Introduction to Securities Domain

1. Introduction to Securities Domain

2. Objective • Creation of a foundation in Securities Domain • Exposure to terminology • Understanding of basic products • Understanding of trading markets and regulations • Understanding of brokerage operations • Encourage further exploration of topic areas Foundation for Domain Certification Course

3. Agenda • Part 1a: Introduction to Financial Instruments • Stocks, Bonds, Derivatives, Packaged Products. • Part 1b: Introduction to Financial Marketplace • Market Development, Order Types, Stock Markets, Margin Trading. • Part 2: Introduction to Brokerage Operations • Execution, Settlement, Clearing

4. Why does an institution need money? • Establish New Business • Expand Existing Business • Pay off Existing Loans • Buy other institutions The needs for capital are numerous, like those of any individual

5. Equity – Share Ownership Shares / Stocks - High return, Liquidity, Capital appreciation, Limited Liability Debt – Take Loan Bond Offerings - Low Risk, Poor Hedge against Inflation, Fixed Yield How do one raise capital? Founders (friends and family) Banks Government Venture Capitalists Broker Dealers Shares and Bonds are fundamental products. Other products are derived

6. Equity – Stock terminology • Authorized stock – Outlined in corporate charter • Issued Stock (A)– The portion of authorized stock that is actually sold to investors by a corporation • Treasury Stock (B)– Stocks that have been bought back by the company that issued them. • Outstanding Shares – Stocks remaining with the various investors (A-B) • Common Stock • Preferred Stock • Par Value / Face Value- Arbitrary value placed on common stock at the time of its authorization; Important only for accounting purpose • Market Capitalization- Market value of the company’s stock = Share Price * Number of shares outstanding (Publicly held)

7. Preferred Stock vs. Common Stock • Common Stock • Junior Status • Ownership • Ease of Transfer • Voting rights • Dividends and /or capital growth • Issuer gives up control (ownership) • Investor may receive dividends/appreciation • Preferred Stock • Pays a fixed dividend • Par Value • No voting rights • Acts more like bond than a stock • In U.S. often bought by other corporations • Has preference over common stock when it comes to Bankruptcy and Dividends Common stock - Ownership; Preferred shares – No Ownership

8. Sale of stock to public for the first Registration statement filed with Securities and Exchange Commission (SEC) Underwriting - The investment banker functions as an intermediary (Underwriter) between the issuing corporation and the investors Underwriter offers stocks to the general public and institutions for sale through selling group members (e.g. CSFBDirect) Prospectus Issue - Legal documents explaining the financial facts important to an offering;must precede or accompany sale of primary offering Issue subscribed to by investors Stock IPO – Primary Markets IPO – Initial Public Offering

9. How can a company pay its shareholders? • Stock Dividend – Giving more shares for existing shares at a predefined ratio eg. 2:1- Two shares for every one share currently held • Stock Split – Break a share into multiple shares • Cash Dividend – Give cash at a particular percentage of face value – 10% Dividend Objective is to increase liquidity and shareholder value

10. American Depository Receipts • Foreign country shares traded in US • Bank purchases ordinary shares of the company • Shares are deposited in a local custodian bank • ADR issued by US depositary bank (e.g. BNY) • ADR trade on U.S. exchanges. India Stock ADR US ADRs - Selling Foreign Shares in America indirectly

11. Introduction to Bonds • Bonds are debt securities sold by a company or government to raise money (Fixed Income Instruments) • Bond holder becomes a Creditor but not owner of bond issuing corporation • Bond holder receives interest yield in addition to principal amount • Bonds characterized by finite life span (determined by Maturity period) • Issuer is responsible for repayment of principal and interest Bond is the other fundamental product giving fixed returns

12. Bond Terminology • Par Value- The value of a bond assigned by the issuer; also called face value. • Coupon - Paper that evidences an issuer's promise to pay interest when due • Coupon rate- The interest as a percent of par paid by a bond • Premium. The amount by which a bond sells above its par value • Maturity date- The date on which a bond is to be redeemed and its principal and interest returned to the owner • Yield- The rate of return on an investment, described as a percentage of the amount of the investment

13. Bond in a Nutshell 8% IBM Issuer $80/2 = $40 Semi-annual interest $1,000 Face Amount Semi Annual 1/15/25 Interest Payment dates are: 1/15 and 7/15 Maturity Date

14. Bond Categories • Issuer Based Categories • Government Securities- Issued by The U.S. government from the U.S. Treasury and several government agencies. • Outstanding securities on 01/19/2005 ---- $7,613,772,338,689.34 • Corporate Bonds- Bonds issues by various corporations to borrow money for operations • Municipal Bonds- Bonds issued by states, cities, counties and various districts to raise money to finance their operations or to pay for infrastructure projects. • Convertible Bonds • Bonds convertible into common stock • Generally lower coupons as there is upside for investors

15. Derivatives $ 175 Save $1,200 One Month Later Pay $25 and Book TV Buy One Month Later Pay Today’s Price $1,000 Buy Today $ 175 Lose $ 850 One Month Later There is no deal without a TV here – Fundamental Product

16. Options • Terminology • Rights and Obligations (to buy or sell) • Specific Stock (Round lot) • Specific Time Frame (Expiration date) • Specific Price (strike) • Premium • Reasons to buy Options • Directional Speculation • Volatility Speculation • Protection of Stock Position • Income Generation • Getting out of options • Liquidate or Buy Back in Market • Exercise • Expiration

17. Options Trading Option Buyer Option Writer “I have a Right” (Control) “I have an Obligation” (No Control) “I got paid $ ” “I paid$” Sellers take on obligations “Are Passive” Get paid for their promise Buyers Have rights “are in Charge” Pay for the privilege

18. Call Options Call Writer Call Buyer Obligation to Sell (No Control) Right to Buy (Control) Bearish Bullish Call Option – Right to Buy assumes price would go up

19. Put Options Put Buyer Put Writer Right to Sell (Control) Obligation to Buy (No Control) Bullish Bearish Put Option – Right To Sell, Assumes Price to Go Down

20. Rights & Warrants • Rights • Securities issued by corporation • Shareholders maintain percentage ownership • Rights offering and standby underwriting • Warrants • Right to buy shares of stock at a specific price. • Warrants are issued by a corporation • Warrants may be long-term or perpetual. • Attached to bond or part of unit • Low cost capital raise Rights and Warrants - Issued by Corporation , not between two parties

21. Mutual Funds • Pool of Investors Money • Financial Expert Manages money • Buys Multiple Company Shares • Investors own units that are priced proportionately • Value of units change based on fluctuations in share prices • Dividends and Capital Appreciation • Diversification at low cost Mutual Funds – Owning shares indirectly

22. Fund Terminology • Net Asset Value - The value of a single unit of the fund determined on a daily basis • Management fee - The fee charged to compensate those who run the fund's portfolio; Approximate around one percent of the fund's assets • Fund Types - Sales Charges i.e. fees payable while buying/redeeming shares in the fund • Front end load Funds- Charges levied when shares in the fund are purchased • Back end load Funds- Charges levied when shares in the fund are redeemed • No load Funds- No sales charge • Fund Types - Continuous / Time Bound • Open end funds- Issue new units continuously as investors buy them. Investors redeem their units directly to the fund, • Closed end funds- Issue a fixed number of units. Fund may redeem only upon termination of the fund's trust. Unit holders may sell their units to other investors.

23. Annuities • Guarantees returns over a period of time, based on initial investment • Monthly income plan, Purchasing power risk • Fixed Annuities • Money invested in general account • Pays a fixed monthly income at retirement • Variable Annuities • Pays variable monthly payment at retirement • Investment risk • Immediate or deferred Payout

24. Reading Material • http://www.brokerage101.com/ - Section on Marketable Securities • http://www.invest-faq.com/ • http://www.fool.com • http://www.investopedia.com • http://stocks.about.com/ - Equities • http://mutualfunds.about.com/ - Mutual Funds • http://www.annuityfyi.com – Annuities • - Futures and Options • http://stocks.about.com/od/bonds/ - Bonds

25. Financial Marketplace • Development of Trading Markets • Order Types • Secondary Markets • NYSE • NASDAQ • Margin Trading

26. Market Development • Buyers and Sellers exist like any other market • “Bidders” are Buyers • “Askers” are Sellers • Difference between the Bid and Ask is the Spread Sell 500 shares @ $20.25 Potential Buyer = Bid Potential Seller =Ask Buy 300 shares @ $19.50 Price Differences prevent a deal

27. Market Development • New bidders and Askers enter • Old Bidders and Askers exit • Existing Bidders and Askers change price and quantity Sell 500 shares @ $20.25 Potential Buyer = Bid Potential Seller =Ask Buy 750 shares @ $20.00 Prices match ultimately for a deal; Volume Not necessarily

28. Trading Positions • Long position - Buy Followed by Sale • Securities owned by an investor • Short Position – Sale Followed by Buy • Securities not owned by an investor, Relevant only when you sell • Selling Short - The sale of a security that the investor does not own in order to take advantage of an anticipated decline in the price of the security. • To sell short, the investor must borrow the security from his broker in order to make delivery to the buyer • The short seller will eventually have to buy the security back, or buy to cover, in order to return it to the broker In the long run, any investor is expected to close the position

29. Market Order “Sell 100,000 Shares at the Market” Order to buy or sell a stock as soon as possible at the best price available

30. “Buy 100,000 Shares at the Market” Market Order Order Format - XYZ, Sell, 100 Price , Time, Quantity – Order of Preference for any trade

31. $20.50 $20.25 Sell Limit Orders $20.00 $19.50 Current Price $19.00 Buy Limit Orders $18.75 $18.50 Limit Orders • Placing a price parameter on order • Not guaranteed execution, but if executed, will receive a better price than the current market price. • Order to buy or sell a stock only at the specified price (the limit price) or better; Safer way for trading • Format for order • XYZ, Sell, 100, $20.25 Buy limit price < Current market price, Sell limit price > Current market price

32. Sell Stop Order Buy @ Market Sell Stop Order (stop-loss order) • Used to protect a long position • Placed below the market • Two Step Process: • 1. “Activation price” or “Trigger price” • 2. Once “activated”, it becomes a market order • Order Format – XYZ, Sell, 100, $18 • Market Price could be $ 20

33. Sell Stop Order 1. Buy 100 XYZ @ the market price of $20.00 (long position) 2. Places the following order to protect his long position: Sell 100 XYZ $18.00 stop GTC Three days later the following trades take place: Activation Price / Execution Price ?

34. Buy Stop Order Buy Stop Order Short Sale • Used to protect a short position • Placed above the market • Two Step Process: • 1. “Activation price” or “Trigger price” • 2. Once “activated”, it becomes a market order • Order Format – XYZ, Buy, 100, $22 • Market Price could be $ 20

35. Buy Stop Order 1. Sell Short 100 XYZ @ the market price of $20.00 (Short position) 2. Places the following order to protect short position: Sell 100 XYZ $22.00 Stop GTC Three days later the following trades take place: Activation Price / Execution Price ? Stop-Limit Order- Like a stop Order but after activation becomes a limit Order instead of Market Order

36. More Order Types • All-or-None Order (AON) • No partial executions • Broker has all day to execute order (no urgency) • Immediate-or-Cancel Order (IOC) • Partials are acceptable • Fill immediately (urgency), and cancel unfilled balance • Fill-or-Kill Order (FOK) • Fill immediately • No partials • If entire order cannot be filled immediately, then cancel order • Day Order • Good for the day • If not executed within the course of day, order is canceled. • GTC Order • Also known as an “open order”. • Order is in effect until executed or canceled by the customer

37. All Fall in Line • Someone records and tracks order information to ensure the best deal for everyone Building Block for a stock exchange

38. Quiz • I placed a sell order for CSCO, even though I never bought any shares of CSCO. What have I done? • Bought GOOG at $230, am hoping it will go up, but I also want some protection in case it goes down, what can I do? • If MSFT issues 85 Million shares and decides to buy back 6 Million shares, how many shares are outstanding in the market? • How many shares of MSFT are authorized in the above case? • What is the market capitalization of MSFT if the market price is $10 per share? • If MSFT declares a 10% dividend, what amount would I get if I own 2000 shares?

39. Securities and Exchange Commission (SEC) www.sec.gov Responsible for administering and enforcing the federal securities laws, and regulating brokerage firms, investment companies and advisers Ensures orderly market performance and information availability to investors Establish accounting norms for securities transactions National Association of Securities Dealers (NASD) www.nasd.com Works to aid and safeguard investors by regulating markets, formulating guidelines, facilitating dispute resolution and monitoring member activities Regulatory Bodies

40. Stock Market Players • Broker – A person or firm that facilitates trades between customers • Acts only as an intermediary and does not assume risks for the trade • Charges commissions • Dealer – A person or firm that buys and sells from his or her own inventory of securities as well as for others • Assumes risk for the transactions • Marks securities up or down to make a profit on their transactions • Registered Representatives –An individual who has passed the NASD's registration process and is therefore licensed to work in the securities industry • Follows NASD rules. • Usually a brokerage firm employee acting as an account executive for clients • Sell to the public; they do not work on exchange floors

41. Market Classification Secondary Markets-Market for outstanding issues Exchange Markets OTC Markets • Stock Exchange • (NYSE, AMEX etc) • Private association of brokers • Auction type of trading • Central meeting place where members trade in listed securities • Over the Counter (OTC) • market (NASDAQ) • Negotiated market, without a central trading floor • Composed of network of brokers and dealers • Bid/ask quotes given by market makers Hybrid Market

43. Auction Markets Specialists Centralized Listing standards NYSE is the model NYSE - SRO Exchange Markets

44. The New York Stock Exchange

45. What does the NYSE do? • Trading and trading services • NYSE charges (directly and indirectly) for trades that occur and for software supplied to its members. • Listing • To be listed on the NYSE, a corporation must meet/maintain certain financial standards and pay listing fees. • An NYSE listing is a certification that enhances a firm’s credibility. • Information • NYSE is (indirectly) an information vendor. • Regulation • NYSE monitors and regulates the trading activity of its members. • Through the listing relationship and the listing standards, it can affect corporate governance behavior. • Other Information • Traditional Auction Market with 2800 Companies Listed and 460 Non US Listings from 48 countries • Listings war with NASD / Overseas markets • Ownership Structure-1366 Seats (constant since 1953)

46. Specialist Role • The Post • Each security is assigned a particular spot on the trading floor. • All activity for each security takes place at the security’s post through open outcry. • The specialist as auctioneer • The specialist may act as either principal or agent • Role of the Specialist • Maintains a fair and orderly market • Provides liquidity • Resolves order imbalances • Floor Brokers • Act in an agency capacity • No risk is assumed on transaction • Compensation is a commission

47. Transactions that occur off the floor of an exchange Negotiated Market Market makers Decentralized Nasdaq is the model for OTC markets NASD – SRO Not face to face Bids and offers entered via phone or computer Market Makers willing to sell or buy OTC Markets

48. NASDAQ

49. NASDAQ ? • Electronic communication and execution network • Market Makers post prices to buy and sell • Think of shopping @ 100s of stores • Inventory of stocks • Computer automatically finds the best prices- inside market • Nasdaq is an NASD operated electronic quote system . • Two tiers of Nasdaq: 1. Nasdaq National Market (NNM) 2. Nasdaq SmallCap • 2872 Company Listings • 11,000 registered traders with 790 firms • 1.2 million terminal users in 82 countries

50. Role of the Market Maker A Dealer Market uses multiple dealers, known as Market Makers. • Compete for investor orders • Commit capital • Maintain inventories • Seek the other side of a trade • Trade on both sides of the market • Generate investor interest