1VolumeOne THECANADIANSECURITIESCOURSE

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Published by the Canadian Securities InstituteVolume 1 Chapters 1-7 Winter 2004

Printed and bound in Canada10 9 8 7 6 5 4 3 2 1

The Canadian Securities Course TextbookVolume 1 Chapters 1-7

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VOLUME 1

Pr-1

This edition of the Canadian Securities Course (CSC) textbook was prepared in the fall of2003 and the winter of 2004. Although the textbook has been revised on a regular basisover the last 30 years, this edition is different from its predecessor, the 2001 edition. Itnot only updates and enhances existing content, but new material has been added to reflect therapidly changing financial services industry. Further enhancements to CSC interactive and theaddition of the CSC Investing Simulator have improved the overall CSC learning experience.

Thanks are due to those students and industry representatives who provided input into the revi-sion process, either through their suggestions or by providing or verifying information for thebook. Within the CSI, contributions were made by the following individuals.

Marshall Beyer

Sean English, MA

Jason Milne, CFA

Bryan Ross, CFP

Helen Prankie, MBA, FCSI

Special acknowledgement goes to Toula Voikos for layout and Jane Kim for the graphics anddesign of the text.

FEATURES TO ENHANCE LEARNINGCSC Investing Simulator

One of the main enhancements to the CSC is the addition of the CSC Investing Simulator. Thisactivity is a sophisticated online investing simulation that is integrated directly into CSC interac-tive. It enables CSC students to choose from three different client types that have their own riskprofile (conservative, moderate, aggressive) and make investment decisions according to theirclient's risk tolerance and objectives. Students are then able to trade under current market condi-tions in Canadian equities, bonds and mutual funds.

The CSC Investing Simulator gives students the opportunity to move beyond theory and applywhat they have learned in the CSC. It challenges students to make investment decisions for their"client", builds their confidence and helps them develop the skills that they will require in thereal world.

Students can access the CSC Investing Simulator through CSC interactive as soon as enrolmentcommences. However, we strongly encourage that students not begin participation until the endof Chapter 8, Analyzing Markets and Products. Participation in the CSC Investing Simulatorends three months after your course expiry date.

Preface

CSC Textbook EnhancementsFurther enhancements to the CSC textbook include providing students with a betterlink between the textbook and CSC interactive. Icons have been placed throughout thetext that corresponds with the various learning aids included in the interactive. Whenworking through the text, the icons indicate where a learning aid in the interactive asso-ciated with that topic is located.

A brief description of each CSC interactive icon follows.

Pre-Test & Post-Test QuizzesTests students understanding of the key concepts in each chapter. The Pre-Test is takenbefore beginning to study the chapter and is designed to activate any prior knowledgethat students may have of the topics that will follow. The Post-Test is completed afterstudying the chapter. Results for both quizzes may suggest areas of weakness that requirefurther study.

Slide Show A slide show presentation that may use interactive activities, audio presentations or acombination of the two.

Video CSC Interactive includes a number of videos of industry professionals covering a widerange of topics, from regulation to covered call writing.

ActivityInteractive learning aids that require students to test their knowledge of the material byutilizing various online exercises. Discussion board forums, where students can interactwith their peers are also included here.

Study GamesThese activities are used to review key terms, definitions and concepts in the chapter.

Preface

Pr-2

PRE-TEST

POST-TEST

Table Of Contents

i

VOLUME 1

VOLUME 1Chapter 1Capital Markets and Financial Services........................................1-1

A. INTRODUCTION ...................................................................................1-1

B. INVESTMENT CAPITAL........................................................................1-2

1. What Is Investment Capital? ..........................................................................1-2

2. Characteristics of Capital ...............................................................................1-3

3. Why Is It Needed? .........................................................................................1-3

C. SOURCES OF CAPITAL ........................................................................1-3

1. Individuals as Capital Suppliers......................................................................1-4

2. Foreign Investors as Capital Suppliers ............................................................1-5

3. Principal Investment Objectives .....................................................................1-6

a) Safety...................................................................................................................1-6

b) Income ................................................................................................................1-6

c) Growth of Capital ...............................................................................................1-7

d) Marketability or Liquidity ...................................................................................1-7

e) Tax Minimization................................................................................................1-7

D. USERS OF CAPITAL ..............................................................................1-7

1. Introduction...................................................................................................1-7

2. Individual Users .............................................................................................1-7

3. Business Users ................................................................................................1-8

4. Government Users..........................................................................................1-8

a) Federal Government ............................................................................................1-8

b) Provincial Governments ......................................................................................1-8

c) Municipal Governments ......................................................................................1-9

5. Foreign Users .................................................................................................1-9

E. THE ROLE OF FINANCIAL INSTRUMENTS.....................................1-9

1. Debt.............................................................................................................1-10

2. Equity ..........................................................................................................1-10

3. Investment Funds.........................................................................................1-10

4. Derivatives ...................................................................................................1-11

5. Other Investment Products ..........................................................................1-11

F. THE ROLE OF FINANCIAL MARKETS ............................................1-11

1. Auction Markets in Canada .........................................................................1-12

a) Canadian Exchanges..........................................................................................1-12

b) Recent History of the Canadian Exchanges .......................................................1-13

2. Stock Exchanges around the World ..............................................................1-14

3. Exchange Memberships................................................................................1-15

4. Governing Bodies and Administration .........................................................1-16

a) Boards of Directors...............................................................................................1-16

b) Statutory Responsibilities ..................................................................................1-16

5. How Exchanges are Financed .......................................................................1-17

6. Future Trends ..............................................................................................1-17

G. DEALER MARKETS THE UNLISTED MARKET............................1-18

1. The Unlisted Equity Market ........................................................................1-18

a) Size of the Unlisted Equity Market....................................................................1-18

b) The Mechanics of Trading.................................................................................1-18

c) Unlisted Reporting Systems...............................................................................1-18

d) Quotation and Trade Reporting Systems ...........................................................1-19

e) Alternative Trading Systems...............................................................................1-19

2. The Fixed-Income Marketplace....................................................................1-20

H. THE ROLE OF FINANCIAL INTERMEDIARIES ..............................1-20

I. THE CANADIAN SECURITIES INDUSTRY.....................................1-22

1. Size and Characteristics of the Securities Industry Today .............................1-23

2. Types of Firms..............................................................................................1-24

3. Organization of Firms ..................................................................................1-25

a) Management .....................................................................................................1-25

b) Departments......................................................................................................1-26

4. Financing Securities Houses .........................................................................1-28

5. Principal and Agency Functions ...................................................................1-28

6. Dealer, Principal and Agency Transactions ...................................................1-29

a) Underwriting/Financing ....................................................................................1-29

b) Principal Trading ...............................................................................................1-30

c) Broker or Agency Transactions ..........................................................................1-30

7. Future Trends in the Securities Industry.......................................................1-30

J. CHARTERED BANKS ..........................................................................1-31

1. Schedule I Chartered Banks .........................................................................1-32

2. Schedule II and Schedule III Banks..............................................................1-34

Table Of Contents

ii

3. Recent Bank Developments and Future Trends ............................................1-35

K. LIFE INSURANCE COMPANIES ........................................................1-36

1. Products and Services ..................................................................................1-36

2. Insurance Regulation....................................................................................1-37

3. Segregated Funds..........................................................................................1-37

4. Recent Developments and Future Trends .....................................................1-38

L. INVESTMENT FUNDS.........................................................................1-39

M. OTHER INTERMEDIARIES .................................................................1-39

1. Trust and Loan Companies ..........................................................................1-40

2. Pension Plans ...............................................................................................1-40

a) Trusteed Pension Plans ......................................................................................1-40

b) Government-Operated Pension Plans ................................................................1-41

3. Credit Unions and Caisses Populaires...........................................................1-41

4. Sales Finance and Consumer Loan Companies ............................................1-42

5. Property and Casualty Insurance Companies ...............................................1-42

6. Savings Banks...............................................................................................1-42

7. Business Development Bank of Canada .......................................................1-42

N. REGULATORY ORGANIZATIONS ....................................................1-43

1. The Office of the Superintendent of Financial Institutions ..........................1-43

2. The Provincial Regulators ............................................................................1-43

3. Canadian Investor Protection Fund..............................................................1-44

a) General Account................................................................................................1-44

b) Separate Accounts..............................................................................................1-44

c) Coverage............................................................................................................1-45

d) Regulatory Oversight.........................................................................................1-46

4. Mutual Fund Dealers Association (MFDA) Investor Protection...................1-46

5. Canada Deposit Insurance Corporation (CDIC) .........................................1-47

6. Credit Union Deposit Insurance Corporations ...........................................1-47

7. The Self-Regulatory Organizations...............................................................1-47

a) The Investment Dealers Association..................................................................1-47

b) The Mutual Fund Dealers Association ..............................................................1-49

8. Arbitration ...................................................................................................1-49

9. Ombudsman for Banking Services and Investments (OBSI) ........................1-50

O. THE CLEARING SYSTEM ..................................................................1-51

P. CSI GLOBAL EDUCATION INC.(formerly the Canadian Securities Institute) .....................................1-51

CSC VOLUME 1

iii

Chapter 2The Canadian Economy .................................................................2-1

A. AN OVERVIEW OF THE ECONOMY ..................................................2-1

1. The Decision Makers .....................................................................................2-1

2. The Market ....................................................................................................2-1

3. Microeconomics .............................................................................................2-2

a) Demand and Supply............................................................................................2-2

b) Market Demand..................................................................................................2-2

c) Market Supply.....................................................................................................2-3

d) Market Equilibrium.............................................................................................2-3

4. Macroeconomics ............................................................................................2-5

B. MEASURING ECONOMIC GROWTH ...............................................2-5

1. Gross Domestic Product.................................................................................2-5

a) Final Goods.........................................................................................................2-5

c) Gross National Product .......................................................................................2-6

d) Real and Nominal GDP .....................................................................................2-8

2. Growth and Productivity................................................................................2-8

C. THE ECONOMY IN THE SHORT RUN...............................................2-9

1. Actual and Potential Growth .........................................................................2-9

2. Phases of the Business Cycle.........................................................................2-10

a) Expansion..........................................................................................................2-10

b) Peak...................................................................................................................2-10

c) Recession or Contraction...................................................................................2-10

d) Trough...............................................................................................................2-10

e) Recovery............................................................................................................2-10

3. Identifying Recessions ..................................................................................2-11

4. Business Cycle Indicators .............................................................................2-12

a) Leading indicators .............................................................................................2-12

b) Coincident indicators ........................................................................................2-13

c) Lagging indicators ............................................................................................2-13

D. THE ECONOMY IN THE LONG RUN...............................................2-13

1. Growth in the Industrialized World .............................................................2-14

2. The Determinants of Economic Growth......................................................2-15

E. INTEREST RATES.................................................................................2-16

1. How Interest Rates Affect the Economy.......................................................2-17

2. Determinants of Interest Rates .....................................................................2-17

3. Expectations and Interest Rates ....................................................................2-18

Table Of Contents

iv

F. MONEY AND INFLATION ..................................................................2-19

1. The Nature of Money ..................................................................................2-19

2. Inflation And The Consumer Price Index (CPI) ..........................................2-20

3. The Costs of Inflation..................................................................................2-21

4. The Causes of Inflation................................................................................2-21

5. The Costs of Disinflation.............................................................................2-23

G. LABOUR MARKETS.............................................................................2-24

1. The Canadian Labour Market......................................................................2-24

2. Types of Unemployment ..............................................................................2-26

H. THE EXTERNAL SECTOR..................................................................2-27

1. The Balance of Payments .............................................................................2-27

a) Trade and The Current Account........................................................................2-29

b) The Capital Account .........................................................................................2-29

2. The Exchange Rate and its Impact on the Economy....................................2-30

a) The Exchange Rate and the Canadian Dollar....................................................2-30

b) Fixed Exchange Rate Regimes ...........................................................................2-32

c) Floating Exchange Rate Regimes ......................................................................2-33

3. The Determinants of the Exchange Rate......................................................2-34

I. ECONOMIC THEORIES.......................................................................2-35

1. Principle Economic Theories........................................................................2-35

2. Rational Expectations...................................................................................2-36

3. Keynesian Theory.........................................................................................2-36

4. Monetarist Theory ......................................................................................2-37

5. Supply-Side Economics ................................................................................2-37

J. FISCAL POLICY....................................................................................2-37

1. The Federal Budget ......................................................................................2-38

2. How Fiscal Policy Affects the Economy .......................................................2-40

3. The Consequences of Failed Fiscal Policy.....................................................2-42

K. MONETARY POLICY ...........................................................................2-42

1. The Bank of Canada ....................................................................................2-42

a) Origins and Organization..................................................................................2-42

b) Role of the Bank of Canada ..............................................................................2-43

2. The Functions of the Bank of Canada .........................................................2-43

a) Issuance and Removal of Bank Notes ................................................................2-43

b) The Bank as Governments Fiscal Agent ............................................................2-43

3. The Bank and Monetary Policy....................................................................2-45

a) Objectives and Limitations of Monetary Policy .................................................2-45

CSC VOLUME 1

v

b) The Monetary Conditions Index.......................................................................2-46

c) Implementing Monetary Policy .........................................................................2-46

d) Tools for Implementing Monetary Policy Cash Management.........................2-47

e) Tools for Implementing Monetary Policy Open Market Operations ..............2-48

f ) Moral Suasion ...................................................................................................2-50

L. THE CHALLENGE FOR GOVERNMENT POLICY..........................2-50

Chapter 3Financing, Listing and Regulation..................................................3-1

A. FINANCING ............................................................................................3-1

1. Government Financing ..................................................................................3-1

a) Federal Issues.......................................................................................................3-2

b) Provincial Issues...................................................................................................3-4

c) Municipal Issues ..................................................................................................3-4

2. The Secondary Markets..................................................................................3-4

3. Corporate Finance..........................................................................................3-5

4. The Financing Process....................................................................................3-5

a) The Dealers Advisory Relationship with Corporations .......................................3-6

b) The Method of Offering .....................................................................................3-6

c) Advice on the Security to be Issued .....................................................................3-7

d) Advice on Protective Provisions ...........................................................................3-9

e) The Prospectus ....................................................................................................3-9

f ) Preliminary or Red Herring Prospectus ...............................................................3-9

g) Other Documents and Sale of the Issue.............................................................3-10

h) Final Prospectus.................................................................................................3-11

i) Simplified or Short Form Prospectus .................................................................3-11

j) Example of the Financing Process......................................................................3-13

k) Internet Prospectus............................................................................................3-15

l) After-market Stabilization..................................................................................3-15

5. Distribution to the Public ............................................................................3-16

a) Junior Company Distributions ..........................................................................3-16

b) Options of Treasury Shares ................................................................................3-17

c) Escrowed Shares ................................................................................................3-17

d) TSX Venture Exchange Capital Pool Company Program...................................3-17

e) NEX..................................................................................................................3-18

B. THE LISTING PROCESS .....................................................................3-18

1. Advantages and Disadvantages of Listing .....................................................3-18

a) Advantages of Listing ........................................................................................3-18

b) Disadvantages of Listing....................................................................................3-19

2. Listing Procedure for a Company.................................................................3-19

Table Of Contents

vi

a) The Listing Application.....................................................................................3-19

b) Regulations for Listed Companies .....................................................................3-20

3. Withdrawing Trading Privileges ...................................................................3-20

a) Temporary Interruption of Trading ...................................................................3-20

b) Cancelling a Listing (Delisting) .........................................................................3-21

C. REGULATION AND INVESTOR PROTECTION..............................3-21

1. Underlying Principles of Provincial Securities Legislation.............................3-21

a) Registration .......................................................................................................3-22

b) The National Registration Database (NRD) .....................................................3-22

c) Designated Non-trading Employees ..................................................................3-23

d) Securities Firms .................................................................................................3-23

e) Know Your Client Rule .....................................................................................3-23

f ) Breach of Fiduciary Duty ..................................................................................3-23

2. Self-Regulatory Organizations (SROs) .........................................................3-24

a) Market Regulation Services Inc. .......................................................................3-24

b) The Exchanges ..................................................................................................3-25

3. Necessity for Ethical Trading and Conduct ..................................................3-25

a) Examples of Unethical Practices ........................................................................3-26

b) Prohibited Sales Practices...................................................................................3-26

4. Public Company Disclosure and Investor Rights..........................................3-27

a) The Purchasers Statutory Rights .......................................................................3-27

b) Continuous Disclosure ......................................................................................3-28

c) Proxies and Proxy Solicitation ...........................................................................3-29

d) Takeover Bids ....................................................................................................3-30

e) Insider Trading ..................................................................................................3-32

f ) Investigation and Prosecution............................................................................3-32

Chapter 4Corporations and their Financial Statements .............................4-1

A. TYPES OF BUSINESS STRUCTURES .................................................4-1

B. INCORPORATED BUSINESSES...........................................................4-2

1. Government Approval ....................................................................................4-2

2. Choice of Jurisdiction ....................................................................................4-2

3. Public and Private Corporations.....................................................................4-3

4. The By-laws ...................................................................................................4-3

5. Voting and Control ........................................................................................4-3

6. Shareholders Meetings...................................................................................4-4

7. Voting by Proxy .............................................................................................4-4

8. Voting Trusts ..................................................................................................4-5

CSC VOLUME 1

vii

9. Directors ........................................................................................................4-5

10. Officers ..........................................................................................................4-6

a) Chairman of the Board........................................................................................4-6

b) President..............................................................................................................4-6

c) Executive Vice-President......................................................................................4-6

d) Vice-Presidents ....................................................................................................4-6

11. Financing the Corporation.............................................................................4-7

a) Equity Financing .................................................................................................4-7

b) Debt Financing ...................................................................................................4-8

c) Other Types of Financing ....................................................................................4-8

12. Advantages of Incorporation ..........................................................................4-9

a) Limited Liability of Shareholders.........................................................................4-9

b) Continuity of Existence.......................................................................................4-9

c) Transfer of Ownership.........................................................................................4-9

d) Ability to Finance ................................................................................................4-9

e) Taxation ..............................................................................................................4-9

f ) Growth................................................................................................................4-9

g) Legal Entity .........................................................................................................4-9

h) Professional Management ....................................................................................4-9

13. Disadvantages of Incorporation....................................................................4-10

a) Loss of Flexibility ..............................................................................................4-10

b) Taxation ............................................................................................................4-10

c) Expense .............................................................................................................4-10

d) Capital Withdrawal ...........................................................................................4-10

C. UNDERSTANDING THE BALANCE SHEET....................................4-10

1. General Form of the Balance Sheet ..............................................................4-11

2. Classification of Assets .................................................................................4-11

a) Current Assets (items 1 to 6).............................................................................4-11

b) Miscellaneous Assets (item 7) ............................................................................4-12

c) Property, Plant and Equipment (item 8)............................................................4-13

d) Capitalization ....................................................................................................4-15

e) Deferred Charges (item 9).................................................................................4-16

f ) Goodwill and other Intangible Assets (item 10) ..............................................4-16

3. Classification of Liabilities............................................................................4-16

a) Current Liabilities (items 12 to 17) ...................................................................4-17

b) Future Income Taxes (item 18)..........................................................................4-17

c) Non-controlling Interest in Subsidiary Companies (item 19) ............................4-18

d) Other Liabilities ................................................................................................4-18

e) Deferred Income ...............................................................................................4-18

Table Of Contents

viii

f ) Long-term Debt (item 20) ................................................................................4-19

4. Shareholders Equity.....................................................................................4-19

a) Share Capital (items 21 and 22) ........................................................................4-19

b) Contributed Surplus (item 23) ..........................................................................4-19

c) Retained Earnings (or Deficit) (item 24) ...........................................................4-19

d) Foreign Currency Translation Adjustment (item 25) .........................................4-20

D. UNDERSTANDING THE EARNINGS STATEMENT........................4-20

1. What It Shows ............................................................................................4-20

2. Structure of the Earnings Statement.............................................................4-20

3. The Operating Section (items 28-34)...........................................................4-21

a) Net Sales (item 28)............................................................................................4-21

b) Cost of Goods Sold (item 29) ...........................................................................4-22

c) Gross Operating Profit (item 30).......................................................................4-22

d) Operating Expenses (items 31 to 33).................................................................4-22

e) The Net Operating Profit (or Loss) (item 34) ...................................................4-23

4. Non-Operating Section (item 35) ................................................................4-23

5. The Creditors Section (items 37and 38)......................................................4-23

6. The Owners Section (items 40 to 45) .........................................................4-24

a) Taxes and Non-controlling Interest (items 40 to 41) .........................................4-24

b) Equity Income (item 42) ...................................................................................4-24

c) Extraordinary Gains or Losses (item 44)............................................................4-25

d) Net Earnings after Extraordinary Items (item 45) .............................................4-25

E. UNDERSTANDING THE RETAINED EARNINGS STATEMENT ....................................................................4-25

F. UNDERSTANDING THE CASH FLOW STATEMENT ...................4-26

1. Introduction.................................................................................................4-26

2. Operating Activities ....................................................................................4-27

3. Financing Activities (items 51 to 54) ..........................................................4-28

4. Investing Activities (items 55 to 57).............................................................4-28

5. Change in Cash Flow (items 58 to 60) ........................................................4-28

6. Supplemental information (items 61 to 62) .................................................4-28

G. OTHER INFORMATION IN THE ANNUAL REPORT .....................4-28

1. Notes to the Financial Statements ................................................................4-28

2. The Auditors Report....................................................................................4-29

H. SPECIMEN FINANCIAL STATEMENTS............................................4-31

Chapter 5Fixed-Income Securities .................................................................5-1

A. OVERVIEW ..............................................................................................5-1

CSC VOLUME 1

ix

1. Definitions .....................................................................................................5-1

a) Fixed-income security..........................................................................................5-1

b) Bonds and debentures .........................................................................................5-1

c) Interest ...............................................................................................................5-2

d) Denomination.....................................................................................................5-2

e) Par, discount, and premium ................................................................................5-2

f ) Term to maturity.................................................................................................5-2

g) Liquid bonds, negotiable bonds, and marketable bonds ......................................5-3

2. The Rationale for Issuing Debt Instruments ..................................................5-3

a) Matching the Term of Assets to the Term of Liabilities........................................5-3

b) Use of Financial Leverage ....................................................................................5-3

c) Financing Deficits ...............................................................................................5-3

3. Size of the Fixed-Income Market....................................................................5-4

B. FEATURES AND PROVISIONS OF BONDS.......................................5-4

1. Call or Redemption Feature ..........................................................................5-4

2. Sinking Funds and Purchase Funds ...............................................................5-5

a) Sinking Fund Debt..............................................................................................5-5

b) Purchase Fund Debt ............................................................................................5-6

3. Extendible and Retractable Bonds..................................................................5-6

a) Extendible Debt ..................................................................................................5-6

b) Retractable Debt..................................................................................................5-6

c) Election Period ....................................................................................................5-7

d) Market Performance ............................................................................................5-7

4. Protective Provisions.......................................................................................5-7

a) Prohibition of Prior Lien .....................................................................................5-8

b) Negative Pledge Provision....................................................................................5-8

c) Restricting Additional Borrowing ........................................................................5-8

d) Working Capital Requirements ..........................................................................5-9

e) Sinking Fund Clause ..........................................................................................5-9

f ) Sale and Leaseback Prohibition............................................................................5-9

g) Sale of Assets and Mergers...................................................................................5-9

h) Disposal of Designated Subsidiaries.....................................................................5-9

C. TYPES OF BONDS...............................................................................5-10

1. Government of Canada Securities ................................................................5-10

a) Marketable Bonds ............................................................................................5-10

b) Treasury Bills .....................................................................................................5-11

c) Canada Savings Bonds.......................................................................................5-12

2. Provincial Government Securities and Guarantees........................................5-14

a) Why Provinces Borrow......................................................................................5-14

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b) Quality of Provincial Bonds ..............................................................................5-14

c) Guaranteed Bonds.............................................................................................5-14

d) Provincial Savings Bonds ...................................................................................5-15

3. Municipal Debentures/Installment Debentures ............................................5-15

4. Corporate Bonds ..........................................................................................5-16

a) Mortgage Bonds ................................................................................................5-16

b) Collateral Trust Bonds .......................................................................................5-17

c) Equipment Trust Certificates.............................................................................5-17

d) Debentures ........................................................................................................5-17

e) Convertible Bonds and Debentures ...................................................................5-18

f ) Corporate Notes ................................................................................................5-20

g) Bonds or Debentures Carrying Warrants...........................................................5-20

h) Units .................................................................................................................5-21

i) Real Estate Bonds..............................................................................................5-21

5. Other Types of Fixed Income Securities .......................................................5-21

a) Strip Bonds .......................................................................................................5-21

b) Domestic, Foreign, and Eurobonds ...................................................................5-21

c) Preferred Securities ............................................................................................5-22

d) Term Deposits and Guaranteed Investment Certificates (GICs) ........................5-23

6. Reading Bond Quotes .................................................................................5-24

7. The Bond Rating Services ............................................................................5-24

D. BOND PRICING PRINCIPLES............................................................5-26

1. The Use of Present Value .............................................................................5-26

a) The Discount Rate ...........................................................................................5-26

b) Present Value of the Income Stream ..................................................................5-26

c) Present Value of the Principal ............................................................................5-28

d) Adding the Present Values .................................................................................5-28

2. Bond Yield Calculations...............................................................................5-28

a) Current Yield.....................................................................................................5-28

b) Treasury Bill Yield .............................................................................................5-29

c) Approximate Yield to Maturity..........................................................................5-29

3. Theories of Interest Rate Determination ......................................................5-30

a) Inflation and the Real Rate of Interest...............................................................5-30

b) Factors Affecting Specific Rates: The Term Structure of Interest Rates ..............5-31

4. Fixed-Income Pricing Properties...................................................................5-32

a) As Interest Rates Rise, Bond Prices Fall; As Interest Rates Fall, Bond Prices Rise................................................................................................5-32

b) Longer-term Bonds are More Volatile in Price than Shorter-term Bonds...........5-33

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c) Lower Coupon Bonds are More Volatile in Price than High Coupon Bonds .........................................................................................5-34

d) Special Features Lead to Special Price Considerations........................................5-34

e) Bond Prices are More Volatile when Interest Rates are Low...............................5-35

f ) Reinvestment Risk.............................................................................................5-35

g) Duration ...........................................................................................................5-36

5. The Yield Curve and Bond Switching ..........................................................5-37

a) Benefits of Bond Switches .................................................................................5-38

b) Bond Switching Tips .........................................................................................5-39

E. DELIVERY, REGULATION AND SETTLEMENT...............................5-40

1. Bond Delivery .............................................................................................5-40

2. The Bond Certificate ...................................................................................5-40

a) Bearer Bonds .....................................................................................................5-40

b) Registered Bonds ...............................................................................................5-41

3. Regulation of Bond Trading .........................................................................5-41

4. Accrued Interest ...........................................................................................5-41

F. BOND INDEXES...................................................................................5-44

1. Uses of Bond Indexes ...................................................................................5-44

2. Scotia Capital Canadian Bond Market Indexes ............................................5-44

3. Merrill Lynch Global Indexes .......................................................................5-45

4. Other Index Providers ..................................................................................5-45

Chapter 6Equities.............................................................................................6-1

A. COMMON SHARES................................................................................6-1

B. RIGHTS AND ADVANTAGES OF COMMON SHARE OWNERSHIP.............................................................................6-2

1. Capital Appreciation ......................................................................................6-2

2. Dividends.......................................................................................................6-3

a) Regular and Extra Dividends...............................................................................6-3

b) Declaring and Claiming Dividends .....................................................................6-4

c) Ex-Dividend/Cum Dividend ...............................................................................6-4

d) Dividend Reinvestment Plans..............................................................................6-5

e) Stock Dividends ..................................................................................................6-6

3. Voting Privileges.............................................................................................6-6

a) Restricted Shares..................................................................................................6-6

b) Rights and Benefits of Restricted Shares ..............................................................6-7

c) Stock Exchange Regulations Regarding Restricted Shares ....................................6-7

4. Tax Treatment ................................................................................................6-7

a) Dividends from Taxable Canadian Corporations .................................................6-8

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b) Minimizing Taxable Income on After-Tax Yield of Investments ..........................6-8

c) Tax on Foreign Dividends ...................................................................................6-8

d) Capital Gains and Losses .....................................................................................6-9

5. Marketability..................................................................................................6-9

6. Stock Splits and Consolidations .....................................................................6-9

a) Stock Splits..........................................................................................................6-9

b) Reverse Splits or Consolidations ........................................................................6-10

7. Reading Stock Quotations............................................................................6-10

C. PREFERRED SHARES ..........................................................................6-11

1. The Preferreds Position................................................................................6-11

2. Preference as to Assets ..................................................................................6-12

3. Preference as to Dividends ...........................................................................6-12

4. Features Of Preferred Shares ........................................................................6-13

a. Introduction ......................................................................................................6-13

b. Cumulative and Non-cumulative ......................................................................6-13

c. Callable and Non-callable..................................................................................6-14

d. Voting Privileges ................................................................................................6-14

e. Purchase Funds and Sinking Funds ...................................................................6-14

5. Special Protective Provisions.........................................................................6-15

a) Restrictions on Common Dividends .................................................................6-15

b) Right to Vote in Event of Arrears ......................................................................6-15

c) Restrictions on Further Preferred Issues.............................................................6-15

d) Restrictions on Sale of Assets.............................................................................6-15

e) Restrictions on Change of Terms.......................................................................6-15

6. Why Do Companies Issue Preferred Shares? ................................................6-16

a) Preferred Issue or Debt Issue? ............................................................................6-16

b) Preferred Shares vs. Common Shares .................................................................6-16

7. Who Buys Preferred Shares? .........................................................................6-16

D. TYPES OF PREFERREDS.....................................................................6-17

1. Fixed Rate (or Straight) Preferreds................................................................6-17

2. Convertible Preferreds ..................................................................................6-17

a) General Description ..........................................................................................6-17

b) Selecting Convertible Preferreds ........................................................................6-18

c) Implications for Investors ..................................................................................6-19

3. Retractable Preferreds ...................................................................................6-19

a) General Description ..........................................................................................6-19

b) Implications for Investors ..................................................................................6-20

c) How to Calculate Annual Pre-Tax Yield for A Retractable Preferred .................6-20

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4. Variable or Floating Rate Preferreds .............................................................6-20

a) General Description ..........................................................................................6-20

b) Implications for Investors ..................................................................................6-21

5. Foreign-pay Preferreds..................................................................................6-21

6. Canadian Originated Preferred Securities (COPrS) ......................................6-21

7. Other Types of Preferreds .............................................................................6-22

a) Participating Preferreds......................................................................................6-22

b) Preferred Issues with Warrants ...........................................................................6-23

c) Auction Preferreds ............................................................................................6-23

d) Deferred Preferreds............................................................................................6-23

e) Split Shares........................................................................................................6-23

E. CASH AND MARGIN ACCOUNTS....................................................6-23

1. Cash Accounts .............................................................................................6-23

a) Cash Account Rules Summary .......................................................................6-24

b) Investment Firms are Allowed the Use of Customers Free Credit Balances ..........................................................................................6-24

2. Margin Accounts..........................................................................................6-24

a) Maximum Loan Values......................................................................................6-24

b) Margining Long Positions in Listed Equities .....................................................6-25

F. SHORT SELLING OF EQUITIES .......................................................6-26

1. What is Short Selling? ..................................................................................6-26

2. How is Short Selling Done? .........................................................................6-27

a) Margin Needed for Short Positions ...................................................................6-27

b) Profit or Loss on Short Sales..............................................................................6-29

c) No Time Limit on Short Sales...........................................................................6-29

d) Covering a Short Sale ........................................................................................6-29

e) Necessity of Declaring a Short Sale....................................................................6-29

f ) Public Reporting of Short Positions...................................................................6-30

g) Dangers of Short Selling....................................................................................6-30

G. EQUITY TRANSACTIONS..................................................................6-30

1. An Agency Transaction Trading Procedures...............................................6-30

2. Settlement Procedures ..................................................................................6-32

3. Other Transaction Models............................................................................6-32

H. BUY AND SELL ORDERS....................................................................6-33

1. At the Market Order ....................................................................................6-33

2. Limit Order .................................................................................................6-34

3. Day Order....................................................................................................6-34

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4. Open or Good Till Cancelled (GTC) Order ................................................6-34

5. All or None Order (AON Order).................................................................6-34

6. Any Part Order ............................................................................................6-34

7. Good Through Order ..................................................................................6-34

8. Stop Loss and Stop Buy Orders....................................................................6-34

a) Stop Loss Order ................................................................................................6-34

b) Stop Buy Order .................................................................................................6-34

9. The Preferential Trading Rule and the Pro or N-C Order ............................6-35

a) Clients Orders Have Priority ............................................................................6-35

b) The Pro Order, N-C or Emp Order ..................................................................6-35

I. STOCK INDEXES AND AVERAGES ..................................................6-35

1. What Is An Index? .......................................................................................6-35

2. What Is an Average? ....................................................................................6-35

3. Canadian Market Indexes.............................................................................6-36

a) The S&P/TSX Composite Index.......................................................................6-36

b) The S&P/TSX 60 Index....................................................................................6-39

c) The S&P/TSX SmallCap, MidCap Indexes ......................................................6-39

d) The S&P/TSX Venture Composite Index .........................................................6-39

4. U.S. Stock Market Indexes ...........................................................................6-40

a) The Dow Jones Industrial Average ....................................................................6-40

b) S&P 500 ...........................................................................................................6-41

c) The New York Stock Exchange Indexes .............................................................6-42

d) The Amex Market Value Index..........................................................................6-42

e) The NASDAQ Composite ................................................................................6-42

f ) The Value Line Composite................................................................................6-42

g) Other U.S. Stock Market Indexes......................................................................6-43

5. International Stock Market Indexes and Averages.........................................6-43

a) Japan: Nikkei Stock Average (225) Price Index..................................................6-44

b) United Kingdom: FTSE 100 Index ...................................................................6-44

c) Germany: DAX .................................................................................................6-44

d) France: CAC 40 Share Price Index ....................................................................6-44

e) Switzerland: Swiss Market Index........................................................................6-44

Chapter 7Derivatives .......................................................................................7-1

A. INTRODUCTION ...................................................................................7-1

B. WHAT IS A DERIVATIVE? .....................................................................7-1

1. Derivative Markets .........................................................................................7-1

a) Over-the-Counter Derivatives .............................................................................7-2

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b) Exchange-Traded Derivatives...............................................................................7-2

2. Reading a Derivatives Quotation....................................................................7-3

3. Key Differences Between Exchange-Traded and OTC Derivatives .................7-5

a) Standardization and Flexibility ............................................................................7-5

b) Privacy.................................................................................................................7-6

c) Ease of Termination.............................................................................................7-6

d) Default Risk ........................................................................................................7-6

e) Regulation ...........................................................................................................7-6

C. TYPES OF UNDERLYING ASSETS......................................................7-7

1. Commodities .................................................................................................7-7

2. Financials .......................................................................................................7-8

a) Equity and Equity Indexes ..................................................................................7-8

b) Interest Rates.......................................................................................................7-8

c) Foreign Currencies ..............................................................................................7-9

D. WHO USES DERIVATIVES AND WHY DO THEY USE THEM? ..................................................................................7-9

1. Individual Investors........................................................................................7-9

2. Institutional Investors...................................................................................7-10

3. Corporations and Businesses ........................................................................7-10

a) Hedging ............................................................................................................7-10

b) To Hedge or Not to Hedge? ..............................................................................7-11

4. Derivative Dealers ........................................................................................7-11

E. OPTIONS..............................................................................................7-11

1. Key Terms and Definitions...........................................................................7-11

2. Basic Option Strategies for Individual and Institutional Investors ................7-14

a) Buying Call Options .........................................................................................7-15

b) Writing Call Options ........................................................................................7-17

c) Buying Put Options ..........................................................................................7-19

d) Writing Put Options .........................................................................................7-20

3. Basic Option Strategies for Corporations .....................................................7-22

a) Call Option Strategies .......................................................................................7-22

b) Put Option Strategies ........................................................................................7-22

F. FORWARDS...........................................................................................7-23

1. Futures: Key Terms and Definitions .............................................................7-23

a) Cash-Settled Futures..........................................................................................7-24

b) Margin Requirements and Marking-to-Market..................................................7-24

2. Basic Futures Strategies ...............................................................................7-24

a) Buying Futures ..................................................................................................7-25

b) Selling Futures...................................................................................................7-26

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3. Basic Futures Strategies for Corporations .....................................................7-26

G. USE OF FUTURES AND OPTIONS BY MUTUAL FUND COMPANIES AND PORTFOLIO MANAGERS.........................................................7-27

1. Market Entry and Exit .................................................................................7-28

2. Yield Enhancement ......................................................................................7-29

H. RIGHTS AND WARRANTS ................................................................7-30

1. Rights...........................................................................................................7-30

a) Why Rights are Issued.......................................................................................7-30

b) The Intrinsic Value of Rights.............................................................................7-31

c) Trading Rights...................................................................................................7-32

2. Warrants.......................................................................................................7-33

a) Why Investors Buy Warrants .............................................................................7-33

b) Other Factors in Warrant Selection ...................................................................7-34

c) Valuing Warrants ...............................................................................................7-34

d) Types of Warrants..............................................................................................7-35

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VOLUME 2Chapter 8Analyzing Markets and Products...................................................8-1

A. OVERVIEW OF ANALYSIS METHODS ...............................................8-1

1. Fundamental Analysis ....................................................................................8-1

2. Quantitative Analysis .....................................................................................8-1

3. Technical Analysis ..........................................................................................8-2

4. Efficient Market Theories...............................................................................8-2

a) The Efficient Market Hypothesis ........................................................................8-2

b) Random Walk Theory .........................................................................................8-2

c) Rational Expectations Hypothesis........................................................................8-2

d) Evidence ..............................................................................................................8-3

B. FUNDAMENTAL MACROECONOMIC ANALYSIS............................8-3

1. External Events ..............................................................................................8-3

2. Fiscal Policies..................................................................................................8-3

a) Tax Changes ........................................................................................................8-4

b) Government Spending.........................................................................................8-4

c) Government Debt ..............................................................................................8-4

3. Monetary Policy .............................................................................................8-5

a) Accumulated Debt and Monetary Policy .............................................................8-5

b) The Currency Market and Monetary Policy ........................................................8-6

c) The Bond Market and Monetary Policy ..............................................................8-6

d) The Tilting Yield Curve .....................................................................................8-6

4. Flow of Funds ................................................................................................8-7

a) Net Purchases of Canadian Equity Mutual Funds ...............................................8-7

b) Non-Resident Net Purchases ...............................................................................8-8

5. Inflation .........................................................................................................8-8

a) Impact on Stocks.................................................................................................8-9

b) Accounting for the Effects of Inflation ................................................................8-9

C. FUNDAMENTAL INDUSTRY ANALYSIS ..........................................8-10

1. Classifying Industries by Product or Service .................................................8-11

a) Estimating Growth............................................................................................8-11

b) Laws of Survivorship .........................................................................................8-11

2. Classifying Industries by their Stage of Growth............................................8-12

a) Initial Growth or Emerging Industries...............................................................8-12

b) Growth Industries and Companies ....................................................................8-12

c) Mature Industries ..............................................................................................8-13

d) Declining Industries ..........................................................................................8-13

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3. Industry Classification by Competitive Forces..............................................8-14

4. Classification by Industry and Stock Characteristics.....................................8-14

a) Return on Equity (ROE)...................................................................................8-14

b) Cyclical Industries .............................................................................................8-15

c) Defensive Industries ..........................................................................................8-15

d) Speculative Industries ........................................................................................8-16

D. FUNDAMENTAL COMPANY ANALYSIS ..........................................8-16

1. Earnings Statement Analysis.........................................................................8-16

a) Sales ..................................................................................................................8-16

b) Operating Costs ................................................................................................8-17

c) Key Ratios .........................................................................................................8-18

d) Dividend Record ...............................................................................................8-18

2. Balance Sheet Analysis..................................................................................8-18

a) The Effect of Leverage.......................................................................................8-18

b) The Capital Structure........................................................................................8-19

3. Qualitative Analysis......................................................................................8-20

4. Liquidity of Common Shares .......................................................................8-20

5. Timing of Purchases and Sales......................................................................8-20

6. Continuous Monitoring of Companies ........................................................8-20

E. INTERPRETING FINANCIAL STATEMENTS ..................................8-20

1. Trend Analysis .............................................................................................8-22

2. External Comparisons ..................................................................................8-23

3. Types of Ratios.............................................................................................8-24

a) Liquidity Ratios.................................................................................................8-24

b) Risk Analysis Ratios .........................................................................................8-24

c) Operating Performance Ratios...........................................................................8-24

d) Value Ratios ......................................................................................................8-25

4. Liquidity Ratios ...........................................................................................8-25

a) Working Capital Ratio or Current Ratio ...........................................................8-25

b) Quick Ratio (The Acid Test) .............................................................................8-26

c) Operating Cash Flow Ratio ...............................................................................8-26

5. Risk Analysis Ratios .....................................................................................8-27

a) Asset Coverage...................................................................................................8-27

b) Percentage of Total Capital Ratios .....................................................................8-29

c) Debt/Equity Ratio.............................................................................................8-30

d) Cash Flow/Total Debt Outstanding ..................................................................8-30

e) Interest Coverage...............................................................................................8-32

f ) Apparent Tax Rate .............................................................................................8-33

g) Preferred Dividend Coverage.............................................................................8-34

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6. Operating Performance Ratios .....................................................................8-36

a) Gross Profit Margin...........................................................................................8-36

b) Operating Profit Margin....................................................................................8-36

c) Pre-Tax Profit Margin........................................................................................8-37

d) Net Profit Margin..............................................................................................8-37

e) Pre-Tax Return on Invested Capital...................................................................8-38

f ) Net (or After-Tax) Return on Invested Capital ..................................................8-38

g) Net (or After-Tax) Return on Common Equity.................................................8-39

h) Inventory Turnover Ratio ..................................................................................8-39

7. Value Ratios .................................................................................................8-41

a) Percentage Dividend Payout Ratios ...................................................................8-41

b) Earnings per Common Share ............................................................................8-41

c) Dividend Yield ..................................................................................................8-44

d) Price-Earnings Ratio or PE Multiple .................................................................8-44

e) The Enterprise Multiple (Enterprise Value to EBITDA) ...................