ba interview notes 1

8/6/2019 BA Interview Notes 1

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Subject: Trading - Basics

This article offers a very basic introduction to stock trading. It goes through the steps of

buying and selling shares, and explains the fundamental issues of how an investor can

make or lose money by buying and selling shares of stock. This article will simplify and

generalize quite a bit; the goal is to get across the basic idea without cluttering the issue

with too many details. In some places I've included links to other articles in the FAQ that

explain the details, but feel free to skip those links the first time you read over this.

You may know already that a share of stock is essentially a portion of a company. The stock

holders are the owners of a company. In theory, the owners (stock holders) make money

when the company makes money, and lose money when the company loses money. Once

there was age of internet stocks where companies lost lots of money but the shareholders

still made lots of money (and then lost money themselves), but let's just say that the main

trick is to buy only stocks that go up.

Next we will walk through a stock purchase and sale to illustrate how you, an investor in

stocks, can make money--or lose money--by buying and selling stocks.

1. One fine day you decide to buy shares of some stock, let's pick on AT&T. Maybe you

think that company will soon return to being the all-powerful, highly profitable "Ma

Bell" that it once was. Or you just think their ads are cool. So now what?

2. Although there are many ways to buy shares of stock, you decide to take the old-

fashioned route of using an old-fashioned stock brokerwho has an office in your town

and (imagine!) takes your phone calls. You open an account with your friendly broker

and deposit some good old-fashioned cash. Let's say you deposit $1,000.3. You ask your broker about the current market price quoted for AT&T shares. Your

broker is a good broker, and like any good broker he knows that AT&T's ticker symbol

is the single letter 'T'. He punches T into his quote request system and asks for the

current market price (supplied from the New York Stock Exchange, where T is

primarily traded), and out pops a price of 20.25 (stocks were once quoted as fractions

like 1/4 but are now done with decimals). Looks like your $1,000 will buy almost 50

shares, but because this is your very first stock trade, you decide to buy just 10

shares.

4. You ask your broker to buy 10 shares for you at the current market price. In the lingo

of your broker, you give a market order for 10 shares of T. Your broker is a nice guyand only charges a commission on a single stock trade of $30 (not too bad for

someone who takes your phone calls). Your broker enters the order, and his

computer then figures the price you will ultimately pay for those 10 shares, which is 10

(the number of shares) times 20.25 (the current price for the shares on the open

market) for a total of 202.50, plus 30 (the broker's commission, don't forget he has to

eat too), for a grand total of $232.50.


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5. Then magic happens: your broker instantly finds someone willing to sell you 10

shares at the current market price of 20.25 and buys them for you from that someone.

Your broker takes money from your account and sends it off to that someone who

sold you the shares. Your broker also takes his $30 commission from your account. In

the end, your hard-earned money is gone, and your account has 10 shares of AT&T.

A (very small) fraction of the company, as represented by those 10 shares, is now inyour hands!

Now it's time for a few details, which you can safely skip if you choose. The person

who sold you the shares was a specialist ("spec") on the NYSE; for more information,

look into the NYSE's auction trading system. Roughly, a specialist is a type of

middleman and a member (like your broker) of the financial services industry. After

you give the order, the shares do not appear instantly; they appear in your account

three business days after you gave the order (called "T+3"). In other words, trades

settle in three business days.

Please pardon a fair amount of oversimplification here, but the trade and settlement

procedures involved with making sure those 10 shares come to your account can

happen in many, many different ways. You're paying that commission so things are

easy for you, and indeed they are: for a relatively modest fee, your broker got you the

shares.

It may be important to point out here that AT&T, that big company from Bedminster,

New Jersey, did not participate in this stock trade. Sure, their shares changed hands,

but that's all. Shares of publicly traded companies that are bought on the open market

never come from the company. Further, the money that you pay for shares bought on

the open market does not go to the company. Sure, the company sold shares to the

public at one point (an event called a public offering), but your trade was done on the

open market.

After the trade settles, then what? Your broker keeps some of the $30 commission

personally, and some goes to the company he works for. The shares are in your

brokerage account. This is called holding shares "in street name." If you really want to

hold the stock certificates, your broker will be happy to arrange this, but he will

probably charge you about another $30. Since you feel you've paid your broker

enough already (and you're right), you decide to leave the shares in your account ("in

street name").

6. The next day, AT&T shares close at a price of 21, which is a rise of $0.75. Great, you

think, I just made $7.50. And in some sense you're right. The value of your holdings

has increased by that amount. This is a paper gain or unrealized gain; i.e., on paper,

you're $7.50 wealthier. That money is not in your pocket, though, and you do not need


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to tell the IRS. The IRS only cares about actual (realized) gains, and you don't have

any, not yet.

7. The following day, AT&T shares close at a price of 22. which is another rise over the

price you paid and a rise over the previous day. Fantastic, you think, boy can I pick

them, today I made another $10! At this point, you have a paper gain of 10 times 1.75

which is 17.50. Not too bad for two days.8. That evening you decide that maybe AT&T really isn't such a great wireless phone

company after all and it's time to sell. You make a call the next morning, and although

your broker is a bit surprised to hear from you again so soon, he's obliging (after all,

it's your money). Again your broker asks for a quote of the current market price for 'T.'

The current market price for AT&T on the NYSE is 22.50 (wow, another rise). Your

broker accepts your order to sell T at the market. Again his computer figures the

money you will receive from the sale: 10 (the number of shares) times 22.50 (the

current market price) for a total of 225, less his commission of 30, for a grand total of

195.

9. Magic happens again: instantly your broker finds someone willing to buy the 10shares of AT&T from you at the current price, and sells your shares to that someone.

That someone sends you $225. Your broker deducts his commission of $30 from the

proceeds of the sale, so eventually the shares of AT&T disappear from your account

and a credit of $195 appears. Note again that the company did not participate in this

trade, although shares (and fractional ownership of the company represented by

those 10 shares) changed hands.

As explained above, that someone was a person at the NYSE called a specialist

("spec"), a member of the financial services industry. The trade will be settled in

exactly 3 business days (upon settlement, the shares are gone and you have thecash). Again I apologize for the oversimplification here.

10. So you calculate the result. Gee, you think, the stock went up every day..and I paid

$232.50.. but I only received $195.. and pretty quickly you come to the inescapable

conclusion that you lost $37.50, even though you had a paper gain every day. This is

the problem with commissions: they reduce your returns. You paid over 15% of your

capital in commissions, so although the share price rose about that much in just a

couple of days, you lost money because the commissions exceeded the gains.

11. Eventually you do your taxes. You have a short-term capital loss of $37.50 from this

pair of trades. Depending on your tax situation, you may be able to deduct your lossfrom your gross income.

Now you should understand the basic mechanics of buying and selling shares of stock, and

you see the importance of commissions.

Just for comparison, let's run the numbers if you had bought 50 shares instead of just 10

(maybe you found another few dollars). The purchase price of (50 * 20.25) + 30 is 1042.50.


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The sales price of (50 * 22.50) - 30 is 1095. The difference is $52.50 in your favor. What this

says is that commissions can really hurt the small investor, and is a good reason for really

small investors to consider investing via no-load mutual funds ordirect investment plans

(DRIPs).

A share of stock is the smallest unit of ownership in a company

There are two types of stock:

Common Stock:

y Common stock represents the majority of stock held by the public. It has voting rights,along with the right to share in dividends.

Preferred stock:

Despite its name, preferred stock has fewer rights than common stock, except in one

important area dividends. Companies that issue preferred stocks usually pay consistentdividends and preferred stock has first call on dividends over common stock.

Earnings per Share: The amount of profit to which each share is entitled.

Going Public: Slang for when a company is planning an IPO.IPO: Short for Initial Public Offering. An IPO is when a company sells stock in itself for thefirst time.

Market Cap: The amount of money you would have to pay if you bought ever share of stockin a company. (To calculate market cap, multiply the number of shares by the price pershare.) Short for Market Capitalization

Share: A share represents an investor's ownership in a "share" of the profits, losses, andassets of a company. It is created when a business carves itself into pieces and sells them toinvestors in exchange for cash.

Ticker Symbol: A short group of letters that represents a particular stock (e.g., "Coca Cola"is referred to as "KO".) Underwriter: The financial institution or investment bank that is

doing all of the paperwork and orchestrating a company's IPO.

Ask: The lowest price a seller is willing to accept when selling a security (stock).

Bear: An investor who believes the market as a whole or a particular stock will decline. Abear is the opposite of a Bull.


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Bid: The highest price a buyer is willing to accept when purchasing a security.

Blue Chip: A company that has a history of solid earnings, regular and increasing dividends,and an impeccable balance sheet. Examples: Coca-Cola, Berkshire Hathaway, & Gillette. Wehave an entire subject area dedicated to Blue Chip stocks! Go Here.

Book Value: The value of the company if all liabilities were subtracted from assets andcommon stock equity. The book value has very little relation to the market value. Inindustries in the technology sector, this number is almost always miniscule compared tomarket capitalization.

Broker: A person that buys or sells an investment vehicle for you (securities, bonds,commodities, etc.,) in exchange for a fee which is called a commission.

Bull: An investor who believes the general market or a particular stock is going to increasein price.

Dividend: A portion of a company's income that is paid out to shareholders on a quarterly orannual basis. Dividends are declared by the Board ofDirectors.

Dow Jones Industrial Average: The Dow Jones Industrial Average (or DJIA for short) is byfar the most popular and widely used gauge of the U.S. Stock Market. It consists of a price-weighted list of 30 highly-traded Blue Chip companies.

Market Capitalization: A company's market capitalization (or "market cap" as it s frequentlycalled) is calculated by taking the number of outstanding shares of stock multiplied by thecurrent price-per-share.

NASDAQ: A stock exchange where mostly shares of technology companies such as Microsoftand Cisco are traded. An exchange is a place where options, futures, and shares in stocks,bonds, indexes, and commodities are traded. The most famous in the United States is theNew York Stock Exchange.

P/E Ratio: How much money you are paying for $1 of the company's earnings. In otherwords, if a company is reporting a profit of $2 per share, and the stock is selling for $20 pershare, the P/E ratio is 10 because you are paying ten-times earnings ($20 per share dividedby $2 per share earnings = 10 P/E.)

Spread: The difference between the Ask and the Bid.

Stock: Stock is ownership. A business is divided up into shares of stock and parts of thecompany (the shares) are sold to investors to raise money. For more information, check outthe investing lessons.

Yield: When a company pays a dividend the yield is the percentage of the stock price inrelation to the dividend paid. In other words, if a stock is trading for $10 and pays a


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dividend of $0.50, the yield is 5%, because for every $10 you invest, you would receive 5%back annually in the form of a fifty-cent dividend

Mutual Funds:

What is a mutualfund?

Put simply, a mutual fund is a pool of money provided by individual investors, companies,and other organizations. A fund manager is hired to invest the cash the investors havecontributed.The goal of the managerdepends upon the type offund; a fixed-incomefund manager, for example, would strive to provide the highest yield at the lowestrisk. A long-term growth manager, on the other hand, should attempt to beat the Dow JonesIndustrial Average or the S&P 500 in a fiscal year

Closed vs.Open-Ended Funds, Load vs. No-Load

Mutual funds are divided along four lines: closed-end and open-ended funds; the latter issubdivided into load and no load.

y Closed-End FundsThis type of fund has a set number of shares issued to the public through an initial publicoffering. These shares trade on the open market; this, combined with the fact that aclosed-end fund does not redeem or issue new shares like a normal mutual fund,subjects the fund shares to the laws of supply and demand. As a result, shares of closed-end funds normally trade at a discount to net asset value.

y Open-End FundsA majority of mutual funds are open-ended. In simple terms, this means that the fund

does not have a set number of shares. Instead, the fund will issue new shares to aninvestor based upon the current net asset value and redeem the shares when theinvestor decides to sell. Open-end funds always reflect the net asset value of the fund'sunderlying investments because shares are created and destroyed as necessary.

Load vs. No LoadA load, in mutual fund speak, is a sales commission. If a fund charges a load, theinvestor will pay the sales commission on top of the net asset value of the funds shares.No load funds tend to generate higher returns for investors due to the lower expensesassociated with ownership.

What are thebenefits of investing through a mutualfund?

Mutual funds are actively managed by a professional money manager who constantlymonitors the stocks and bonds in the fund's portfolio. Because this is his or her primaryoccupation, they can devote considerably more time to selecting investments than anindividual investor. This provides the peace of mind that comes with informed investingwithout the stress ofanalyzing financial statements or calculating financial ratios.


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How do I select a fund that's right for me?

Every fund has a particular investing strategy, style or purpose; some, for instance, investonly in blue chip companies. Others invest in start-up businesses or specific sectors. Findinga mutual fund that fits your investment criteria and style is absolutely vital; if you don'tknow anything about biotechnology, you have no business investing in a biotech fund. Youmust know and understand your investment.

After youve settled upon a type of fund, turn to Morningstar or Standard and Poors (S&P).Both of these companies issue fund rankings based on past record. You must take theserankings with a grain of salt. Past success is no indication of the future, especially if thefund manager has recently changed.

How do I begin investing in a fund?

If you already have a brokerage account, you can purchase mutual fund shares as youwould a share of stock. If you don't, you can visit the fund's web page or call them andrequest information and an application. Most funds have a minimum initial investment whichcan vary from $25 - $100,000+ with most in the $1,000 - $5,000 range (the minimuminitial investment may be substantially lowered or waived altogether if the investment is fora retirement account such as a 401k, traditional IRA or Roth IRA, and / or the investoragrees to automatic, reoccurring deductions from a checking or savings account to invest inthe fund.


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Fixed income:

Fixed income refers to any type ofinvestment that yields a regular (or fixed) return.

For example, if you lend money to a borrower and the borrower has to pay interest once a month,

you have been issued a fixed-income security. Governments issue government bonds in theirown currency and sovereign bonds in foreign currencies. Local governments issue municipal

bonds to finance themselves. Debt issued by government-backed agencies is called an agencybond. Companies can issue a corporate bond or get money from a bank through a corporate loan

("preferred stock" is also sometimes considered to be fixed income). Securitized bank lending(e.g. credit card debt, car loans or mortgages) can be structured into other types of fixed income

products such as ABS - asset backed securities which can be traded on exchanges just like

corporate and government bonds.

The term fixed income is also applied to a person's income that does not vary with each period.

This can include income derived from fixed-income investments such as bonds andpreferredstocks orpensions that guarantee a fixed income. When pensioners or retirees are dependent on

their pension as their dominant source of income, the term "fixed income" can also carry theimplication that they have relatively limited discretionary income or have little financial freedom

to make large expenditures.

Fixed-income securities can be contrasted with variable return securities such as stocks. In order

for a company to grow as a business, it often must raise money; to finance an acquisition, buy

equipment or land or invest in new product development. Investors will only give money to thecompany if they believe that they will be given something in return commensurate with the riskprofile of the company. The company can either pledge a part of itself, by giving equity in the

company (stock), or the company can give a promise to pay regularinterest and repay principalon the loan (bond or bank loan) or (preferred stock).

While a bond is simply a promise to pay interest on borrowed money, there is some important

terminology used by the fixed-income industry:

y

The issuer is the entity (company or govt.) who borrows an amount of money (issuing the bond)and pays the interest.

y The principal of a bond - also known as maturity value, face value, par value - is the amount that

the issuer borrows which must be repaid to the lender.[1]

y The coupon (of a bond) is the interest that the issuer must pay.

y Thematurity is the end of the bond, the date that the issuer must return the principal.

y The issue is another term for the bond itself.

y The indenture is the contract that states all of the terms of the bond


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Investment bank

As the credit crisis unfolded, I've heard a lot of investors asking the question "What is aninvestment bank and how does it differ from a regular, commercial bank?" Unless you workin finance, you may not have come across the term investment bank before the globalmeltdown began.

To put it simply, an investment bank is nothing like the corner institution you're used todealing with to get a business loan or deposit your paycheck. Instead, an investment bankis a special type of financial institution that works primarily in higher finance by helpingcompany access the capital markets (stock market and bond market, for instance) to raisemoney for expansion or other needs. IfCoca-Cola Enterprises wanted to sell $10 billionworth ofbonds to build new bottling plants in Asia, an investment bank would help them

find buyers for the bonds and handle the paperwork, along with a team of lawyers andaccountants.

In the next few minutes, you're learn how investment banks make their money and whythey helped cause one of the greatest financial meltdowns in history.

Activities ofa Typical Investment Bank

A typical investment bank will engage in some or all of the following activities:

y Raise equity capital (e.g., helping launch an IPO or creating a special class ofpreferred

stock that can be placed with sophisticated investors such as insurance companies orbanks)

y Raise debt capital (e.g., issuing bonds to help raise money for a factory expansion)y Insure bonds or launching new products (e.g., such as credit default swaps)y Engage in proprietary trading where teams of in-house money managers invests or

trades the company's own money for its private account (e.g., the investment bankbelieves gold will rise so they speculate in gold futures, acquire call options on goldmining firms, or purchase gold bullion outright for storage in secure vaults).

Up until ten years ago, investment banks in the United States were not allowed to be part ofa larger commercial bank because the activities, although extremely profitable if managedwell, posed far more risk than the traditional lending of money done by commercial banks.

This was not the case in the rest of the world. Countries such as Switzerland, in fact, oftenboasted asset management accounts that allowed investors to manage their entire financiallife from a single account that combined banking, brokerage, cash management, and creditneeds.

Most of the problems you've read about as part of the credit crisis and massive bank failureswere caused by the internal investment banks speculating heavily with leverage oncollateralized debt obligations (CDOs). These losses had to be covered by the parent bank


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holding companies, causing huge write-downs and the need for dilutive equity issuances, insome cases nearly wiping out regular stockholders. A perfect example is the venerableUnion Bank of Switzerland, or UBS, which reported losses in excess of 21 billion CHF (SwissFrancs), most of which originated in the investment bank. The legendary institution wasforced to issue shares as well as mandatory convertible securities, diluting the existingstockholders, to replace the more than 60% of shareholder equity that was obliterated

during the meltdown.

The Buy Side vs. Sell Side ofan Investment Bank

Investment banks are often divided into two camps: the buy side and the sell side. Manyinvestment banks offer both buy side and sell side services. The sell side typically refers toselling shares of newly issued IPOs, placing new bond issues, engaging in market makingservices, or helping clients facilitate transactions. The buy side, in contrast, worked withpension funds, mutual funds, hedge funds, and the investing public to help them maximizetheir returns when trading or investing in securities such as stocks and bonds.

Front Office, MiddleOffice, and Bank Office

Many investment banks are divided into three categories that deal with front office, backoffice, or middle office services.

y Front Office Investment Bank Services: Front office services typically consist ofinvestment banking such as helping companies in mergers and acquisitions, corporatefinance (such as issuing billions of dollars in commercial paper to help fund day-to-dayoperations, professional investment management for institutions or high net worthindividuals, merchant banking (which is just a fancy word for private equity where thebank puts money into companies that are not publicly traded in exchange for ownership),investment and capital market research reports prepared by professional analysts either

for in-house use or for use for a group of highly selective clients, and strategyformulation including parameters such as asset allocation and risk limits.

y MiddleOffice Investment Bank Services: Middle office investment banking servicesinclude compliance with government regulations and restrictions for professional clientssuch as banks, insurance companies, finance divisions, etc. This is sometimes considereda back office function. It also includes capital flows. These are the people that watchmoney coming into and out of the firm to determine the amount of liquidity the companyneeds to keep on hand so that it doesn't get into financial trouble. The team in charge ofcapital flows can use that information to restrict trades by reducing the buying / tradingpower available for other divisions.

y Back Office Investment Bank Services: The back office services include the nuts andbolts of the investment bank. It handles things such as trade confirmations, ensuringthat the correct securities are bought, sold, and settled for the correct amounts, the

software and technology platforms that allow traders to do their job are state-of-the-artand functional, the creation of new trading algorithms, and more. The back office jobsare often considered unglamorous and some investment banks outsource to specialtyshops such as custodial companies. Nevertheless, they allow the whole thing to run.Without them, nothing else would be possible.


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Hedge fund:

A hedge fund is simply a term used to describe an investment partnership setup by a moneymanager. It can take the legal form of a limited liability company or a limited partnership sothat if the company goes bankrupt, the creditors can't go after the investors for moremoney than they've put into the hedge fund.

The manager of the hedge fund, typically the person that created it, is paid a percentage ofthe profits he or she earns on the money investors have deposited with his company. Theterm was originally used because the purpose of many of the first hedge funds was to makemoney regardless of if the market increased or decreased because the managers couldeither buy stocks or short them (shorting is a way to make money when a stock falls - formore information read The Basics of Shorting Stock). Today, the term hedge fund is ageneric term used for any such arrangement.

A Fictional Hedge Fund to Help You Understand What a Hedge Fund Is

To make the idea easy to understand, lets take an extreme example. Imagine that I setupa company called Global Umbrella Investments, LLC as a Delaware corporation. Theoperating agreement, which is the legal document that says how the company is managed,states that I will receive 25% of any profits over 4% per year and that I can invest inanything stocks, bonds, mutual funds, real estate, startups, art, rare stamps, collectibles,gold, wine, or anything else of value.

Along comes a single investor that puts $100 million into my hedge fund. He writes thecompany a check, I put it into our brokerage account, and invest the cash according to anyguidelines that were spelled out in the operating agreement. Perhaps I use the money tobuy up local restaurants. Maybe I start a new company. Either way, the point is that everyday when I wake up and go to the office, my purpose is to put my investors capital to workat the highest rate possible (adjusted for risk, of course), because the more I make him, themore I get to take home.

For arguments sake, image that I made an unbelievable investment the first year, doublingthe companys assets from $100 million to $200 million. Now, according to the companysoperating agreement, the first 4% belongs to the investor with anything above that beingsplit 25% to me 75% to my investor. In this case, the $100 million gain would be reduced

by $4 million for that hurdle rate, as it is often called on Wall Street (because you have toclear that hurdle as the hedge fund manager before you are ever paid a dime under anarrangement like this). The remaining $96 million is split 25% to me and 75% to myinvestor.

The net result is that I walk away with $24 million in compensation. My investor gets the $4million hurdle earned and $72 million from the split to which they are entitled above thathurdle for a grand total of $76 million. The news headlines are going to say, Hedge Fund


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Manager Earns $24 Million!yet it doesnt tell you that I earned my investors $76 million. IfI were managing $10 billion, my compensation would have been $2.4 billion and I wouldhave made my investors $7.6 billion. The newspapers would write articles about how I wasearning ridiculous amounts of money, never once mentioning the massive payday Idelivered to the people who entrusted me with their funds.

The Infamous 2 and 20 Hedge FundArrangement

If you ask the question, "what is a hedge fund?" then you are certainly going to need toknow about the most famous compensation formula in the industry. Its called the 2 and 20and it is used by a large majority of hedge funds currently in operation according to someestimates.

The 2 and 20 formula basically means that the hedge funds operating agreement calls forthe hedge fund manager to receive 2% of assets and 20% of profits each year. That meansthat even if they lose money, they are at least guaranteed the 2% return with little or nohurdle rate. So, a manager earning $1 billion might make $20 million even if the company

did nothing but park the money in the bank. Obviously, with anemic returns like that, clientswould defect before long so it really is in the best interest of the fund manager to maximizereturns.


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BONDS:

A Bond is simply an 'IOU' in which an investor agrees to loan money to a company orgovernment in exchange for a predetermined interest rate.

If a business wants to expand, one of its options is to borrow money from individualinvestors, pension funds, or mutual funds. The company issues bonds at various interestrates and sells them to the public. Investors purchase them with the understanding that thecompany will pay back their original principal (the amount the investor loaned to thecompany) plus any interest that is due by a set date (this is called the "maturity" date).

A bondholder is mailed a check from the company at set intervals; in the United States, it iscommon for bonds to pay interest twice a year. In some other countries, bonds pay interestonce a year. Still other bonds can pay monthly interest. It is entirely up to the "contract"that governs the bond offering. Unfortunately, these documents can be very difficult tocome by, unlike the 10K or annual report of a share of stock.

The rate of interest a bondholder earns depends on the strength of the corporation thatissued the bond. For example, a blue chip is more stable and has a lower risk of defaultingon its debt. When companies such as Exxon Mobile, General Electric, et cetera, issue bonds,they may only pay 7% interest, while a much less stable start-up pays 10%. A general ruleof thumb when investing in bonds is "the higher the interest rate, the riskier the bond."

Who can issue bonds? Governments, municipalities, a variety of institutions, andcorporations.

There are many types of bonds, each having different features and characteristics. A few ofthe most notable are zero coupon and convertible.

What AreThey?

Say you are in the grocery store with a friend on a Thursday afternoon and see somethingyou need for your house; a broom for example. Although you get your paycheck the nextday, you ask your shopping buddy to borrow a few dollars so you can purchase the broomnow, in return for which you will not only pay them back tomorrow, but buy them dinner aswell. Your friend, finding these terms acceptable, loans you the money and you purchasethe item.


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This is, in essence, what happens in the corporate world when a company issues bonds.Generally, as a business grows, it doesn't generate enough cash internally to pay for thesupplies and equipment necessary to keep it growing. Because of this, most businesseshave one of two options. They can either 1.) sell a portion of the company to the generalpublic by issuing additional shares of stock, or they can 2.) issue bonds. When a companyissues bonds, it is borrowing money from investors in exchange for which it agrees to pay

them interest at set intervals for a predetermined amount of time. In essence, it is thesame thing as a mortgage only you, the investor, are the bank.

Why WouldAnyone Invest in Bonds?

Most everyone knows that over the long-run, nothing beats the stock market. This being thecase, why would anyone invest in bonds? Although they pale in comparison to equities inthe long run, bonds have several traits that stocks simply can't match.

First, capital preservation. Unless a company goes bankrupt, a bondholder can be almostcompletely certain that they will receive the amount they originally invested. Stocks, which

are subordinate to bonds, bear the brunt of unfavorable developments.

Secondly, bonds pay interest at set intervals of time, which can provide valuable income forretired couples, individuals, or those who need the cash flow. For instance, if someoneowned $100,000 worth of bonds that paid 8% interest annually (that would be $8,000yearly), a fraction of that interest would be sent to the bondholder either monthly orquarterly, giving them money to live on or invest elsewhere.

Bonds can also have large tax advantage for some people. When a government ormunicipality issues various types of bonds to raise money to build bridges, roads, etc., theinterest that is earned is tax exempt. This can be especially advantageous for those whomare retired or want to minimize their total tax liability.

The Ways to Invest in Bonds

There are several types of bonds in which you can invest and even more ways you can holdthese bonds. Here are some resources and articles that you may want to consider.

Investing in Municipal Bonds: This complete beginner's guide to investing in municipalbonds, which are immune from most state taxes, is a great place to begin if you are in amiddle to high tax bracket. By investing in your local schools, hospitals, and municipalities,you can not only help your community, but make money. Once you're ready to movebeyond the very basics, you can read Tests of Safety for Municipal Bonds. This article willteach you some of the calculations you can do, the considerations you should make, whenlooking at a municipal bond investment. It is our hope that it lowers your risk and helps youavoid expensive mistakes.

US Savings Bonds: Get a broad education on savings bonds, their history, considerationsbefore adding them to your portfolio, and tax notes.


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Series EE Savings Bonds: These unique bonds offer tax advantages for education funding,the guarantee of the United States Treasury, a fixed rate of return for up to thirty years,and more.

Series I Savings Bonds: Series I savings bonds feature an interest rate based, in part, onchanges in inflation, are guaranteed to never lose money, and are backed by the taxingpower of the United States Government. This collection of articles will teach you how toinvest in Series I savings bonds, tell you who is eligible to own them, and explain the annualpurchase limits.

Bond Funds vs. Bonds: Many new investors don't know whether they should own bondsoutright or invest in bonds through a special type of mutual fund known as a bond fund.What are the differences, benefits, and advantages? Take a few moments to read the articleto discover the answers.

Junk Bonds: One of the most alluring types of bonds new investors often spot is somethingknown as a junk bond. Boasting high, double-digit yields, these dangerous bonds can lure

you in with the promise of big checks in the mail, yet leave you high and dry when thecompanies that issue them miss payments or go bankrupt.

The Many Flavors of Preferred Stock: The preferred stock of many companies is actuallyvery comparable to bond investments because both types of investments tend to behavethe same way. To understand bond investing, you need to understand preferred stocksbecause the tax laws allow you to pay only 15% on dividend income received from preferredstocks, compared to full 35%+ depending upon your tax bracket on interest income onbonds.


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Derivatives:

In non-financial-expert terms, a derivative is an agreement or contract that is not based on a real,or true, exchange ie: There is nothing tangible like money, or a product, that is being exchanged.

For example, a person goes to the grocery store, exchanges a currency (money) for a commodity(say, an apple). The exchange is complete, both parties have something tangible. If the purchaser

had called the store and asked for the apple to be held for one hour while the purchaser drives tothe store, and the seller agrees, then a derivative has been created. The agreement (derivative) is

derived from a proposed exchange (trade money for apple in one hour, not now).

In financial terms, a derivative is a financial instrument - or more simply, an agreement betweentwo people or two parties - that has a value determined by the price of something else (called the

underlying).[1]

It is a financial contract with a value linked to the expected future pricemovements of the asset it is linked to - such as a share or a currency. There are many kinds of

derivatives, with the most notable being swaps, futures, and options. However, since a derivativecan be placed on any sort of security, the scope of all derivatives possible is near endless. Thus,

the real definition of a derivative is an agreement between two parties that is contingent on afuture outcome of the underlying.

A common misconception is to refer to derivatives as assets. This is erroneous, since a derivative

is incapable of having value of its own. However, some more commonplace derivatives, such asswaps, futures, and options, which have a theoretical face value that can be calculated using

formulas, such as Black-Scholes, are frequently traded on open markets before their expirationdate as if they were assets.

Derivatives are usually broadly categorized by the:

y relationship between the underlying and the derivative (e.g., forward, option, swap)

y type of underlying (e.g., equity derivatives, foreign exchange derivatives, interest rate

derivatives, commodity derivatives or credit derivatives)

y market in which they trade (e.g., exchange-traded or over-the-counter)

y

pay-off profile (Some derivatives have non-linear payoff diagrams due to embedded optionality)

[2]Another arbitrary distinction is between:

y vanilla derivatives (simple and more common) and

y exotic derivatives (more complicated and specialized)


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There is no definitive rule for distinguishing one from the other, so the distinction is mostly amatter of custom.

Derivatives are used by investors to

y

provide leverage or gearing, such that a small movement in the underlying value can cause alarge difference in the value of the derivative

y speculate and to make a profit if the value of the underlying asset moves the way they expect

(e.g., moves in a given direction, stays in or out of a specified range, reaches a certain level)

y hedge or mitigate risk in the underlying, by entering into a derivative contract whose value

moves in the opposite direction to their underlying position and cancels part or all of it out

y obtain exposure to underlying where it is not possible to trade in the underlying (e.g., weather

derivatives)

y create optionability where the value of the derivative is l inked to a specific condition or event

(e.g., the underlying reaching a specific price level)

Derivatives - Basics

A derivative is a contract with financial performance that is derived from the performance of

something else. That "something else" is an underlying asset commonly termed "the

underlying" and may be another financial instrument, another derivative, or an index of

some kind. An example is a call option on a stock, in which the option is the derivative and

the stock is the underlying asset (also see the FAQ article on stock option basics).

How are derivatives used?

Derivatives are generally used to manage the risk of monetary loss or gain. A person ororganization can take on additional risk by buying or selling derivatives, or similarly can

reduce risk by buying or selling derivatives.

A commonly used example is a grain (i.e., commodity) future. The contract is the derivative,

and the underlying asset is the edible grain such as wheat or corn. A farmer who grows

grains can enter into a contract that is an obligation to sell the grain at a fixed price at a date

in the future. An investor takes the other side of the contract agreeing to buy the grain at

that fixed price for delivery on that future date. The farmer obtains a guarantee he will be

able to sell his grain for the agreed price, thus eliminating the risk of the price falling

between now and when the crop is ready for delivery. If the grain price falls sharply, thefarmer still receives the payment specified in the contract, and the investor loses money. If

the grain price rises sharply, again the farmer receives the payment specified in the

contract, and the investor may make a profit by reselling the grain at the current, higher

price. Although it is crucial that a mechanism for delivery or settlement exists to tie the

futures contract price to "the underlying", it is important to note that for most futures only a


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small fraction of the contracts traded are actually delivered or settled. Most positions are

closed before the delivery or settlement date.

How are derivatives traded?

Derivatives may be traded on exchanges or over-the-counter. Exchanges for derivatives

include the Chicago Mercantile Exchange (CME) and the London International FinancialFutures Exchange (LIFFE). Over-the-counter (or "OTC") derivatives are simply derivativecontracts agreed by two counterparties between themselves, without reference to an

exchange or any other third party.

To reduce the risk of default by either party to a contract, an exchange-traded derivatives

contract usually goes through a clearing process whereby a clearinghouse becomes the

counterparty to each of the traders rather than each other. The clearinghouse is well

capitalized and has rules regarding collateral that must be posted by each trader reflecting

the financial performance of that trader's contracts so as to minimize the risk of losses by

the clearinghouse. These measures minimize the possibility of a clearinghouse defaulting.

Exchange Traded derivatives are standardized contracts. Standardization should improve

liquidity but obviously comes at the expense of the ability to customize a transaction to an

individual trader's requirements. Trading in OTC derivatives is generally only available to

professional investors in the wholesale market. Banks, fund managers, pension funds,

insurance companies and hedge funds are active users of the OTC derivatives market.

What are some types of derivatives?

A future or forward contact is an agreement to enter into a financial transaction at a givenprice on a given date or dates in the future. Such a contract is called a "future" when traded

on an exchange or a "forward" when traded OTC.

Swap contracts are agreements to exchange one asset or liability for another. The asset or

liability is usually a future payment or stream of payments. If it is a foreign currency swap

this may entail buying a currency on the spot market and simultaneously selling it forward. If

it is an interest rate swap this may involve exchanging income flows; for example,

exchanging a stream of fixed rate payments (such as those received from a fixed rate bond)

for a variable rate payment stream.

Options are the right but importantly not the obligation to enter into a pre-arranged financial

agreement at a pre-defined price on a future date or dates. As with futures and forwards,

options may be traced either on exchanges or OTC. There may be conditions that must befulfilled before the right to enter in to the agreement is conferred. Credit default swaps

(which are typically traded OTC) are a good example of this.

In general, futures, forwards and swaps have payoff profiles that are approximately linear

functions of the performance of the underlying. In derivatives-speak they are said to have

approximately constant delta, delta being the change in value of the derivative contract for

the change in the price of the underlying instrument. Options, however, will have a payoff


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profile that is a non-linear function of the value of the underlying instrument. This can make

option trading much more complex than trading approximately linear derivatives.

For what types of underlying markets are derivatives traded?

A wide variety of derivatives exist. The "underlying" may include the following.

y Spot foreign exchange. This is the buying and selling of foreign currency at the

exchange rates that you see quoted on the news. As these rates change relative to

your "home currency" (dollars if you are in the US) you make or lose money.

y Commodities, like grain discussed in the example above. Others include pork bellies,

coffee beans, orange juice, gold, silver, and crude oil.

y Equities (termed stocks in the US).

y Government bonds. Bonds are medium to long-term negotiable debt securities issued

by national governments. They may generally be freely traded without reference to the

issuer of the security, unlike loans.

y

Short term ("money market") negotiable debt securities such as Treasury Bills (issuedby governments), Commercial Paper (issued by companies) or Bankers Acceptances.

These are much like bonds, differing mainly in their maturity - always less than one

year, and typically less than 90 days.

y OTC money market indexes - typically LIBOR (the London Interbank Offered Rate) or

some other similar index of the rates at which banks are willing to enter OTC lending

transactions with each other.

y Credit risk - a credit default swap (CDS), despite its name, is actually more like an

option or insurance contract. In exchange for a stream of premium payments the buyer

of a vanilla (or "single issuer") CDS obtains the right to require the CDS seller to

purchase bonds of the issuer named in the agreement at a given price (usually the face

value) but only if the named issuer triggers a default or other similar "credit event". The

market price of these bonds is typically much less than face value when a default

occurs so the CDS buyer will profit and the CDS seller will lose. If the named issuer

does not default during the agreed period of the CDS the contract expires worthless,

just as an option would if it was not worth exercising.

y Indexes - many index varieties are used as the underlying for derivative contracts.

They may be constructed with reference to financial assets (such as stock market

indexes like the Dow Jones Industrial Average) or even to temperature or rainfall (in

the case of weather derivatives).

Stock index futures, interest rate futures (including deposit futures, bill futures andgovernment bond futures) and commodity futures are the most widely traded futures.

Interest rate "forward rate agreements" (FRAs), interest rate swaps (IRS), forward foreignexchange contracts and credit default swaps (CDS) are the most widely traded OTC

derivatives.

This FAQ offers many articles about futures and options. Please see those sections.


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Derivatives, risk-taking and regulation

In the last few years derivatives and their use by large institutions became a hot topic,especially to regulatory agencies. What really concerns regulators is the fact that big banks

swap all kinds of promises - like interest rate swaps, forward currency swaps, options onfutures - all the time. They try to balance all these promises (hedging), but there remains a

danger that one large institution will go bankrupt and leave others holding worthlesspromises. Such a collapse could cascade, as more and more institutions fail to meet theirobligations because they were counting on the defaulted contracts to protect them from

losses. This is termed "systemic risk" - the risk that the failure of one institution could bringdown many others in the financial system.

Some hedging (risk reduction) with derivatives is done by offsetting an existing position with

a related derivative that is strongly correlated with the position to be hedged. An example is

selling a stock index future to protect against a loss in a generalized (non sector specific)

stock portfolio. Although the stock portfolio may contain a different mix of stocks than the

stock index, typically we would still expect the index future to move in roughly the same

fashion as the portfolio. The risk that the value of the derivatives position does not move inexactly the same way as that of the stock portfolio is termed "basis risk". There is significant

basis risk when the correlation between the derivatives hedge and the risky position is

weak, or breaks down in a crisis - exactly when effective hedging is needed most.

Potentially big losses (or if the investor is lucky, profit) can ensue.

However it is easy for a bank to take accidentally take on too much basis risk. And of

course although banks may be using derivatives to hedge (reduce) risk, they may also be

using them as a way of increasing risk to make money. Taking on risk is how a bank makes

money; for example, issuing loans is a risk.

As of this update (2009), derivatives are being blamed for many of the financial lossessuffered by banks and other financial institutions around the world. Many banks took on so

much risk (bought assets that suffered losses) that they collapsed, and taxpayers around

the world are being forced to pay huge sums so financial markets keep functioning. New

regulations are promised so that use of derivatives is more transparent.


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Financial regulations:

Financial regulations are a form ofregulation or supervision, which subjects financial institutions to

certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial

system. This may be handled by either a government or non-government organization.

Aims of regulation

The specific aims of financial regulators are usually:

y To enforce applicable laws

y To prosecute cases of market misconduct, such as insider trading

y To license providers of financial services

y To protect clients, and investigate complaints

y To maintain confidence in the financial system

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