings. Adds to

liquidity and efficiency (investors dont have to find buyers / sellers and wait)

Broker agent or intermediary (earns a cut through commissions)

CDS Clearing & Depository Services

Banks, investment dealers, trust companies have access to this institution. Daily settlement process

between members greatly shortens transaction costs and enhances effficiency. CDS founding member of CdnCapital Markets Association.

Trends in Securities Industry

a) Mergers, alliances between CDN and global brokerage housesb) Harmonization of securities laws, creation of national securitie regulatorc) Trend towards FEE-based accounts instead of COMMISSIONS-based. Switch from individual ownership

to managed products like mutual funds

d) Creation of innovative financial products

BAN KS ( FINANCIAL INTERMEDIARIES)

Bank Act: sets out specifically what banks may do, operating regulations; Banking Industry:


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CSC Summary

2009: 77 banks (22 domestic, 26 foreign subs, 29 foreign branches) Largest six banks control 90% and $2.9 trillion in assets, employs 249k people Regulations designed to protect Canadian banks from foreign competition Schedules I, II, and III (most Canadian-owned banks Schedule I, and foreign are Schedules II and III) Voting shares of Schedule I must be widely held (less than 20% per shareholder) Banks less than $5 billion in Shareholders Equity can be owned by single shareholder (65% voting shares) Remaining shares have to be publicly traded Small bank (SE of < $1 billion) can be owned by individuals or organizations Banks can now hold other corporations: IT, E-Commerce, Real Estate, etc.

Schedule I Banks:

22 banks (RBC, CIBC, BMO, TD, SCOTIA, NATIONAL included) More than 9,000 retail branches, over 50,000 ABMs (business) Consumer, commercial banking products & services, mortgages, loans, accounts, investments, asset

management, some through subs, mutual funds, financial planning, etc.

Inv estment dealer ac t iv i ties, discount brokerag, and insurance must be handled bysubsidiaries.

CHINESE WALL sets controls about how different subsidiaries of banks can share informationSchedule II Banks:

Schedule II INCORPORATED in CANADA, operate as federally regulated foreign bank subsidiaries Accepting deposits eligible for protection from CDIC (AMEX, Citibank, BNP Paribas) May engage in all types of business of Schedule I (RETAIL and ELECTRONIC SERVICES mainly)

Schedule III Banks:

Federally regulated foreign bank branches of foreign institutions authorized by Bank Act HSBC, Comerica Bank & Bank of NY Mellon are examples Tend to focus on CORPORATE and INSTITUTIONAL FINANCE, IBANKING

Trust and Loan Companies

Many services overlap with chartered banks. Issue deposits, accept savings, personal and mortgage loans,sell RRSPs, other tax-deferred plans. Regulated underTrust and Loan Companies Act and by the OSFI

Credit Unions (Caisse s Populaires)

Many investors felt banks too profit-oriented. Offer various services like deposit taking and lending,

mortgages, mutual funds, insurance, trust services, debit and credit cards, etc. Governed by the federal regulation

Cooperative Credit Associations Act. Limits activities to providing financial services to their members,which they have substantial investment. Requires adherance to prudent portfo li o approach

Insurance Companies

Employs 200k people, $400 b assets. 2 main businesses, life insurance and property & casualtyinsurance. Source of funds mainly premiums on health, disability, term, whole life and pension plans. Largest

premiums created by auto industry. Life insurance companies act as TRUSTEES, must be extremely cautiousabout investment selection. Underwriting in this case means assessing business risks and evaluating premiums.

Governed by the Insurance Companies Act of 1992. Permits life insurance to own trust and loan

companies through subsidiaries, and also could own Schedule I banks. However, it restricts in-house trust servicesand deposit-taking. Prudent portfo li o approach which replaces legal for life brules (prohibited in

acquiring substantial investments in unauthorizeed financial & quasi-financial entities)

Trends in Insurance


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CSC Summary

Demutualization process by which insurance companies reorganize into being owned by shareholders

rather than policy holders. Gives them access to capital markets and make acquisitions. Likely leads toconsolidation, emergence of larger, fewer companies. Banks can own insurance companies but are restricted in

distriubtion of insurance products. Companies have access to the Payments S ystem. Can offer chequing

accounts, debit cards

Inves tment Funds sell shares to the public and invest them in diverse portfolio

1) Closed-End Funds only issue shares at startup.2) Open-End (MUTUAL) Funds continually issue shares to investors. Range in term of risk-preferences

Savings Banks

Alberta Treasury Branches formed in 1938. Funds on deposit guaranteed by province (100%)

Sales Finance make direct cash loans to consumers (purchase at discount sales contracts)

CH 3 CAN ADIAN REGULATORY ENVIRONMENT

Office of the Superintendent of Financial Institutions ( OSFI) established in 1987 to REGULATE andSUPERVISE 153 deposite taking institutions (banks, trusts, credit unions, life insurance companies, etc). It

does NOT regulate the Canadian securities industry. Also provides advice to Govt of Canada.

Canadian Deposit Insurance Corporation (CDIC) is a fed crown corporation, 1967 to provide DEPOSITINSURANCE and stabilize financial system. Insures $100,000 per eligible depositor in eaach member

institution (banks, trusts, loan companies, etc.) Products include savings, chequing accounts, GICs

(les s than 5 ye ars), money o rders, certife d cheques, bank drafts, etc. It does NOT insuremutual funds, stocks, GICs more than 5 ye ars, bonds, T-bills , debentures, etc.

Note: Could have > $100,000 in deposits eligible, but must be held in more than one of CDICs 6 Deposit

Insurance Categoriesin 1 name, jointly >1 name, trust acccount, RRSP, RRIF, mortgagetax acct

Credit Union Deposit Insurance Corporation (CUDIC) established in BC 1958 to protect credit unions,unlimited deposit insurance protection on all deposit and money invested in non-equity shares with

a BC credit union. Accrued interest & unpaid dividends are included. In Ontario, each client of a credit

union or caisse populaire is insured up until $100,000 for combination of principal, interest, dividends.

Canadian Securities Administrators (CSA) is the group of 13 provincial Canadian securities regulators, aforum to coordinate and harmonize regulation of capital markets.

Sel f-Reg ulatory Organizations (S ROs) are private organizations that have been granted the privilege of

regulating their own members.The provincial securities commissions monitor the conduct of SROs. If anSRO rule differs from a provincial rule, the more strict of the two applies.

Investment Industry Regulatory Organization of Canada (IIROC) and Mutual Fund De alersAssociation

IIROC was the consolidation ofInvestment Dealers Association of Canada and Market Regulation

Services

Financial Compliance (ensure dealer members have enough capital to carry out operations) Business Conduct Compliance (ensure policies and procedures are being properly placed) Registration responsibility for overseeing professional standards and educational programs


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CSC Summary

Enforcement includes making sure rules and regulations are being followed Market surveillance by regulating securities trading and market activities in marketplaces Enforcing timely disclosure of information by publicly traded companies

ID A has two missions: protecting investors and creating professional association for membersApril 1, 2006, the professional association was separated into Investment Industry Association of Canada

IIAC provides support and services, represents investment industrys views and interest to provies and govies.

MFDA regulates distribution and sales of mutual funds.

The CIPF primary role is INVESTOR PROTECTION and OVERSEEING SROs. No compensation from

changing market values of investments, mutual funds or non-members of IIROC. Dec 2009 $559M to

pay claims. Covers customers losses ofsecurities and cash balances from insolvency of an IIROCmember. Certain persons excluded, such as those who deal with CIFP members through accounts for

financing purposes, securities lending are NOT eligible. Limited to $1MM for losses with regards to cashand securities.

If the CIPF is insolvent, quarterly assessments wihin prescribed limits will be charged against dealermembers, proceeds will be distributed until the Fund has been discharged.

Works with financial examiners and senior regulatory officials to provide regulatory oversight.

Under supervision of the CSA, CIPF and SRO reviews national standards for capital adequacy, etc.

MFDA Investor Protection Corporation (MFDA IPC) protects eligible customers from insolvence of

MFDA member firms, limited up to $1 MM per customer account. Covered as part of a GENERAL orSEPARATE account, similar to a CIPF. Separate include RRSP, RRIF, etc.

Note: Clients who feel they have been treated unfairly by SROs can go through arbitration. SROs can only

DISCIPLINE member firms, but CANNOT orderrestitution. Clients must receive arbitration brochure

when opening an account. Going through arbitration forfeits chance to go through courts. Beforearbitration,

1) Attempts must have to solve problem with dealer member2) Claim CANNOT exceed $100k3) Events must have originated after 1992 in BC, after 1996 in Quebec, after 1998 in Ontario

Note: Alternative is the Ombudsman for Banking Services and Investments (OBSI) independent

organization investigating complaints against financial service providers, give prompt and impartialsolutions. Ombudsmans decision is non-binding, but those failing to comply till be publicly reported (none

so far)

Principles of Securities Legislation

Administratorusually implies regulatory authority, commission, registrar or other govt official. General

principle is full, true, plain disc los ure of all important facts when selling securities to the public. 3 basicmethods exist to protect investors: registration of securities dealers, disclosure of facts and enforcement.

Registration: Every firm and IA must be registered1) Investment Adviso rs (IAs): CSC, Conduct and Practices Handbook (CPH). Each new IA must

complete 90-day training program, also Wealth Management Essentials (WME) within 30 months.

2) Investment Represe ntatives (IRs): may not give advice to clients. Their training is only 30 days, no30 month requirement for completing the WME.

3) Sales Manager: Branch Managers Course (BMC), within 18 months the Effective Management SeminarNote: Employees not engaged in sales may accept orders form public: Non-Trading Employee s

National Instrument (N I) 3 1-1 03, Regis tration Requirements, lists 9 registration categories:

1) Investment Rep: to take unsolicited orders


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CSC Summary

2) Registered Rep: give investment advice3) Trader: enter orders into trading systems of exchanges4) Supervisor: supervise other apporved persons5) Exeuctive: participate in management of investment dealer6) Director: sit on BoD or occupy similar position7) Ultimate Designated Person: CEO or similar position, responsible for statutory compliance8) CFO: compliance with financial adequacy requirements of IIROC rules9) Chief Compliance Officer: systems and controls reasonably designed to ensure compliance

National Regi stration Database ( NRD) is a web-based system used by employees, dealers to file registrationforms electronically forAPPORVAL by CSA, IIROC, single submission for all of CDN.

Know Yo ur Client Rule: Acceptance of any order bound by good business practices, recommendations foraccounts should be appropriate with investment objectives (suitability principle). First step in comlying is a

completion ofNew Account Application Form (NAAF) PRIOR toACCEPTANCE of any order.

Fiduciary Obligation: not reveal inside info, not release info before public disclosure, prevent conflicts ofinterest, providing investment advice, advising fully, honestly and in good faith.

National Do Not Call List: using the telephone in soliciting clients is telemarketing. The Canadian Radio-Television and Telecommunications Commission (CRTC) has established certain rules, cannot

call clients on the list. SROs have developed extensive rules and regulations, infractions punished by fines,suspension and expulsion. Criminal charges can be laid. Omissio n, conduct, manner of business areexamples.

Examples of Une thical Prac tices:

Any conduct deceiving the public, purchaser or vendor of any security. False appearance of active public trading, sales and repurchase schemes to manipulate the market Sell and repurchase scheme to manipulate the market Deliberately causing last sale price of security to be higher than warranted (window dressing). Attempt to mislead board of governors or committee Confirming a transaction where no trade has been executed (bucketing), making fictitious trades Pressuring clients to trade securities, improper solicitation, making clients believe there is no risk in trading Selling or attempting to sell prospective dividend Trading a security prior to effectingg a trade for a client (front running)

Public Company Disclosures

Companies need to file financial statements, insider trading reports, information circulars, annualinformation form, press releases, material change reports

Continuous public dis clo re requirement of the acts (primary: preses release, material change report) Material Change means any change in company that can dramatically effect market price of securities Examples: change in BoD, affairs, disposition / acquisition, contracts, takeovers, sale of shares foreigners Companies MUST FILE with administrators annual and interim reports No selective disclosure of confidential materials occur to 3rd parties during meetings with analysts

Financial disclosure provisions requre these materials to be sent to shareholders: financial statements,comparative audited FS including all 4 statements within 120 days of year-ends in Venture Exchange, 90 days for

TSX listed stocks, quarterly intereims 60 days for Venture, 45 days for TSX

Statutory Investors Rights

1) Right of Withdrawal: right to withdraw from purchase 2 business days after receipt of prospectus or anyamendment by giving notice to agene. If done without a prospectus, purchasers can revoke with time limits


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CSC Summary

2) Right of Rescis sion: cancelling contract for purchase if the prospectus/amended prospectus contains amisrepresentation (omission of material fact or untrue statement). Must be brought within 180 days. Remedycan be eiteher RESCISSION or DAMAGES.

3) Right of Action for Damages: issuer, director, sellers, underwriters may be liable for damages if theprospectus contains a misrepresentation. This right applies to any EXPERT (auditor, lawyer, geologist,appraiser) who reports an opinion and the misrepresentation happens with his / her consent. They are not liable

if the misrepresentation did not appear in their report or opinion. If company can prove purchaser knows of the

misrepresentation, claim may be invalid. Acts also provide certain limitations with respect to maximumliability. Misrep may also be a criminal offence.

Proxies and Proxy Solicitation: power of attorney given by shareholder, MUST be in WRITING and signed

by the shareholder. Inactive shareholders who leave the proxy unmarked or unvoted is castAUTOMATICALLY with managements viewpoint. Most provinces require solicitation of proxies by

management

Street form: registering shares in name of someone other than true beneficial owner, referred as nominee(bank, dealer, etc.) Nominees are required to mail out all materials related to meetings and shareholder

information.

Takeover bid is an offer to acquire shares of company totalling in excess of20% voting outstanding

securities. Offers, if successful will obtain enough shares to control company.1) Bid must be sent to all shareholders of securities class, including convertibles. 2) Offeror will distribute takeover bid circular (bids, holdings in target, management relations)3) Directors circularmust be sent within 15 days to security holders to provide certain info and

include a RECO to ACCEPT/DECLINE the bid.4) Any securities taken up by offeror MUST BE PAID WITHIN 3 DAYS.

Exemptions from takeover bid regulations:1) Made through facilitates of exchange in accordance with by-lwas, regulations, policies 2) Acquisitions do not aggregate more than 5% of securities of a class within 12 months, price paid for the

securities does NOT exceed price on date of acquisition3) Offer by way of private agreement with five or less security holders at price 10% fo voting shares 3) Director or senior officer of the parent company 4) Reporting issuer which has redeemed, purchased or acquired any of its securities

Insiders MUST REPORT to adminstrators any change from the previous report WITHIN 10 DAYS or any trade.

CHAPTER 4 ECONOMIC PRINCIPLES


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CSC Summary

Microeconomics analyzes behaviour of individual firms and consumers, price determination, production,distribution, use of goods and services. Macroeconomics is the evaluation of the economys performance as a

whole, such as price levels, natural resources, technological impacts, unemployment, recession, spending, etc.

Consumers, firms, governments interact with the economy (DECISION MAKERS). Resources used by themare called factors of production. It includes labour, capital, entrepreneurship, services, etc.

Market is any arrangement that allows buyers & sellers to conduct business.

Gross Domes tic Product (GDP) market value of all final goods and services PRODUCED in a country

1) EXPENDITURE: total spending on final goods and services (who spends: consumers, govies, investment)2) INCOME: total income earned (wages, rent for land, interest for capital goods, profits for entrepreneurs)

Nominal GDP reflects change in prices as well as volume, Real GDP only reflects volume

Canadian GDP is around $1.5 trillion in 2009

Economic growth comes from increases in output per worker, capital, liquidity to support investments.

a) Capital accumulation alone cannot sustain growth.Higher savings cannot result in sustained growth rate.b) Sustained growth requires technological progress with complex pattern of basic, applied research and

product development in a supportive entrepreneurial context.

Growth Acc ounting: technique to differentiate real GDP growth due to CAPITAL or TECH PROGRESS

Canadian Stats:

On average, Canadian GDP has grown by about 3.35% since 1960s Growth is highest in 1960s and slowest in 1980s. Fluctuations in output and employment are called the business cy cle

Expansions happen during times of normal growth, stable inflation, profits rising, inventories have been adjusted

(rising) to meet excess consumer demand. Overall, GDP is rising. As we reach a Peak, demand begins to outstripcapacity, labour gets expensive, inflation, interest rates rise, bond prices fall. This dampens business investment

and reduce sales of houses and durables.

Contractions follow, economic activities decline, unwanted inventories, declining profits, business conditions

worsen, formation of a troughnears, falling demand and excess capacity disbales firms from raising prices.Inflation falls, interest rates fall, business investment increases, bonds rally. Recoveries usually help GDPreturn to its peak. People buy interest-rate sensitive items like houses, cars, furniture, etc. Expansionhappens when economy surpasses its previous high.

Economic indicators are statistics, data series we use to analyze business conditions and economicactivity. Classified as LEADING, COINCIDENT and LAGGING:

LEADING INDICATORS

Designed to anticipate emerging trends (housing starts, manufacturers new orders, spotcommodity prices), average hours worked, stock prices and money supply (available liquidity)

Composite Leading Indicator (10 leading indicators combined by StatCan into single index):S&P/TSX Composite, real money supply, US Composite Leading Index, US Composite LeadingIndex, new orders durables, Shipments-to-Inventory Ratio (FG), average work week, employment,furniture & appliance sales, durable goods, sales of other retail durables, Housing Index, etc.

Note: Trends in published statistics is only observable after economy has already moved into the trend.Sometimes false signals may be given.


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CSC Summary

COINCIDENT INDICATORS

Change at approximately same time as direction of whole economy. Examples: Personal income, GDP, industrial production, retail sales

LAGGING INDICATORS

Changes after the economy as a whole changes Examples: UNEMPLOYMENT, private sector plant and equipment spending, business loans, interest

rates, labour costs, inventory levels and inflation rate.

Note: Popular definition of recession involves 2 consecutive quarters of declining growth. StatCan, however judgesrecessions by depth, duration and diffusion of decline of business activity.

Sof t landing refers to business cycle phase in which economic growth slows sharply but does NOT turnnegative, while inflation falls or remains low. Considered Holy Grail of policy makers

Labour Force is defined as sum of working-age population who are EMPLOYED or UNEMPLOYEDIn 2010, 27.6M Canadians were working-age, 18.6M were labour force, 17.1M were employed

Participation rate is going up over last 50 years, from 54% in 1960s to 67% in 2010

Unemployment highest during recessions of 1980-1983 (11.9%)1) Partici pation Rate is the % of working-age population that is in the labour force (willingness to enter)2) Unemployment Rate is the % of labour force who are unemployed and actively looking for work3) Discouraged workers are available and willing to work but feel they cannot find jobsA) Cyclical unemployment: closely tied to fluctuations of business cycleB) Fricitional unemployment: normal turnover, switching jobs, creation or destruction of jobsC) Structural unemployment: unable to find work, live in different places, lack skills, wage too low. Very

closely tied to changes in technology, intl competition, govt policy, etc.

Rising Unemployment in Canada:

Labour market regulations discourage hiring (minimum wage) Rigidities such as labour unions, payroll taxes, indirect labour costs Welfare and unemployment insurance benefits, generosity of social assistance programs Severity of current recessions, obsolescence of certain types of jobs, changing tech environment

Natural unemployment rate, full employment unemployment rate, non-accelerating inflation

rate of unemployment (N AIRU) is the minimal level of unemployment that does NOT ca. use other negativeeffects.This rate is estimated by BoC at 6.5% - 7%. Divergences between actual unemployment rate and NAIRU can help

us gauge where the economy is at. NAIRU is often viewed as the rate that corresponds to STABLE INFLATION.

Interest rates important to link between current & future economic activity. These factors might bedeterminants:

Supply and Demand (preferred habitat) Default Risk, Inflation, Central Bank Credibility Central bank operations (has much more of a long-term impact esp on bond yields) Foreign interest rates and exchange rates

Interest rates affect the economy in the following ways:

Affect cost of capital for business investments Discourages consumer spending, increasing household portion of income spent on financing homes, etc.


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CSC Summary

Money and Inflation

Functions as store of value, unit of account and medium of exchange.M1 : currency, personal chequing, demand deposits (chartered banks) held by individuals & businesses

M2 : personal savings at chartered banks, non-personal notice deposits (chartered banks)

M2+: deposits at trusts, loan, mortgage, credit unions, life insurance annuities, money market mutual fundsM2++: CSBs (saving bonds), non money-market mutual fundsM3 : non-personal term depositsat chartered banks, foreign-currency deposits at chartered banks

Consumer Price Index (CPI) shopping basket of 600 different goods and services, weighted to reflectspending

Impacts o f Inflation:

Erodes standard of living on fixed income and those who lack bargaining power. Rewards those who canincrease income through wages, investment strategy, magnifies social inequities

Reduces real value of investments, mortgages, debt, etc. Distorts price signals (price is critical in balancing supply & demand) Usually brings about rising interest rates and recession (if accelerating so much)

Causes of Inflation:

Neutrality of money (changes in money growth fully reflected in inflation rates)

Higher money growth, lower interest rates, boost spending and investment, cause inflation Phillips Curve relationship between inflation and unemployment (short-run inverse relationship) Output Gap (Actual GDP Potential GDP) Potential means max level of real GDP without inflation Demand-Pull Inflation scenario when strong demand allows corporation to charge higher prices,

pushing inflation higher. Cost-push inflation caused by shocks from supply side of economy increaseprices

Disinflation is a decrease in the inflation rate. Phillips c urve explains relationship withunemployment

Sacrifice Ratio: how much should GDP be reduced to lower inflation by 1%. Could be as high as 5% Deflation is a sustained fall in prices, leading to decline in corporate prices, businesses have to lower

prices, cut back on production costs and wages, layoffs, unemployment rises, growth slows, no investments

International EconomicsBalance of payments is a detailed statement of countrys ECONOMIC transactions over a period of

time. The two components are current account (exchanges of goods and services between Canada & foreigners,earnings from investment income, net transfers like foreign aid) and the capital account (financial flows ofinvestmentts and capital between Canada and foreigners).

It can be thought of as a SUPPLY or DEMAND of Canadian currency. Current account deficitsDEPRECIATE the CDN$ because there is a demand for foreign goods. CDN$ has to be exchanged for foreign $.

In theory, the current account has to EQUAL capital account balances. Think about spending and financing!!

Current A cco unt Components

Merchandise trade most important of current account (Export $437b, imported $464b in 2009) 73% of CDN exports are to the US, import 63% from the US. Current account deficit of $43.5b in 2009 Investment Income is also important (paying interest or rents on capital goods) Canada usually runs a DEFICIT on services trade (freight charges, engineering & accounting, tourism) Transfers refer to assistance or unilateral transfers (immigrants, aids, donations, etc.)

Capital Account Components

Direct Investment: owning more than 10% of companies overseas Portfolio Investment:debt and equity securities (newly issued or T-Bills, etc.) International Reserve Transactions: Bank of Canada buying / selling CDN$ in curency markets

Exchange rates most important with the US. CDN manufacturers may elect to keep US$ price constant


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CSC Summary

Inflation differentials : countries with low inflation rates appreciate in currency Interest rate differentials: higher rates temporarily can appreciate currencies, attracts capital Current Account deficits mean spending more than earning. Depreciate currencies, demand more

foreign

Economic Performance Public debts and defici ts: sometimes incentive to let inflation grow to reduce debt, running deficits if

domestic savings are insufficient, may cast doubts about credibility to pay back

Terms of trade: ratio of changes in export prices to import prices.

Political stability: investors seldom like unstable or disreputable govies Can be STABILIZED by moving interest rates

CH5 ECONOMIC POLICY

Rational Expectations Theory suggests that firms and workers alike are rational thinkers, can undoconsequences of government policy.

Keynesian Economics advocates use of DIRECT GOVT INTERVENTION (1930 worldwide depression at thattime John Maynard Keynes) to achieve growth and stability by lowering taxes or increasing spending

Monetarist Theory suggests economy is INHERENTLY stable, will automatically lead to a stable pathof growth. Milton Friedman proposes that instability in MI is the major cause of fluctuations ofreal GDP & inflation. Central banks should raise MI by 2%-3%, economys long-term growth

Supply-Side Economics proposes that markets should be left on its own. However, contrary to the monetarist

view, supply-siders suggest interventions should only occur through TAX RATES which stimulates invest

Fiscal Policy is the use of govt spending & taxation powers to pursue goals like employment, sustained growth,

etc Federal government responsible for EI, defence, old age security. Provies healthcare, education, welfare.

Federal Budget is submitted by Minister of Finance to the House of Comons every year. National debt is the

sum of past deficits and surpluses. Important because it tells the public and foreign investors how much theywill be refinancing or borrowing in future years. Alternative is to tap on civil service pension fund

Government Revenues: Personal, corporate, non-resident income taxes, goods & services tax, energy taxes,

custom import duties, others, EI premium revenuesGovernment Expenses: transfers to persons, other levels of government, direct program expenses, debt charges

Fiscal policy affects economy in SPENDING, TAXES and DEFICIT. Taxes discourage activities being taxed.Deficits lead to borrowing, national debt, interest payments. Highest in 96-97 $563b, fell $100b until 2009

A utomat ic Stab iliz ers are built in measures to stabilize GDP without real intervention. Makes business cyclesless severe. Tax system hits individuals more if the economy is good. EI increases during bad times.

BANK OF CANAD A (founded in 1934: BoD, Governor, Senior Deputy Governer, 12 Directors)

Regulate credit & currency in the best interests of economic life of nation Control and protect external value of national monetary unit Mitigate by its influence on general levels of production, trade, prices and employment Promote financial and economic welfare of the Dominion Act does NOT specify methods in which BoC may achieve these objectives, but grants powers


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CSC Summary

Functions of the BoC: Issuance and removal of bank notes, fiscal agent of Government (debt management,

advisory, forex, monetary) and to conduct Monetary Policy

Fiscal Ag ent: manages accounts & deposits (BoC & chartered banks) and the Exchange Fund Account (forex

reserves). Act empowers BoC to buy or sell gold, silver and forex, maintain deposits with other banksinside and outside Canada, act as agent and depositary for central banks & intl institutions.

Monetary Polic y sets to improve economys performance, regulates growth in money supply & credit.

Curerntly, TARGET INFLATION RATE is between 1%-3% per year.

Overnight Rate: interest rate set in the overnight market (financial institutions borrowing & lending). Operating

band is 50 basis points, target is in the MIDDLE. Bank Rate is the MINIMUM rate (upper limit of theband) at which BofC lend money to chartered banks, members of the Cdn Payments Association

(CPA).

Open Market Ope rations

Special Purchase & Resale Agreements (SPRAs): combats upward pressure on overnight rates(WANT LOWER INTEREST RATES). Prevents dampening of business acitivity, BoC offers to LEND at

the UPPER LIMIT (BANK RATE). They purchase bonds from chartered banks and resell them the next

day.

Sale and Repurchase A greements ( SRAs) : relieve undesired downward pressure. BoC proposes toborrow from members at LOWER LIMIT if the overnight money is trading below that rate. Preventsinflationary pressures. Sell government securities to members and repurchase them the next day.

Note: Changes in overnight band accompanied by press releases to reduce confusion and increase transparency.

Large Value Transfer System (LVTS) created in 1991 for participating financial institutions to conduct

large trades with each other through electronic wire system. Tracks receipts and payments throughout the day.

Members send payments back and forth to each other. Does NOT make sense for institutions to lend orborrow money outside the operating band

Drawdowns refer to the TRANSFER of deposits FROM chartered banks TO BoC (raise interest rates) Redeposits TRANSFER of deposits FROM BoC TO chartered banks (lower interest rates)

Notes: Monetary policy may be effective in the SR but NOT in the LR. In late 1970s and early 80s, governmentdid not try hard enough to reduce national debt, remained really high until most of 1990s. Interest burden

made it hard to reduce deficit. Budget surpluses in 2000 helped. Often, fiscal policy is unsynchronized with

monetary policy. For instance, late 1980s, inflationary pressures and growing economy was not coupled bylarge deficits (increase pressures and raise interest rates more, cost of debt servicing increased. Largenational debt PREVENTS govies from running counter-cyclical fiscal policy. Investors sell

bonds, driving up interest rates.

CH6 FIXED INCOME TYPES & FEATURES

Fixed income market is $6.1 trillion in 2009 (secondary debt market), approximately 5 imes total equity trading of$1.2 trillion and over 4.5 times of Canadas GDP of nearly $1.34 trillion.

Bond issues are accompanied by a trust deed, outlining details of the issue and written into a bond contract. Trustdeed provisions enable physical assets to be sold if bankruptcy occurs. Most pay interest 2X a year.

Debentures are the same as bonds but are not secured by physical assets (general claim on residual assets or byissuers general credit rating). Some fixed income are floating-rate securities, index-linked notes.


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CSC Summary

Denominations are usually $1,000s or $10,000s. Larger ones may be issued to suit preferences of big

institutions. Money market funds have maturities


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CSC Summary

Can only be purchased between October and April each year Not transferrable, not sold in bearer form, no secondary market Prices dont fluctuate, may always be cashed at FULL PAR VALUE plus INTEREST ACCRUED Must be registered in individual, estate or trusts name May be given as collateral for loans from chartered banks Sold to PAYROLL SAVINGS PLAN by Bank of Canada

Regular Interest CSBs Pays annual interest either by cheque or direct deposit (November 1st each year) $300, $500, $1000, $5000, $10,000 Maximum of five $300 and $500 bonds each for each registered owner Cashing i n first 3 months after issue date: Only receive face v alue Interest payments taxable at regular income tax rate

Compound Interest CSBs

Allows borrower to forgo interest, minimum denomination of $100 Compound interest calculated each November 1st, accrued in equal payments for next 12 months Redemption: Whole face value plus total interest Should be redeemed early in the month if not lose interest for the month not ended Report accrued compound interest as taxable income

Canada Premium Bonds

Very similar to CSBs, higher interest rate, only redeemable once a year without penalty Redemption: Anniversary date and 30 days thereafter

Real Return Bonds

Pays interest throught life of bond, principal at the end Coupon payments and principal repayment are adjusted for inflation Fixed REAL COUPON RATE, principal also adjusted for inflation Bonds inflation compensation

PROVINCIAL AND MUNICIPAL SECURITIES:

For program spending, social welfare Same like Govies, Provies are actually debentures (promises to pay, no assets pledged) Provincial bonds have lower credit rating than govies, taxation powers 2nd to government Bond quality determined by credit and market conditions Credit depends on amount of debt, federal transfer transfer payments, stability of provincial government

and wealth (natural resources, industrials, agriculture, etc.)

Guaranteed Bonds

Crown corporations (provinces guarantee their bonds) Provinces also borrow from international markets, or lend Issues sold abroad underwritten by syndicate of dealers and banks Global Bo nd Offerings distributed simultaneously in local and foreign markets, settle in different

clearing agencies (EuroClear or Cedel)

Provincial Savings Bonds: only residents, only certain time of year, 6 mths redemptionsInstalment Debenture (Serial Bond)

Used by most municipalities, part of the bond matures during the term (amortization) Only Montreal, Toronto and Vancouver issue term debentures with bullet maturities Usually non-callable, rank below provies and govies


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CSC Summary

Credit rating depends on taxation power and resource, transportation facilities, good paymentrecords, industrial growth, debt per capita, etc.

CORPORATE BONDS:

More options for financing, sell assets, issue equity, borrow funds from investors, higher yieldMost common types are listed below:

Mortgage Bond

Legal agreement to pledge land, buildigns or equipment (protective covenant) Created when capital requirement of firms became too large to be covered by individuals Deposited with trustee, usually split into $1,000 multiples First Mortgage Bonds: senior securities (1st charge on assets); best security companies can issue,

especially if it applies to all fixed assets hereafter acquired

After acquired clause means that all assets can secure the loan, even those purchased afterwards Collateral Trust Bond

Secured by pledge of securities (own securities of subsidiaries) Equipment Trust Certif ic ates a variation: pledge equipment as securities instead of real property

Floating Rate Se curities (Variable Rate)

Offer protection when interest rates are volatile When interest rates fall, however, payments are adjusted every six months Minimum rate protection sometimes

Corporate Notes

Unsecured promise to pay interest and repay funds Secured note or a collateral trust note (finance companies often pledge notes as security) Sold to financial institutions or investors with diversified portfolio Secured Term Note backed by a written promise to pay (auto loans, appliances)

Strip Bonds

Group of high-quality bonds, separates individual coupons from the principal payments and the rest of thebond, bond residue

These bonds have no interest payments (income is considered interest) Should be held in a tax-deferred plan RRSP

Foreign-pay bonds offer increased opportunity for portfolio diversification, choice of interest paymentsin two or more currencies

Eurobonds are issued in foreigncurrency. For example, canadian issuer in France issuing US$ bonds

Yankee bonds for US$ bonds

Preferred Securities

Very long-term instruments (25-99 years) Subordinated to all other debentures, but rank above preferred shares Interest can often be deferred Often traded on an exchange, better yields, lower priority than other debentures More secured than preferred shares, may be taxed on accrued unpaid interest

Bankers Acc eptance


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CSC Summary

Written instruction to make payment (commercial draft) Guaranteed at maturity by borrowers bank Sold at a discount like T-bills, mature at face value Minimum initial investment of $25,000, generally between 30 to 90 days maturity

Commercial Paper

Unsecured promoissory note (asset-backed by financial assets)


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CSC Summary

Current Yield on Bond = Annual Cash Flow / Current Market Price X 100 (doesnt consider purchase)

Yield to Maturity = total return expected to earn over life of the bond (assume no defaut)

YTM includes investors return from coupons and also the capital gain or loss from purchasing the bond at a price

different from par vaue.

Approxi mate Y TM Formula: [(Interest +/ - A nnual Price change)] / [ (Purchase + 100 )/2 ] X 100

Reinves tment Risk: risk that coupons cannot be reinvested at the same rateOnly a zero-coupon bond has no reinvestment risk

Term Structure of Interest Rate: Graph is called a Yie ld Curve . Why interest rates vary?

Real Rate of Return and Inflation Rate Determined by supply and demand for funds Real rate rises 1) through business cycles, lower during recessions and higher during booms and 2)

Unexpected changes in inflation rate (satisfactory real rate)

Yie ld Curve depicts relationship between long and short-term bonds1) Expectation Theory: what investors expect future interest rates to be, consensus2) Liquidity Preference: short-term bonds will have lower yields because of more demand3) Market Segmentation Theory: where big players concentrate their investments (pension funds)

Inverse Relationship between Interest Rates and Bond Prices

Long-term bonds are more volatile than short-term bonds: Interest Rate RiskLower-coupon bonds are much more volatile than high-coupon bondsRelative Yield changes are much more important than absolute yie ld changes

Duration used to compare bonds with different coupons and different terms to maturityMeasure of the sensitivity of a bonds price to changes in interest rates

The higher the duration of the bond, the more it will react to changes in interest ratesIf Duration = 10, price will change 10% for every increase of 1% in interest rates

Bond Switches involve replacing a bond with another to capture possible benefits:Net Yi eld Improve ment improve after-tax yield without adversely affecting quality

High-tax bracket will be better off in deep discount bonds (capital gains taxes)Low-tax bracket would be safer in a high-coupon bond

Time Reduction or Extensio n change in the maturity terms of the bonds

Credit Improvement can improve yields for corporate bonds

Portfolio Diversification

Cash Take-Outs possible when proceeds from sale is greater than reinvestment (discount)

Settlement Period: period of time until the securities have to be delivered

GoC Treasury Bills Same day

GoC < 3 years Second clearing day after transactionGoC > 3 years & all others Third clearing day after transaction

Bearer Bonds : risk of losin gcertificatesRegis tered Bo nds : non-transferrable (only when owner signed back of certificate) coupons mailed

Boo k-Based f ormat: issuance only with depository, trade clearing and settlement services provided byparticipating providers, CDS (Clearing and Depository Services Inc.)


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CSC Summary

Accured Interest: calculated from principal amount, coupon rate, time period

**Amount is based on par values, NOT on market values could have been purchased at discount orpremium. Also the interest rate is the coupon rate instead of its yield

** Do not include the date of last coupon payment, but include the day of settlement!

** But ONLY the lesser of the accrued interest and a full coupon payment is paid

Bond Indexes are used:

Performance of the overall bond market Performance of bond managers Bond index funds

PC Bond, business unit of TMX Group: offers set of Cdn bond indices

DEX Universe Bond Index tracks the overall Canadian bond market, best known Represented govies and corpories About $1 trillion in market cap as of September 2010 Measures TOTAL RETURN including realized and unrealized capital gains and also reinvestment of

coupons

Capitalization weighted index Merrill Lynch also maintains set of bond indexes for the US RBC Dominion Securities, CIBC Wood Gundy, S&P, Salomon Smith Barney and JPM(US)

CH8 EQUITY SECURITIES COMMON & PREFERRED

Common Shares

Provide initial equity capital to start business Sometimes referred to as venture / risk capital (risk profile) Dividends payable at discretion of BoD, less certainty for cyclical companies Street certificates registered in name of securities firm (readily transferrable to new owner) CD S offers computer-based systems to replace certificates (no need to handle physically) Standard Trading Unit (100 shares), otherwise odd lot Viewpoint of the company: Effect of a sale is that a new name appears on its list of shareholders

Benefits of comm on shares: potential for appreciation, dividends, voting rights, favourable tax treatment, liquidity,right to receive annual reports, limited liability, right to question management in meetings

Regular dividend: indicates payments investors can expect to be maintained

Extra dividend: usually at end of FY, extra bonus if favourable economic conditionsStreet certificates: dividends are mailed to the securities firm

Ex-dividend: The date after which purchase will not receive dividends

Cum-dividend: opposite of ex-dividend

Div idend Record date: two to four weeks in advance of the payment date (second business day after ex-dividend)Payment date **Trade settle on the third business day after a trade

Open orders: limit orders to buy/sell security can more likely be executed when stock goes ex-dividend

Div idend Reinvestment Plan: reinvested in common stock, taxable as ordinary cash dividendsMade on the open market (repurchases) under trusteeCommission savings for companies to repurchase shares in bulk

Dollar Cost Average (reduce average cost per unit paid), fractions of shares cannot be purchased individually


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CSC Summary

Stock Dividends: cash is conserved for expansion purposes, additional shareholders receive shares

Treatment on Retained Earnings would be the same as cash dividends (tax purposes also)

Restricted Shares

Unlimited participation in the earnings of a company (no full voting rights) Non-voting: no right to vote at all, except in limited circumstances Subordinate voting: class of shares with higher voting power Restricted v oting: carry right to vote, limited to % shares that may be voted by an individual Must be identified by the appropriate restricted share term (Stock exchange regulations) Disclosure documents, info circulars, annual reports, statements must be sent to holders, invited to meeting Must be identified in financial press with a code, must be confirmed when making trade

Tax Treatment

Current taxation 50% of capital gains taxed Dividend tax credit, Stock savings plans (deduct annual amounts from cost of some stocks in

provinces)

Pre-tax yield lower than debt investments (tax treatments of interest vs. dividends) Debt is paid from companys pre-tax dollars, dividends after-tax dollars Foreig n divi dends dont have the same privilege (non-taxable Canadian corporations)

Example: $100 dividend, $45 (45% is the grossed-up amount), $145 (taxable amount of dividend)

Then claim a 19% credit of $27.55 (reduces income tax paid)

Stock Split directors pass a by-law for approval by voting common shareholders

Usually a dividend increase anounced at the same time can have a bullish impact after splitMain reason for splits: investor aversion to purchasing odd lots of high-priced securities, commissions

Reverse Splits: company shares fell to unattractive levels for large capital investors, can put company in a betterposition to raise new capital

Preferred Shares: each class has to be separately identified, pari passu means preferred share issues which

rank the same to asset an dividend entitlements, preferreds have no maturity dateNo voting privileges as long as dividends are paid as schedule (unless certain number of dividends omitted)

Voting available on matters affecting the quality of their security (new issuance)Preferrence as to assets clause ahead of common shares is not unusual

Dividends are paid from earnings: current or past (not obligatory, but have to be paid if enough earnings)Div idend Rate is very important, no upside potential like common

Investors may buy preferred to seek income, good tax treatment

Cumulative Feature unpaid dividends pile up, favourable for purchaser, no payments to preferred shareholders

who sold their shares, Non-cumulativeonly entitled to payment in a specific year, when declared

Why issue preferred but not debt?

Not feasible to issue debt (market conditions unfavourablle) Debt/equity issue already high, financial conditions not stellar enough to support interest & principal Low tax rate, not too much of a burden paying preferred dividends Avoids dilution of equity Before issuance of preferred, rights of bondholders in trust deeds or indentures have to be considered

Callable Pref erreds provide for a small premium above par value as compensation (open market or tenderoffer)Non-callable Preferreds cannot be called unless company is liquidated or delisted: freezes capital structure

Rarely built into the security


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CSC Summary

Straight Preferreds pay fixed dividend rate, trade on a yield basis (normal preferences to assets & dividends)

Tax advantage dividend tax credit, less safe than debt howeverFixed dividend rate which will NOT be increased

No voting privileges, no maturity date, poorer marketability, limited appreciation potential

Conve rtible Pref erreds similar to convertible debt-like instruments at a predetermined conve rsio n price

Specify the number of common shares the preferred is convertible Preferred price is set at a modest premium (10-15%) to discourage early conversion Expire after a stated period of time, usually 5-12 years after the issue Dividends usually less than straight preferreds, provide higher yield than common No need to pay commission to obtain common shares, vulnerable to decline if common is going down Revert back to straight preferred if conversion expires

Conversion Cost Premium Illustration:

P = $62.50, C = $18.50 can convert 1P for 3C, 3 X 18.50 = 55.50, $7 premium $7 / $55.50 = 12.61% premium see below: 12.61% / 1.70% = 7 years to repay premium Div (P) = $2, Yield = 3.2%; Div (C) = $0.2775, Yield = 1.5%, Difference = 1.70%

Retractible Pref erreds shareholders can force company to buy back preferreds for cash at specific date & price

Soft retractable preferreds may be paid, when redeemed in CASH or COMMON SHARES (choice) Shorter time to retraction date causes more stable stock price when interest rates move Will provide capital gain if bought at a discount, sell above retraction price if interest rates fall Privilege will expire after a certain time if no action taken by holder during election period Become straight preferreds if not retracted

Floating-Rate Preferreds:

Are issued in markets where straight preferreds hard to sell, or when issuer believes interest rates peaked Delayed floaters, fixed-reset or fixed floaters: entitle holder to fixed dividend after rates become

variable

High income if interest rates high, low if they fall (less responsive to changes in interest rates)Foreign-Pay Preferreds:

Desirability of receiving dividends in funds other than Canadian, foreign currency risk DIVIDEND IS ELIGIBLE FOR TAX CREDIT: issued by CANADIAN COMPANY TAXABLE

Participating preferreds share in earnings power of common above their specified dividend rate

Deferred preferreds do NOT pay regular dividend, return based on purchase price (discount) & redemption

value

Dividend premium is the difference between purchase price and redemption value Not eligible for dividend tax credit, taxed as ordinary interest income If sold before maturity date, then taxable as CAPITAL GAINS Allow deferral of payment of income taxes until a later date

Stock Index indicators (value-weighted) used to measure overall performance of stock market, create indexmutual funds, enable fund managers to measure performance, underlying for options, futures, ETFs

Stock Average indicator that is arithmetic average of current prices (price-weighted)

DOW JONES INDUSTRIAL AVERAGE is PRICE-WEIGHTED 30 blue-chip stocks that trade on the NYSE (sum of the prices, divided by divisor which adjusts sum of

stock prices to accurately reflect changes in value from mergers orstock splits)

Canadian Market Indexes


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CSC Summary

Toronto Stock Exchange and TSX Venture Exchange publish stock prices for different industries Indexes, dividend yields, P/E ratios can be found in TSX Monthly Review, Bank of Canada review S&P/TSX Composite Index began first index in 1934, measures changes in total market cap of stocks Composite Index: weight changes if price and number of shares change

How c an a stock be included in the S&P/TSX Composi te Index?

Must be listed on the TSX for at least 12 full calendar months

Minimum trade-weighted price of $1.00 over the past quarter Closing price greater than or equal to $1.00 at previous month-end Must represent a minimu weight of 0 .05% Trading volume, value, transactions for the 12 months preceeding must be at least 0.025% of the

sum of all eligible companies, trading volume, value and number of transactions

No more than 25 non-trading days bover the past 12 full calendar months Stocks are reviewed quarterly Stocks classified into 10 sectors based on Global Industry Classification Standard (GICS), developed by

Morgan Stanley Capital Intl (MSCI): Financials, Energy, Materials, Industrials, Consumer

Dis cretionary, Utili ties, Health Care, Consumer Staples, Tel eco mmunications, IT

Three subsector indices specific to CDN market: Diversified Mining, Real Estate, GoldTotal Return Indexes measure change in value of portfolio by stock price fluctuations AND reinvestment of

dividends and other distributions (total compoudn return): recalculated dailyThe base was set equal to 1,000 in December 1976, closed 31,019 Dec 2009, S&P TSX closed 11,746% chnges are more accurate barometer for market performance rather than point changes

S&P/TSX 60 Index: Dec 1998 new partnership S&P and TSX (60 largest companies by market cap), dividedinto 10 sectors that cover all the subgroup (everything on this index must be included in S&P/TSXComposite

S&P/TSX Venture Composite Index: Managed by S&P, market cap based index, companies eligible to be

listed if they are incorporated in Canada and represent at least 0.05% of the index capitalization;

revised quarterly; stocks eligible must be listed on the TSX Venture Exchange for at least 12 full calendar

months

Dow Jones Industrial Ave rage

2,300 issues trade on NYSE, 30 make up the DJIA, only few companies included in average Price-weighted, higher priced stock distorts average, greater day-to-day fluctuations Divisor continuously adjusted (if there is a 2 for 1 stock split, divisor decreases by 1) Composed of blue-chip stocks with lower-risk profile, tend to underperform broader market

New York Stock Exchange five indexes: composite, industrials, transportation, utilities, finance & real

estate

American Market Value Index AMEX market-weighted 800 stocks includes reinves tments, Total

Return

NASDAQ Composite Index: market-weighted 4,000 stocks, dominated by smaller market-cap companies

Value Line Composite Index: 1,700 stocks average daily % change in eah stock (equally weighted),

created by Wiltshire Associates and is the broadest available barometer of US indexes

Nikkei Stock Average (225 Price Index): price-weighted, first released in Tokyo Stock Exchange in 1950

(DJIA)


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CSC Summary

FTSE 100 Index: 100 largest listed companies, market-cap weighted, calculated by the minute

German DAX Index: 30 blue-chip market-cap weighted stocks (Total Return, reinvestment of dividends)Set to 1,000 in 1987

CAC 40 Share Price Index: 1988 based on 40 of the largest 100 companies in FranceSet to base of 1,000 on Dec 31, 1987

Swi ss Market Index (S MI): Swisss blue-chip index maximum of 30 largest and most liquid stocks

Set to 1,500 in June 30, 1988

CH9 EQUITY SECURITIES TRANSACTIONS

Cash Account: make full payment for purchases or full delivery for sales before settlement dateMargin Account: buy/sell securities on credit (pay part of full price, interest charged daily on debit balance)Free Credit Balances: uninvested funds held in accounts, dealer member may use as financing, payable on

deand

Margin: amount of funds investors must personally provide

Long margin positio n: partially finance the purchase of securitiesShort margin position: arranging for dealer to borrow securities to cover short positionMargin Account Agreement Form: need to be obtained before client opens an account

Long Margin Accounts: Maximum Equity Value Loans (strictly enforced and regulated

by IIROC)

At $2.00 and over 50% of market value

At $1.75 to $1.99 40% of market value


Under $1.50 No Loan Value

Securities Eligible for Margin Reduction 70% of market value

IIROC produces a quarterly list of securities eligible for reduced margin (high liquidity, low volatility)

Exchange prohibits one dealer member from accepting another dealer member transfers of any under-marginedaccount unless the member holds sufficient funds or collateral to the credit of the account

Increased market risk(magnifies outcome) Loan and interest must eventually be repaid Margin calls must be paid without delay Dealer can sell securities or vcover a short position (cut loss) No limit on how long a short-sale can be maintained as long as no de-listing or liquidation Dealers loan securities to clients of other firms because the short seller must put up margin, can be

used in the investment dealers business free of interest

Short sales best done on large-capitalization companies on which trading is liquid IAs entering orders for short sales must clearly mark the sell-order ticket with a Short or S Difficulty in borrowing sufficent shares for shorting, responsible for maintaining adequate margin Liable for dividends or other benefits paid when the account is short Difficult to obtain info on total short sales on a security Prices very volatile when shorts are scrambling to cover

Short Margin Accounts: Minimum Credit Balance (strictly enforced and regulated by

IIROC)

At $2.00 and over 150% of market value

At $1.50 to $1.99 $3.00 per share


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CSC Summary


Under $0.25 100% of market value plus $0.25 per share

Securities Eligible for Margin Reduction 130% of market value

Trading Proc edures :

Buyer and seller consults IAs and decide to trade after confirming the bid and ask prices Instruction given to IAs to give best possible price (orders above 2,000 handled electronically + personally) Exchanges data transmission system reports trade over exchanges ticker, details relayed to IAs

IAs originate transaction, confirm transactions to clients

Settlement Procedures:

Confirmation provided, settle transaction, commissions, provide additional margins, etc. Entries made in the security firms book of recordsTRADITIONAL AGENCY TRANSACTION Traditional Agency Transaction Model: 2 different parties buying and selling through 2 different

firms

Single Investment Dealer: transaction price is determined from that on the exchange CROSS Client vs. Investment Dealer: From firms inventory, price is market value on the exchange

(regulated)

Market Order, Limit Order, Day Order

GTC Order (30 days) , Al l or No ne (AON) , Any Part OrderGood Through Order specified period, automatically cancelledStop Loss Order becomes Market Order when stop price is reached: for long positionsStop Buy Order protect a short positionProfessional (Pro) Order protect public interest; clients order given priority (partner, director, officer,

shareholder, IA, holder of confidential information); labelled Pro orN-C (non-client)orEmp (Employee)

CH10 D ERIVATIVES

Derivative financial K between two parties dependent on underlyi ng asset: stock, bond, currency, interest

rate...Options and forwards: with forwards, both parties obligate themselves to trade at the specified price

Forwards: one or both parties make a performance bond orgood-faith deposit which gives other partyhigher assurance that terms will be honoured.

Options: payment is made to seller from buyer (premium)Derivatives are a ze ro-s um game, unlike stocks and bonds

The difference between exchange-traded and OTC stocks or bonds is simply trading mechanicsThe difference between exchange-traded and OTC derivatives is much more pronounced!!

OTC Derivatives: active market with loosely connected and lightly regulated brokers and dealers Negotiate deals directly with one another over telephone ./ computer terminals Dominated by financial institutions, brokerage houses, trading firms (no regular hours) Contracts that can be tailor-made to meet specific needs

Exchange-Traded Derivatives

Legal entity for the purpose of trading derivatives, standardization, liquidity and credit risk Exchange provides floor for trading, regular hours, regulations, order and transparency Montreal Exchange (Bourse de Montreal) and ICE Futures Canada Montreal Exchange lists options on stocks, bonds, indexes and futures on bonds and indexes ICE Futures Canada lists futures and futures options on agricultural goods


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CSC Summary

Why have the two markets existed harmoniously: differences?

OTC Markets are flexible (contract terms), but NOT Exchange-Traded Markets, Unregulated! Neither the public nor competitors know the transaction in an OTC market. OTC contracts cannot be transferred through a secondary market, standardized derivatives in exchanges Default riskmajor concern for OTC (have to establish creditworthiness) restricted to large players Clearinghouses, set up by exchanges, guarantee financial obligation of each party.

These clearinghouses become seller for each buyer and buyer for each seller. Once transaction is made, the counterparty is the clearinghouse Canadian Derivatives Clearing Corporation (CDCC) is responsible for Montreal Exchange ICE Clear Canada is responsible for clearing ICE Futures Canada trades Unrestricted growth and financial innovation and engineering in OTC markets Efficiency, transparency and fairness is brought about by the exchange-traded markets Fees are built into prices for private OTC transactions

Underlying Assets: generally commodities and financial assets

Commodity Futures and Options (most are exchange-traded, except energy):

Commonly used by producers, purchasers, processors to protect themselves (hedging) Soyeans, crude oil, copper, cattle (consumption) or gold, silver (speculation) Depends on supply, demand, political & economic conditions, agricultural production, weather, etc. Grains & oilseeds: wheat, corn, soybean, canola Livestock and meat: pork bellies, hogs, live cattle, feeder cattle Forest, fibre and food: timber, cocoa, sugar, cotton, orange juice and coffee Precious and industrial metals: gold, silver, platinum, copper, aluminum Energy products: crude oil, heating oil, gasoline, natural gas, propane (mostly OTC derivative s)

Derivatives growth for past two decades fuelled by interest rates, exchange rates, f inancial deregulation,globalization of trade, information technology advancement, innovation in f inancial engineering

Equi ty Options mostly traded in Montreal Exchange, Chicago Board Options Exchange (CBOE), Intl Securities

Exchange (ISE), Boston Options Exchange (BOX), American Stock Exchange (AMEX)

Int ere st Rate Future s in Canada all trade at the Montreal Exchange (Bourse de montreal)

Mostly based on well-defined floating interest rates like LIBORCurrency Futures most commonly in US$, Pounds, Yen, Francs and Euros (exchanges)

Currency Forwards and Swaps traded in the OTC market, NO DERIVATIVES ON CDN EXCHANGES

1) Individual Investors 2) Institutional Investors 3) Business & Corporations 4) Derivative DealersFirst three groups are end users of derivatives (speculation or protection, risk management)

Last group of derivative users (dealers): try to trade derivatives with end users (earn profits from volume)Adverse effects (bid-ask spreads), transaction costs, commissions, admin fees can be hefty in thinly-traded markets

Derivative Dealers in Canada: big six banks and subsidiaries, Canadian subsidiaries of large foreign banks.

OPTIONS

Strike / Exercise Price, Option Premium (always on a per-unit basis, NOT per contract)

Writers of Exchange-Traded Options are required to maintain sufficient marginTrading Unit: one option contract consists of 100 shares

LEAPS: Long-Term Equity AnticiPation Securities (long-term option contracts with same risks and rewards)Equity and Long-Term Options: Volume rose from 10M to 15M from 2005 to 2009 in Canada


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CSC Summary

Volume came mostly from Montreal Exchange, ICE Futures Canada and futures options not so heavily traded

Opening Transaction (buy to open or sell to open)

1. Offsetting transaction: cancels the original position (sell to close or buy to close)2. Long position exercises the option, Short position assigned the option3. Left to be expired

Underlying Asset + Expiration Month + Strike Price + Option Type 10 PVG December 2011 9 calls

Exchange-traded option prices reported in business press the next day, just like stocks

Option v olume: sum of trading days volume in all series of XYZ optionsOpen interest: contracts that are outstanding and has not been executed

Buy call options: challenge is to select appropriate strike price and expiration date

Can limit potential losses in short position, profit by exercising oroffseting Offsetting allows investor to recover time value built into the option premium Risk Management: fund manager wants to purchase a stock but funds are not available yet CDN company could buy call option on US$ to hedge against exchange rate risk, OTC derivative

Writing call options: primarily for income, speculative but can be risk-management

Covered call ornaked call

All exchange-traded stock options are A merican-Style !

Buying put options: can be used to lock in minimum selling price (floor price) for stocks

Speculation or risk-management (married put / put hedge) Oil company CDN wants to sell 1 million barrels in the next six months Could buy put options at $68 a barrel to protect company against lower oil prices

Writing put options: provides income, speculative or risk-management

Covered put (not as common as covered call) ornaked put Cash-secured put write: writing a put and setting aside cash equal to strike price If possible, cash should be invested in short-term liquid money-market instrument Corporations use put options to hedge against interest rates, exchange rates or commodity prices

Forward: buyer and seller agree to a price today (OTC markets)

FUTURES: standardized forward contractfinancial futures and commodity futuresNo cash inflow or outflow during transaction date for futures, if NOT offset, then delivery will occur

Longs will have to acccept delivery and shorts have to deliver (if NOT offset or cash-settled)

S&P/TSX 60 Futures expire third Friday of each month Ten-year Govies expire third business day before last business day of the month Equity index futures are cash-settled (payment based on price differential) Futures margins represent a good-faith deposit or perforamnce bond Marking-to-market cash settling of gains and losses daily Initial (original) margin required when the contract is entered into Maintenance margin account balance that has to be maintained while contract is open 3-Month Bankers Acce ptances is the underlying interest rate for futures Month refers to the delivery month Change ( 1) is the difference between the price that day and closing price previous day Change ( 2) is the change in the number of futures contracts open on underlying interests Est Sales is the estimated volume for trading that day Previous Sales estimated volume the previous day Open Interest (1) the open interest on that specific futures contract


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CSC Summary

Open Interest (2) the total number of futures contracts open on the underlying interest Only two basic positions with futures: LONG or SHORT Buy and Sell Futures to Speculate or Risk management Firms in the commodity business might want to offset their hedges instead of continuing with delivery:

1) Save on delivery expenses 2) Quality differential 3) Standardized date in futures may differRIGHTS AND WARRANTS

Issued by companies to raise capitalRights are usually very short term (4-6 weeks), Warrants are long term (3 to 5 years)

Right: privilege to acquire additional shares from issuing company (direct proportion to shares they own)Exercis e, Subscription or Offering Price almost always lower than market price

Record Date, Ex-Rights D ate, Cum-Rights D ate

Usually, one right is granted for each number of outstanding common shares Should pay the subscription price, no commissions, fractional shares may or may not be issued Rights have very little time value, mostly intrinsic value Rights are listed on an exchange automatically if the stock is listed on the same exchange

Regular delivery: rights have to be settledd by the third business day TSX Venture: since three days before expiry, buyer and seller have to transact in cash (same day) TSX: 3 days before expiry (settle 1 day before); 2 days and 1 day (settle next day); Expiry date (same day) Rights to trade terminated at noon on the expiry date

Intrinsic Value of Rights during Ex-Rights Period = (S X) / N

Intrinsic Value of Rights during Cum-Rights Period = (S X) / (N+1)

During the Cum-Rights period, the rights are embedded in the common stock.A portion of the stock price

represents the value of the rights.

Warrant: security that gives holder right to buy shares at a set price for a specified period of time

Warrants are issued by companies themselves, unlike call options (by other investors / traders) Often issued as a sweeterner when raising capital through debt or preferred stock Warrants have lots oftime value, but may have no intrinsic value if market price below exercise price Leverage potential is attractive, magnifies positive and downside risk

CH11 FINANCING AND LISTING SECURITIES

Sole Proprietorship: fully liable debts, losses and obligations (one person), not regulated, free to make

decisions

Partnership: involves two or more persons (contributing capital, expertise), legistlated underPartnership Ac tGeneral Partnership: involved in day-to-day operations, personally liable for all debts

Limited Partnership: cannot participate in daily activities, liability limited to investment made in the business

In these forms of business organizations, there is unlimited personal risk

Corporation: unique distinct legal entity separate from its shareholders, can be sued or sue in court of law

Properties acquired do not belong to individuals, pays own taxes, liable for its own obligations Able to raise funds through debt or equity, suitable for large business units Basic procedure: file documents with appropriate department of federal and provincial govt, pay fees Government: issue charter, the formal document (name, date, location, authorized max capital, restrictions) Limited, corporation, incorporated


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CSC Summary

Chartered Banks must be incorporated under the Bank Act (companies formed by a specific act might nothave the word limited or equivalent included in its name

Advantages:

Limited liability, growth, ability to handle large amounts of capital Continuity of existence: not affected by death of shareholders (bankruptcy or termination only) Transfer of ownership between shareholders is relatively easy (liquidity)

Ability to finance by raising capital, shares of class, debt instruments, etc. Taxation benefits: tax deferrals and legitimate tax avoidance

Disadvantages:

Loss of flexibility (adhere to many rules and laws) Partnerships and sole proprietorships free of statutory regulations Earnings have to be transferred through dividends, changes in charters and by-laws require approval Taxation can be complex, possibility of double taxation (corporate and individual levels) Annual cost for tax returns, audits, shareholders meetings, compliance Withdrawal of funds can be cumbersome

The jurisdiction of incorporation must be selected usually pick the province where the corporations chief place

of business will take place (or incorporate underCanada Business Corporation Act: CBCA)

Decision-making depend on method of incorporation, tax rates, corporate names available, director residences,

Provincially incorporated firm might have to obtain permit to conduct business in other provinces

Federally incorporated firm may not be discriminated by provincial laws

Priv ate Corporation: right of shareholder transfer shares, limit to 50 shareholder names, prohibition to invite m

members of the public to subscribe for their securities

BY-LAWS OF A CORPORATION

Corporation is regulated by the federal or provincial ac t, its own charter, and its by-laws General by-law prepared at time of incorporation: contains rules that governs conduct of corporation:

1) Shareholders meetings: time, place and method of notifying shareholders, votes, quorum, proxy votes2) Directors meetings: time, place and methods3) Qualification, election and removal of directors, appointments, duties renumerations4) Declaration and payment of dividends5) Signing authority for documents; date of fiscal year end

Right to vote allows shareholders to control direction of corporation Unusual and non-recurring events like merger, liquidation, amendment of charter must receive approval To vote, individual must have shares registered in his/her own name Regular meeting: eligible shareholders notified of the meeting, elect directors, appoint auditors, receive FS Proxy power of attorney given by shareholder to designated person to vote (only for one meeting) Proxies are always revocable, they can also be for all meetings within a stated period. Information circular to notify shareholders meeting (must contain details about directors,

renumeration)

Voting trust for companies undergoing financial difficulties, restructuring (for example, newinvestments)

Transfer voting control: shareholders asked to deposit sh

Documents

Csc Summary i