Finance Exam 1 Study Guide

Chapter 1 – Investment
The investment process consists of two broad tasks:
(a) Security (micro) analysis.
(b) Market (macro) analysis.

Financial assets:
(a) Financial claims on the issuers of the securities
(b) Marketable securities are financial assets that are easily and cheaply tradable in
organized markets.
(c) What are three categories of securities?
(1) Equity securities
(2) Debt securities
(3) Derivative securities

The rate of return (Ri) is what you earn on an investment over a time period.
(a) The return is usually stated in percentage terms.
(b) The rate of return on an asset over a period is also known as (a.k.a.) total return (TR) or
holding period return (HPR).
(c) The return can represent growth in wealth and purchasing power.

The quantitative measure of return consists of two components:

(a) The income component of a return arises from income that an investor receives from
the asset while he or she owns it.
e.g.,
(1) What is the term that describes an income component from stock investments?
(2) What is the term that describes an income component from bond investments?
(3) What is the term that describes an income component from real estate investments?
(b) The capital appreciation component of a return arises from a change in the price of the
asset over the holding period.
(1) Capital gain is often used to mean realized capital gain. An unrealized capital gain is
an investment that hasn't been sold yet but would result in a profit if sold.
(2) If the price of the security rises above what we paid for, we have a capital
_______________.
(3) If the price of the security drops below what we paid for, we have a capital
_______________.

Equation:
Dollar gains Cash flow+Capital Appreciation
Ri = = =
P0 Initial Price
CF 1 +( P1−P 0) CF 1 +∆ P CF 1 ∆ P
= = +
P0 P0 P0 P 0

(a) Ri = the holding period return over the period

(b) CF1 = the cash flow from the dividend (or the cash received from the investment)
 (c) P1 = the price of the asset at a later point in time
(d) P0 = the price of the asset at time zero

Two types of returns:

(a) Actual return (AR)
(b) Expected return (ER)

Expected Return on Security = E(Ri)

1. The anticipated rate of return on an investment for some future period of time.

2. The expected return is a weighted average of the possible returns from an

investment, where each of these returns is weighted by the probability that it will
occur.

Two-Step Process of Investment Decisions

1. Valuation and analysis of individual securities

2. Portfolio management
(a) Construct a portfolio with stocks, bonds, and other assets.
(b) Revise the portfolio on a continuous basis.

Chapter 2 – Investment Alternatives

The Role of Financial Markets
1. Help firms and governments raise cash by selling claims against themselves.
2. Provide a place where investors can buy and sell securities (investments).
3. Help the private companies to become public and original investors to cash out.

Two Main Choices of Savings

Exhibit 2-1 (p. 24) Major types of financial assets
1. Direct investing:
(a) Investors hold securities directly through brokers and other intermediaries.
(b) What financial assets can be invested directly?

2. Indirect investing:
(a) Investors hold securities indirectly through investment companies.
(b) What financial assets can be invested indirectly?
Hold securities indirectly, through mutual funds and pension funds. [Details in Chapter 3]

Direct Investing
1. Nonmarketable securities:
Exhibit 2-2 (p. 25) Important nonmarketable financial assets.
(a) Examples:
(1) Savings deposits (savings account)
(2) Nonnegotiable Certificates of deposits
(3) Money market deposit accounts (MMDAs)
(4) U.S. government savings bonds
 (b) Personal transactions between the owner and the issuer

2. Marketable securities:
(a) Marketable securities are financial assets that are negotiable or salable in the
marketplace.
(b) Impersonal transactions between the buyer and seller because the buyer (seller) does not
know who the seller (buyer) is.

3. Three types of markets for marketable securities:

(a) Money market
(b) Capital market
(c) Derivatives market

Money Market
1. Money market is where short-term debt instruments are traded.

2. Features of money market securities:

(a) Short-term securities with a maturity of one year or less.
(b) ______________ liquidity.
(c) ______________ default risk
3. Money market securities are most appropriate for temporary cash storage or short-
term horizons.
(a) Money market securities are generally very safe investments which return a relatively
low interest rate.
(b) To manage liquidity, a firm can invest idle cash in money market instruments; then, if the
firm has a temporary cash shortfall, it can raise cash overnight by selling money market
instruments.

4. Selected money market instruments:

FIN 352 Exhibit 2-3 (p. 27) Important Money Market Securities
(a) US Treasury bill (T-Bill):
(1) A negotiable debt obligation issued by the U.S. government and backed by its full
faith and credit, having a maturity of one year or less.
(2) The premier money market instrument, a fully guaranteed, very liquid IOU from the
U.S. Treasury.
(3) They are sold on an auction basis every week at a discount from face value in
denominations starting at $10,000.
(4) The greater the discount at time of purchase, the higher the return earned by investors.
(b) Commercial paper (CP):
(1) A short-term, unsecured promissory note issued by large, well-known, and financially
strong corporations (including financial companies).
(2) Denominations start at $100,000.
(c) Negotiable certificate of deposit (NCD)

5. Money market securities are dominated by financial institutions.

 (a) The size of the transactions in the money market typically is large, usually in the amount
of at least $10,000 for T-bills and $100,000 for Commercial Papers.

Capital Market
1. Capital market is where long-term securities are traded.

2. Features of capital market securities:

(a) Long-term securities with a maturity greater than one year.
(b) Higher default risk than money market securities.
(1) The time to maturity
(2) The very nature of the securities sold in the capital market.
(c) Compared with money market instruments, capital market instruments are less
marketable, have higher default risk, and have longer maturities.

3. Selected capital market instruments:

FIN 352 Exhibit 2-1 (p. 24) Major types of financial assets
(a) Fixed-income securities
e.g., corporate bonds, state and local government bonds, Treasury notes, Treasury bond
(1) Have a specified payment schedule
(2) Mature at some future dates
(b) Equity securities
(1) Denote an ownership interest in a corporation.
(2) Two forms of equities:
- Preferred stock (PS): some have maturities in the 30-49-year range.
- Common stock (CS): no maturity.

4. Which of the following financial asset accounts for the largest security market in the
U.S.?
(a) Corporate bonds
(b) Corporate stocks
(c) Treasury bills
(d) Treasury bonds

5. True or false: Transaction in US Treasury bills takes place in the capital market.

Four Major Types of Bonds

1. Treasury securities (also known as Federal government securities) issued by the U.S.
government
(a) Treasury notes, or T-notes, are issued for a term of two, five, or 10 years.
(b) Treasury bonds, or T-bonds, are issued with maturities of 10 to 30 years.
- The 10-year Treasury yield is the centerpiece of the global financial system and helps
set prices for all kinds of other loans and investments.

2. Federal agency securities

(a) Federal Agencies:
(1) Part of the federal government.
(2) Their securities are fully guaranteed by the Treasury.
 (3) Example:
o The Federal National Mortgage Association (“Fannie Mae”)
o The Federal Home Loan Mortgage Corporation (“Freddie Mac”)
(b) Federally Sponsored Enterprises (GSEs):
(1) Publicly held, for-profit corporations
(2) Their securities are not explicitly guaranteed by the government as to principal and
interest.
(3) Example:
o Federal Home Loan Bank
o Farm Credit System

3. Municipal securities (Munis)

(a) They are securities issued by political entities other than the federal government and its
agencies, such as states and cities.
(1) Municipal bonds are issued by state and local governments to raise money for major
infrastructure projects, such as local roads, hospitals, and stadiums.
(2) Like any borrower, state and local governments pay interest to investors who hold the
bonds.
(b) What are three potential benefits that set Munis apart?
(1) safety of principal
(2) regular predictable income
(3) tax-free benefits for interest income
(c) Municipal bond yields are typically stated on an after-tax basis.
(1) Is interest income received from muni bonds free from federal income tax?
(2) Is interest income from municipal bonds exempt from state and local income taxes?
(3) Interest income may also be exempt from state and local income taxes if investors
live in the same state as the bonds were issued.

4. Corporate bonds
(a) They are securities issued by corporations.
(b) Bond yields are typically stated on a before-tax basis.
(c) Interest income received from corporate bonds is ______________.

Taxable Equivalent Yield (TEY)

p. 34. Tax implications for investors.
1. Because of the tax-exempt advantages of muni bonds, the TEY is used to compare a muni
bond with a similar bond producing taxable income.

2. The TEY can show the before-tax interest rate on a municipal bond, given any marginal tax
rate.
Muni yield
1−marginal tax rate
Formula: TEY =

Bond Basics 101

1. Bonds are used by businesses (firms) and governments to raise large sums of capital.
(a) Most of the large corporations, several thousand in total, issue corporate bonds to help
finance their operations.
(b) Many of firms have more than one issue outstanding.

2. Bonds are viewed as long-term debt instruments that represent the issuer’s contractual
obligation.
(a) Debt instruments are also known as IOUs; IOU is an abbreviation, in phonetic terms, of
“I owe you.”
(b) The buyer (bondholder) of a bond is lending money to the issuer who agrees to repay
principal and interest.
(c) Bonds usually have an initial maturity of 10 years or more.
(d) Because bonds are debt instruments where the interest paid to investors is fixed for the
life of the contract, they are called fixed-___________ securities.
(e) Bonds can be viewed as fixed-cost financing securities for issuers (firms or governments)
because of equal and periodic interest costs.
(f) Is the interest expense on bonds tax-deductible for corporations?

3. Most corporate bonds are issued with a face value of $________.

(a) This par value of a bond is assumed throughout this class, unless otherwise specified.
(b) The face value is also known as (a.k.a.) the par value or principal amount.
(c) When is the par value paid to the bondholder?

4. Types of corporate bonds:

(a) Typical bonds
(b) Zero-coupon bonds
(c) Convertible bonds that can be converted into shares of common stock at some
predetermined ratio at the discretion of the bondholder.

5. Other characteristics:
(a) If a bond is callable, the issuer (the firm issuing the bonds) can repurchase bonds prior to
maturity.
(b) Bond ratings indicate the relative probability of default risk.

Characteristics of Typical Bonds (a.k.a. Vanilla bonds) 101

1. Vanilla bonds, the most common bonds issued by corporations, have coupon payments
that are fixed for the life of the bond. At maturity, the entire original principal is paid
and the bonds are retired.
(a) The face value (F) of a bond will be repaid at maturity.
(b) Coupon payments (C) on bonds are the interest payments (or cash payments) made to
bondholders until maturity.
(c) Coupons are paid for the life of the bond.

2. The cash flows (coupon and principal payments) are contractual obligations of the bond
issuer and are known by bondholders, since they are stated in the bond contract.

3. Coupons are paid to bondholders at a fixed annual coupon interest rate (rc).
 (a) The coupon rate is stated in the contract. Does it change as interest rates go up or down?
(b) How to figure out the annual coupon payment using the given information?
(c) How to figure out the semiannual coupon payment using the given information?
(d) Coupons are paid semiannually in the U.S. (annually in Europe) until maturity.

Characteristics of Zero-Coupon Bond 101

1. They are issued with no coupons to be paid during the life of the bond.
(a) Corporations issue bonds that have no coupon payments but promise a single payment at
maturity.
(b) The interest paid to a bondholder is the difference between the price paid for the bond
and the face amount received at maturity.
(c) The difference in these two amounts generates an effective interest rate, or rate of return.

2. Zero-coupon bonds are sold at a large discount from the par value.
(a) These bonds are sold at a price well below their face value because all of the interest is
“paid” when the bonds are retired at maturity rather than in semiannual or yearly coupon
payments. That’s why the discount determines the yield.
(b) The greater the discount at time of purchase, the higher the return earned by investors.
(c) As in the case of Treasury bills, which are sold at discount, the lower the price paid for
the coupon bond, the higher the effective return.

3. Zero-coupon bonds respond sharply to interest rate changes.

4. Firms that are expanding operations but have little cash on hand are especially likely to
use zero coupon bonds for funding.

5. Zero-coupon bonds are attractive to investors who expect to lock in a fixed rate of
return and eliminate reinvestment rate risk.

Credit Ratings for Companies or Governments

FIN 352 Exhibit 2-4 S&P’s Debt-Rating Definitions (p. 37)
1. A credit rating evaluates companies or governments, while a credit score usually
applies to individuals.
(a) Your credit score is based on information in your credit history.
(1) Your credit score can change over time.
(2) Credit scores take time to build and are generally based on your track record of
making payments. Improving a credit score typically happens over months and years,
not overnight.
(b) Your credit score can affect whether you can get a loan and how much you will have to
pay for that loan.
(c) Generally, the higher your score, the more likely you are to be offered better credit terms.

2. Bond ratings are a reflection of the relative probability of default, which say little or
nothing about the absolute probability of default.
(a) Show the issuer’s ability to meet debt obligations.
(b) Indicate the riskiness of publicly traded bonds.
3. Rating organizations/agencies:
(a) Rating firms perform the credit analysis for the investor.
(b) Agencies such as Standard and Poor’s, Moody’s, Fitch Ratings, and A.M. Best

4. Bonds are generally divided into two categories: (1) Investment-grade and (2) Non-
investment-grade.
(a) Investment-grade bonds that are rated ________ or above have low risk of default.

(b) Noninvestment-grade bonds that are rated ______or lower have high risk of default.
e.g., BB, B, CCC, C.
(c) The highest-grade bonds carry the lowest default risk.
(d) Typically, institutional investors must confine themselves to investment-grade bonds.
(e) Investment-grade companies usually pay lower rates to borrow than non-investment ones.

5. Three nicknames for noninvestment-grade bonds.

(a) Speculative-grade bonds
(b) High-yield bonds
(c) Junk bonds

6. As the credit rating declines, the default risk of the bonds ___________.
(a) For example, if a corporate bond’s rating changes from A to BBB, it means that its
default risk has _________.
(b) Read the assigned article below:
“Foot Locker Gets Credit Rating Lowered To Junk,” Forbes, 9-15-2023

7. The default risk premium on corporate bonds increases as the bond rating drops. The
default risk premium measures the yield difference between the yield on
Treasury securities (the risk-free rate) and the yields on riskier securities
of the same maturity.
FIN 303 Exhibit 8-5 Default Risk Premiums for Selected Bond Ratings (p.256)

8. An ___________ relationship exists between the grade of a bond and the rate of return that it
must provide bondholders.
(a) What’s the impact on its default risk, required return, and price when a bond is
downgraded in rating?
(1) Default risk: _____
(2) Required return (i): _____
(3) Bond price (PB): _____
(b) What’s the impact on its default risk, required return, and price when a bond is upgraded
in rating?
(1) Default Risk: _____
(2) Required return (i): _____
(3) Bond price (PB): _____

Common Stock
1. Common stock is one of the equities that represent the ownership interest of
shareholders in a corporation.
(a) Equities are referred to as shares of common stock or preferred stock.
 (b) Equities are also called equity securities or corporate stocks.
(c) Equity shareholders are considered owners of a corporation.

2. Voting rights:
(a) Common stockholders have the right to vote on corporate matters, such as the election of
the board of directors.
(b) Each share of stock has one vote to elect at the company’s annual shareholder meeting.
(c) Common stock shareholders elect the members of the board of directors at the company’s
annual shareholder meeting. Then, directors elect management.

3. The par value (or face value) of a share of common stock is usually economically
insignificant, just for legal purposes.
(a) The face value is the nominal dollar amount assigned to a security by the issuer.
(b) For an equity security, face value is usually a very small amount that bears no
relationship to its market price, except for preferred stock, in which case face value is
used to calculate dividend payments.
(c) In comparison, face value for a debt security is the amount repaid to the investor when
the bond matures (usually, corporate bonds have a face value of $1,000, municipal bonds
$5,000, and federal bonds $10,000).

4. Common stockholders have a __residual___ claim on assets in liquidation. Common

stockholders are residual claimants on income and assets.
(a) An equity holder's claim is subordinated to creditors’ claims, and the equity holder will
only enjoy distributions from earnings after these higher priority claims are satisfied.
(b) Common stockholders are entitled to income remaining after the fixed-income claimants
(including bondholders, other debt holders, and preferred stockholders) have been paid.
(c) In case of liquidation of the corporation, common stockholders are entitled to the
remaining assets after all other claims are satisfied.

5. Shareholders of common stock are subject to limited liability.

(a) The shareholders may lose their investments in a company, but they have NO personal
liability beyond that.
(b) Your loss is limited to your investment.
(c) The shareholders are NOT liable for the actions of the company.

6. Dividends (D) are cash payments to shareholders. Are they important to investors?
(a) Dividends are extremely important to many investors. Since 1926, over __50%____
percent of the total return on the S&P 500 Index came from dividends.
(b) The dividend is at the company’s discretion.
(c) Dividends represent the income component for the total return on stock investment.
Please recall your memory on the return equation below:
Dollar gains Capital Appreciation+Cash flow CF 1 +(P1−P 0) CF 1 +∆ P
Return (Ri) = = = =
P0 InitialPrice P0 P0
(1) Ri = the holding period return over the period
 (2) CF1 = the cash flow from the dividend (or the cash received from the investment)
(3) P1 = the price (value) of the asset at a later point in time
(4) P0 = the price (value) of the asset at time zero
(d) Are dividends tax-deductible for a corporation?
No. For a corporation, your dividends are distributed after taxes.
(e) Are interest payments on debt tax-deductible for a corporation? yes
Income statement: revenues – expenses = net income
(f) The dividend yield is the income component of a stock’s return on a percentage basis =
dividend/price.
(g) The payout ratio is the ratio of dividends to earnings = dividend/net income_
(h) Retention ratio = 1- payout ratio

7. CHANG, Inc.’s earnings were $2 per share, and it paid an annual dividend per share of
$1. Assume a price for CHANG, Inc. is $24.
(a) What is the dividend yield?
(b) What is the payout ratio?

8. Shares:
(a) Authorized shares: the number of shares indicated in a firm’s corporate charter.
(b) Outstanding shares: the number of shares held by the public.
(c) Treasury stock: shares repurchased by the firm through a stock buyback.
(d) Issued shares = (b) +(C) = outstanding shares + treasury stock

9. Other features:
(a) Book value is the accounting value of a share.
(b) Market value is the current market price of a share.
(c) Stock dividend is payment to owners in the form of stock, not in the form of cash.
(d) Stock split is the issuance of additional shares in proportion to the shares outstanding.
(e) The P/E ratio is the ratio of current market price of equity to the firm’s earnings.

Preferred Stock (PS)

1. Like common stock, preferred stock represents an ownership interest in the
corporation.
(a) Preferred stock shareholders do not enjoy any of the voting rights of common
stockholders.
(b) While both preferred stockholders and common stockholders are investors in the
corporation and provide it with capital, it is the __common_ stockholders who actually
own the firm.

2. Preferred stocks are hybrid securities that share the features of both debt and equity.
(a) Preferred stock is an equity security with an intermediate claim on a firm’s assets and
earnings between (1) _bondholders_ and (2) __common stockholders
________________________.
(b) As the name implies, preferred stock receives preferential treatment over common stock.
(c) Preferred stockholders are paid after the bondholders but before the common stockholders
in terms of priority of dividend payments and in case of corporate liquidation.
3. Why does preferred stock resemble a bond?
(a) Preferred stock pays fixed dividends which are similar to the interest paid on bonds.
(b) Preferred stock has a credit rating.
(c) Preferred stock is considered fixed-cost financing for issuers.
(d) Preferred stock is considered fixed-income for investors.

4. Other features:
(a) Preferred stock is sometimes convertible into common stock.
(b) Most preferred stock issues are not true perpetuities. For these reasons, many investors
consider PS to be a special type of debt rather than equity.

American Depository Receipts (ADRs)

1. ADRs represent indirect ownership of a specified number of shares of a foreign company.
2. ADRs are issued by depositories having physical possession of foreign securities.
3. Investors invest in ADRs to isolate themselves from currency fluctuations.

Derivative Securities 101

1. The value of a derivative security is derived from its connected underlying security.
(a) A derivative security is a financial instrument whose characteristics and value depend
upon the characteristics and value of an underlying asset (underlie), typically a
commodity, bond, equity or currency.
(b) Examples of derivatives include futures and options.
(c) Our class focuses on equity options.

2. General characteristics of futures and options contracts:

(a) Both have standardized features that allow them to be traded quickly and cheaply on
organized exchanges.
(b) The exchange guarantees the performance of these contracts.
(c) A clearinghouse allows an investor to reverse his or her original position before maturity.

3. Potential benefits of derivatives:

(a) Derivatives allow investors to speculate, which involves taking a market position when a
change in prices or interest rates is expected.
(b) Derivatives contribute to market completeness.
Figure 1-1 (p. 11) The Expected return-risk trade-off available to investors
(1) A complete market is one where all identifiable payoffs can be obtained by trading
the securities that are in that market.
(2) Incomplete markets occur as a result of investors not being able to exploit all
opportunities that may exist.
(c) Derivatives may serve as risk management tools.
(1) Derivatives offer an opportunity to limit/hedge the risk faced by both individual
investors and firms.
(2) They can be used as a substitute for the underlying positions, and may offer lower
transaction costs as well as more liquidity.
 (3) In the finance field, the term hedging is generally used to denote an activity of taking
an offsetting position in a related asset.

Equity Options 101

1. In general, options on common stocks represent short-term claims on the underlying
stock.
(a) Does the corporation whose common stock underlies these claims have direct interest in
the transaction?

(b) Is the underlying corporation responsible for creating, terminating, or executing put and
call contracts?

2. A standard contract is designed for 100 shares of the underlying stock.

3. Quotations provide the following information:

(a) Underlying stock
(b) Exercise price (or strike price)
(c) Expiration date
(d) Volume of contracts

4. Option contracts give the buyer the _right_____ to buy or sell a stated number of shares
of the underlying security at a stated price (also called the exercise price) within a
specified period.

(a) A call option on a stock gives the buyer the right to __buy_______ 100 shares of
particular common stock at a specified price any time prior to a specified expiration date.
(b) A put option on a stock gives the buyer the right to __sell_____ 100 shares of particular
common stock at a specified price any time prior to a specified expiration date.

5. The exercise price is the per-share price at which the common stock may be purchased
(in the case of a call) or sold to a writer (in the case of put).
(a) The exercise price (E) is also called the strike price.
(b) Most stocks in the options market have options available at several different exercise
prices, thereby providing investors with multiple alternatives.

6. Every option has an expiration date—the date an option expires.

(a) The expiration date is the last date at which an option can be exercised.
(b) All puts and calls are designated by the date of expiration.
(c) The expiration dates for options contracts vary from stock to stock but do not exceed 9
months for regular options (LEAPS have longer expiration dates).

7. The option premium is the price paid by the option buyer to the writer (seller) of the
option, whether put or call. That is, the buyer is charged an amount called the option
premium.
(a) The premium is stated on a per share basis for options on organized exchanges.
(b) Since the standard contract is for 100 shares, a $1.5 premium represents $_150____.
 (c) The option premium is often small, which might run a fraction of the current market price
of the underlying stock.
(d) A small investment can be “leveraged” into high profits (or losses). Thus, options provide
one way to leverage one’s investment to increase the potential rewards as well as the
risks.

8. Learn the following basics before browsing on Yahoo Finance for real trades.
(a) Bid price: the price that a prospective buyer is prepared to pay for securities.
(b) Ask price: the lowest price that a seller of a security is willing to accept for a share of that
given security.
(c) Open interest of options suggests the number of outstanding options.

9. Let’s look up the options on Coca-Cola (KO) on-line.

https://finance.yahoo.com/q/op?s=KO+Options
or https://finance.yahoo.com/quote/KO/options?date=1663286400&ltr=1
(a) Click on the link above and find the current stock price of KO?
6/1/23 1/24/24 Today
$60 $58.91 60.04
(b) Just above “Calls,” please select the expiration date of April 19, 2024 from the top-down
box. Then, look for the strike price of $60 in the column “Strike.” Find out the quotes
below:
(1) What’s the ask price of $60 Calls on KO?
(2) What’s the ask price of $60 Puts on KO?
2024/1/24: Call = $1.24; Put = $2.09.
2024/2/5: Call: 1.75, put = 1.53

(c) Assume you are betting that the price of Coca-Cola (KO) will move up and buy a $60
call option on Coca-Cola (KO) with the expiration date above. According to the ask price
you found previously, what’s the option premium?
Ask price*100 = 175
(1) It gives the buyer the right to purchase 100 shares of Coke at the strike price per share
from a writer (a seller) of the option any time before the specified expiration date.
(2) The buyer pays a premium (the price of the call) to the seller for this option.
(d) Assume you are betting that the price of Coca-Cola (KO) will move down and buy a $60
put option on Coca-Cola (KO) with the expiration date above. According to the ask price
you found previously, what’s the option premium?
Ask price*100.
(1) It gives the buyer the right to sell 100 shares of Coke at the strike price per share to a
writer (a seller) of the option any time before the specified expiration date.
(2) The buyer pays a premium (the price of the call) to the seller for this option.

10. Let’s try options on Nvidia (NVDA).

https://finance.yahoo.com/quote/NVDA/options
(a) Click on the link above and find the current stock price of NVDA?
6/1/23 1/24/24 Today
$397 $613
 (b) Just above “Calls,” please select the expiration date of April 19, 2024 from the top-down
box. Then, look for the strike price of $700 in the column “Strike.” Find out the quotes
below:
(1) What’s the ask price of $700 Calls on NVDA?
(2) What’s the ask price of $700 Puts on KO?
2024/1/24: Call = $20.30; Put = $99.95

Two Types of Option Investors in the Primary Market

1. Buyers of options (or option holders) who take a long strategy.
(a) Investors purchase calls if they expect the stock price to _________.
(1) Calls permit investors to speculate on a rise in the price of the underlying stock
without buying the stock itself.
(2) Because the call and stock prices will move together, an increase in stock price makes
the call option ________ valuable.
(3) The value of the call will _______ as the stock price increases.
(b) Investors purchase puts if they expect the stock price to _________.
(1) Puts allow investors to speculate on a decline in the price of the underlying stock
without selling the stock short.
(2) Because the put and stock prices will move inversely to each other, a decrease in
stock price makes the put option ________ valuable.
(3) The value of the put will _________ as the stock price declines.
(c) Puts work the same way as calls, except in reverse.

2. Sellers of options (or option writers)

(a) Options writers are betting the opposite of their respective purchasers.
(b) A call writer expects the price of the underlying security to ___________. That is, the
writer takes a __________ position in a call.

(c) A put writer expects the price of the underlying security to ___________.

3. Options are created by writers (investors), and sold to buyers (other investors) in the
primary market.
(a) An option is created when someone writes (sells) it. This investor is named the writer.
(b) Who receives an option premium for selling each new contract in the primary market?
(c) Who pays an option premium for buying each new contract in the primary market?

Option Investors in the Secondary Market

1. Once the option is created in the primary market, it can be traded repeatedly between
buyers and sellers in the secondary market.

2. A _____________ who received option premiums in the primary market may be

assigned to take action in the form of making or taking delivery of the stock.
(a) The writer of a call is obligated to ______ the stock at the exercise price when the buyer
exercises the right to buy the stock.
(b) The writer of a put is obligated to ______ the stock at the exercise price when the buyer
exercises the right to sell.
3. The premium is simply the market price of the contract as determined by investors.
(a) The price will fluctuate constantly, just as the price of the underlying common stock
changes.
(b) If an option expires worthless, the most the buyer can lose is the cost of the option.

Chapter 3 – Indirect Investing

Indirect Investing
Figure 3.1 (p. 55) Direct versus Indirect Investing
1. Indirect investing is an alternative to direct investment in or ownership of securities.
2. Indirect investing refers to buying and selling the shares of intermediaries that hold securities
in portfolios.
3. Shares represent an ownership interest in the portfolio.
4. Shareholders also pay expenses.

Mutual funds 101

Figure 3-2 (p. 61) Possible Benefits to investors of owning a mutual fund.
1. Investment companies are professional money-management companies.
(a) They are in business to make profits.
(b) Do they charge fees to operate and manage funds?
(c) Generally speaking, investment companies are also known as mutual fund companies.

2. A mutual fund is a financial instrument that allows a group of investors to pool its
money, giving an appointed portfolio manager the flexibility to invest in multiple
sectors and securities at a scale that individual and institutional investors would not be
able to themselves.
(a) When you invest in a mutual fund, you are hiring a professional portfolio manager to
make investment choices on your behalf.
(b) The type of fund that is the right choice for each investor often depends on a number of
factors. However, one thing that is true across all of these products is the need for due
diligence on the part of the investor, as each, essentially, provides for the “outsourcing”
of investment decisions.

3. The investment company uses the services of a professional portfolio manager to make
investments that are consistent with the goals and mandates of the fund.
Exhibit 3-1 (p. 66) Mutual Fund Investment Objectives
(a) Fund’s prospectus
(b) Which federal agency sets forth the rules for investment companies?

4. Investment companies sell shares of mutual funds to the public and use the proceeds to
invest in marketable securities.
(a) When you invest in a mutual fund, you buy shares representing partial ownership of the
fund’s securities.
(b) Each investor shares proportionately in the income and investment gains and losses, as
well as the brokerage expenses and management fees.

5. Benefits of mutual funds:

 Figure 3-2 (p. 61) Possible Benefits to Investors of Owning a Mutual Fund
(a) Diversification
(b) Professional management
(c) Low capital requirement
(d) Reduced transaction costs
(e) Access to illiquid markets
(f) Access to non-traditional trading strategies

Three Major Types of Investment Companies

Table 3.1 (p. 57) Assets for each of the three major types of investment company.
1. Closed-End funds
2. Exchange Traded Funds (ETFs)
3. Open-End funds or simply mutual funds
4. Which of following investment companies manages the largest assets?
(a) Closed-end funds
(b) ETFs
(c) Open-end funds

Net Asset Value (NAV)

1. The NAV is the per share value of the securities in the fund’s portfolio.
(a) It is computed daily after the market close at 4:00 p.m. Eastern Time.
(b) The NAV is used as a basis for valuation of mutual funds.
e.g.,
(1) Buy new shares of open-end funds
(2) Redeem existing shares of open-end funds

2. Calculation:
Market value of a fund’s securities – Liabilities
Number of investor shares outstanding

3. Suppose a mutual fund has $100 million in assets and $3 million in liabilities. There are
10.765 million shares outstanding. What is the NAV of this fund?

Closed-End Fund
1. The oldest form of the three major types of investment company.
2. It is professionally and actively managed by an investment company.
 (a) Try to beat the market.
(b) Try to select winners within various classes of equities.

3. A closed-end fund has a set number of shares that can only be sold and purchased on
exchanges. Thus, the fund’s capitalization is said to be closed-end.
(a) The number of shares in issue is fixed, rather than constantly changing with investor
demand.
(b) Closed-end funds trade on an exchange and behave like regular stocks.
(c) Students are often confused closed-end funds (CEFs) with open-end funds—what most
people call mutual funds.

4. An investment company collects money from investors through an initial public

offering (IPO) in the primary market. Then, investors can buy and sell throughout the
trading day in the secondary market.
(a) Unlike open-end funds, where you buy and sell units through the fund itself, closed-end
funds don’t have to handle inflows and redemptions, so the manager isn’t handcuffed by
the need to pull out cash to pay off skittish investors when the market tanks.
(b) Normal stock exchange hours are from 9:30 a.m. to 4:00 p.m. Eastern Time on Monday
through Friday.

5. Because shares of closed-end funds trade on stock exchanges, their prices are
determined by market demand.
(a) Their market value is driven by the supply and demand for the shares.
(b) The basis for an economic theory stating that when supply exceeds demand, the market
value (price) of a product will drop and when demand exceeds supply, its value will rise.
(c) Shares of a closed-end fund may trade above or below its NAV.
(1) When the market price exceeds its NAV, the fund sells at a premium.
(2) When the market price is less than its NAV, the fund sells at a discount.
(3) Is the market price of a closed-end fund always the same as its NAV?

Exchange Traded Funds (ETFs)

1. The newest form of the three major types of investment companies.
(a) ETFs began trading in 1993.
(b) ETFs are a relatively recent innovation.

2. Typical ETFs are passively-managed portfolios.

(a) They hold a basket of stocks that tracks a particular index, sector, etc.
(b) These ETFs are also known as ___________ funds because they are constructed to
replicate the performance of market indexes such as the S&P 500, the DJIA, and the
NASDAQ 100.
(c) ETF Index funds are considered a simple way to ensure that investors see the same return
as the overall stock market-and they’re cheaper too, since index funds don’t employ
stock-picking wizards and charge related fees.
(d) Some ETFs are actively managed after 2008. Unless otherwise specified, the term ETF is
intended throughout out study to refer to traditional, passively managed ETFs.
3. Like a closed-end fund, an ETF has a set/fixed number of shares that trade on a stock
exchange.
(a) A fixed number of shares trade on a stock exchange like individual stocks.
(b) Shares can be bought and sold when the market is open.
(c) The NAV and the share price don’t usually diverge because of the arbitrage opportunity.

4. Advantage of tax-efficiency for ETFs.

(a) ETFs are vastly more tax efficient than competing mutual funds.
(b) Because they’re index funds, most ETFs have very low turnover, and thus amass far
fewer capital gains than an actively managed mutual fund would.
(c) When an open-end mutual fund investor asks for his money back, the mutual fund must
sell securities to raise cash to meet that redemption. But when an individual investor
wants to sell an ETF, he simply sells it to another investor like a stock. No muss, no fuss,
no capital gains transaction for the ETF.

5. ETFs trade on exchanges like individual stocks. Therefore, ETFs can be bought on
margin or sold short (both concepts will be explained in Chapter 5).

6. Some investment companies focusing on EFTs:

(a) State Street Global Advisors SPDR ETFs: www.spdrs.com
(1) What’s the ticker for the SPDR S&P500 ETF (which tracks the S&P 500)?
(2) What’s the ticker for the SPDR DJIA ETF (which tracks the DJIA)?
(b) iShares: www.ishares.com
(1) What’s the ticker for the iShares S&P 500 Growth ETF?
(2) What’s the ticker for the iShares Russell 1000 ETF?
(c) Vanguard: https://personal.vanguard.com/us/funds/etf/all
(1) What’s the ticker for the Vanguard S&P 500 ETF?
(2) What’s the ticker for the Vanguard Health Care ETF?

7. QQQ vs. VOO: Which is the better ETF?

https://moneywise.com/investing/reviews/qqq-vs-voo
(a) ETFs offer diversity and some sense of stability since you don’t have to worry about
tracking the stock market daily.
(b) While VOO is a Vanguard index ETF that tracks the S&P 500 index, QQQ is an Invesco
ETF that tracks the Nasdaq-100 Index.
(1) Two of the most popular ETFs.
(2) Both of these ETFs follow a different index, and they allow you to invest in some of
the largest companies on the market.

Open-end Mutual Fund (or simply a Mutual Fund)

1. The most popular form of the three major types of investment company.
(a) Mutual funds are assumed to be open-end throughout this class, unless otherwise
specified. In practice, people use the term mutual funds that include all sorts of funds
managed by investment companies.
(b) They may be actively or passively-managed.
2. An open-end fund creates additional shares to meet demands from investors. Thus, the
fund’s capitalization is said to be open-ended.
(a) The number of shares outstanding of a mutual fund constantly changes—that is, it is
open-ended.
(b) The number of shares issued solely depends on investor demand.
(c) Investors buy shares directly from ___________________________ and sell them back
(i.e., redeem).
(1) New shares are sold.
(2) Outstanding shares are redeemed.
(d) Do (open-end) mutual funds trade on stock exchanges?
(e) What kind of funds that have a fixed number of shares that can only be sold and
purchased on stock exchanges?
(f) Are there secondary markets for (open-end) mutual fund shares?

3. Investors buy and sell shares every day at the NAV at the market close.

Typical Classifications of Mutual Funds

Exhibit 3-1 (p. 66) Mutual Fund Investment Objectives
1. Equity (stocks) funds
(a) Large-cap
(b) Small-cap
(c) Specialized
(d) International
(e) Target-date fund
(f) Indexed

2. Hybrid funds (stocks and bonds)

3. Fixed-Income funds
(a) Taxable bond funds
(b) Tax-exempt bond funds

4. Money Market funds

(a) Invest in short-term securities, such as T-bills and commercial papers.
(b) Money market funds are not insured.

5. Refer to Figure 3-4 (p. 63) Types of mutual funds based on the potential risk-reward
spectrum.
(a) Which fund offers the lowest expected return?
(b) Which fund offers the highest expected return?

6. What are differences between typical ETFs and indexed (open-end) mutual funds?

ETF Indexed mutual funds

Tax efficiency
Trading
Capitalization
 Management style
Short selling

Costs of Investing in Funds

1. Mutual fund fees and expenses are required by law to be clearly disclosed to investors.
(a) They can be found in the fund’s prospectus.
(b) Keep in mind that investing in a mutual fund is not free.
(c) Fees dilute performance.

2. Mutual fund fees are paid directly by the shareholders.

(a) Sales charge (“load”)
(1) Front-end load (at time of purchase) vs. Back-end load (at time of sale)
(2) Load funds (those that charge a sales fee) vs. No-load funds (that do not charge a
sales fee)
(b) Redemption fee
(c) Exchange fee
(d) Annual account maintenance fee

3. Mutual fund expenses are indirect expenses.

(a) They are automatically deducted from fund assets before earnings are distributed to
shareholders.
(b) The expense ratio is calculated as a percent of the assets under management by a fund.
(c) Two types:
(1) Management fee (Operating expenses)
(2) Distribution (12 b-1) fee
o distribution costs paid by the fund
o Alternative to a load

4. When it comes to management fees, the average is 1.4% for stock mutual funds,
compared with as little as 0.04% for a plain index fund.
(a) Fees and expenses vary from one fund to another.
(b) All mutual funds charge management fees.

Performance of Mutual Funds

1. It’s not conclusive that mutual funds outperform their benchmarks.

2. The evidence shows that it’s not easy to find funds that outperform for a long period of
time.
(a) Typically, over a period such as five years, about _____ percent of mutual fund managers
fail to outperform the market.
(b) The vast majority of U.S. stock funds fail to beat their benchmarks over a 15-year period.
(c) Passive index funds typically beat all but a handful of actively managed funds.

3. Nonetheless, “hot” funds receive a disproportionately amount of new money.

Morningstar Rating
1. Created in 1984 to provide comprehensive assessment of mutual funds.

2. 5-star rating system:

(a) The top 10% receive five stars.
(b) The next 22.5% receive four stars, and the middle 35% receive three stars.
(c) The bottom 20% receive one star.

3. Morningstar’s star ratings are not meant to predict future performance or a fund’s
quality.

Hedge Funds
1. Hedge funds are ___________________ investment companies that attempt to exploit
various market opportunities and thereby earn larger returns than are ordinarily
available to investment companies.
(a) No restrictions in terms of investment strategies, asset classes and use of leverage.
(b) Handle funds for a small group of sophisticated investors.

2. Charge 1-2% of the assets under management and take a percentage of the profits
earned, typically at least 20%.

Chapter 4 – Security Markets and Market Indices

The Role of Financial Markets
5. Help firms and governments raise cash by selling claims against themselves.
6. Provide a place where investors can buy and sell securities (investments).
7. Help the private companies to become public and original investors to cash out.

Primary Markets
1. The primary market is where ____________ securities are sold.

(a) All securities are initially issued in the primary market.

(b) When a company publicly sells new stocks and bonds for the first time, it does so on the
primary capital market. In many cases, this takes the form of an initial public offering, or
IPO.
(c) The issuer (that is, the company that issued the security) receives the proceeds from the
sale of securities.
(d) Does an IPO take on the primary market?

2. New issues are sold in the primary market first, and subsequently trade in the
___________ market.
(a) Once the original purchasers sell the securities, they trade in the secondary market.
(b) Existing securities trade repeatedly in the secondary market, but the original issuers will
be unaffected in the sense that they receive no additional cash from these transactions.
3. Two methods of sales of new securities to investors: Public offering and Private
placement.
(a) What is the term used to describe the first sale of shares to the general public by
corporations?

(b) A private placement means new securities are sold directly (i.e., privately) to specific
investors, bypassing the open market (or the general public).

4. New securities are issued by issuers, such as firms and governments, with the help of
_________________ banks.

(a) Investment banking is a specific type of banking that focuses mainly on creating capital
for companies.
(b) Investment banks advise companies on matters related to
the issue and placement of stock.
(c) Investment banks act as agents or underwriters for companies in the process
of issuing securities.
(d) Does the corporate or government issuer receive proceeds from the sale of securities?

Secondary Markets
1. The secondary market is where _________________securities are traded among
investors after the company has sold all the stocks and bonds offered on the primary
market.

(a) Secondary markets provide investors with a mechanism for trading previously issued
securities.
(b) Markets such as the New York Stock Exchange (NYSE), London Stock Exchange, and
Nasdaq are secondary markets.
(c) In the primary market, investors buy securities directly from the company issuing them,
while in the secondary market, investors trade securities among themselves, and the
company with the security being traded does not participate in the transaction.
(d) Does the issuer (that is, the company that issued the security) receive any proceeds from
the trade in the secondary market?

2. Secondary markets are like used-car markets in that they allow investors to buy and
sell previously owned securities for cash.

U.S. Securities Markets for the Trading of Equities

1. _______________________: the oldest and most prominent secondary market in the
U.S.
NYSE (New York Stock Exchange). https://www.nyse.com/index, Tab “Markets”
(a) An agency auction market founded in 1792.
(b) All trading in a specific stock on the NYSE is done at the post where that stock is assigned
on the NYSE floor.
(c) Trading is managed by the specialist.
2. ________________________: the home of numerous prominent technology companies.
NASDAQ
http://www.nasdaqomx.com/ Choose “Company Information” from Tab “About US”
(a) Created in 1971, this electronic marketplace provides instantaneous transactions as its
market makers compete for investor orders.
(b) Market makers (a.k.a. dealers) are those who make markets in stocks by buying them
from and selling to investors. They compete freely with each other and with customers.
(c) Trading in technology stocks is a prominent feature of NASDAQ.
e.g., Apple (AAPL), Intel (INTL), Microsoft (MSFT), Alphabet Inc (GOOGL) – the
parent company of Google, Adobe System (ADBE), Tesla (TSLA)

3. Over-the-Counter (OTC) Markets: a forum for equity securities not listed on a U.S.
exchange.
(a) Over-the-counter securities refer to securities not listed or traded on a national securities
exchange or market.
(b) Handle unlisted securities.
(c) Over-the-Counter Bulletin Board: 3,000+ securities offered by 300+ market makers.
(d) Penny stocks are traded here.

4. Better Alternative Trading System (BATS):

(a) BATS accounts for about 11% of daily trading in U.S. listed shares.
(b) Appeals to hedge funds and others who want speed.

5. Electronic Communication Networks (ECNs):

(a) Match buy and sell orders from their own subscribers.
(b) Order-matching systems.

Ticker Symbol
1. The ticker symbol is used to identify a particular stock or mutual fund.
(a) Ticker symbols are a unique combination of letters that identify a particular stock within
a particular stock market.
(b) The ticker symbol is used to obtain quotes and place orders.

2. Symbols with up to three letters are used for stocks, closed-end funds and ETFs which
are listed and trade on an exchange.
Following are some examples.
- Citigroup Inc. trades on the NYSE under the symbol C.
- American Express Company trades on the NYSE under (the symbol) AXP.

3. Symbols with four letters are usually used for NASDAQ stocks.
(a) Some examples are Apple (AAPL), Intel (INTL), Microsoft (MSFT), and Alphabet
Inc/Google (GOOG).
(b) Check out the index constituents of NASDAQ-100 at
https://indexes.nasdaqomx.com/Index/Weighting/NDX.

4. Symbols with five letters ending in X are used for mutual funds.
e.g., Vanguard, https://investor.vanguard.com/mutual-funds/select-funds
Equity Market Indicators/indices
1. Market indices provide a composite report of market behavior on a given day.
(a) The most popular financial question asked by individuals daily is probably, “What did the
market do today?”

(b) Indices often serve as barometers for a given market or industry and benchmarks against
which financial or economic performance is measured.

2. Equity market indices measure only the price change.

(a) They do not include the cash payments received on the stocks.
(b) They understate the total returns to investors from owning common stocks.

3. Widely recognized indexes:

(a) Dow Jones Industrial Average (DJIA)
(b) Standard & Poor’s (S&P) Indices
(c) Nasdaq Indexes
(d) Russell Indexes
(e) Wilshire Indexes

Dow Jones Industrial Average (DJIA)

1. DJIA is the oldest, most well-known measure, composed of _______“blue-chip” stocks.

(a) DJIA was started in 1896; blue-Chip Stocks are well-known, stable, mature companies
with long records of earnings and dividends.
(b) Please check out DJIA components at the link below.
https://www.tradingview.com/symbols/DJ-DJI/components/
(c) Is Apple Inc., one of the world’s most valuable companies by market capitalization,
currently a component of the DJIA? (Optional video: ”Inside Apple’s Rise to $2
Trillion,” WSJ, 9-11-2020, https://www.youtube.com/watch?
v=cp6CwhayNZY&feature=youtu.be.)

(d) Is Meta Platforms, Inc. (META), parent of FaceBook, a constituent of the DJIA?

(e) Is Alphabet Inc. (GOOGL), parent of Google, one of the securities in the DJIA?

(f) Which property and casualty insurance company is listed on the DJIA?

2. The index consists of 30 companies that represent about ______% of the market value of
all U.S. stocks.

(a) Is the DJIA considered a broad measure of U.S. stock market performance?

3. DJIA is a _________-weighted index:

 .
(a) Essentially, the index is the sum of the prices of 30 stocks divided by 30.
(b) DJIA gives ________weight to dollar changes.

4. Assume both Stock A and Stock B are components of the DJIA. Compare a $100 stock
A that increases 10% changes by $10 with a $10 stock B that increases 10% changes by
$1. A change of $10 moves the DJIA ten times more than a $1 change.

5. What is the key issue/problem with price-weighted averages?

(a) High-priced stocks carry more weight than low-priced stocks.
(b) Is it true that high-priced stocks move the DJIA index more than low-priced stocks for
the same percentage price change?

Standard & Poor’s (S&P) Indices

http://www.spindices.com/ Tab “Indices by asset class” Choose “Equity: U.S.”
5. S&P 500 index:
http://us.spindices.com/indices/equity/sp-500
a. The 500-firm index started in 1957.
b. The index selects its companies (members, or constituents) based upon their market
size, liquidity, and sector.
c. This index represents about ______ of the investable U.S. equity, making it very useful
as a benchmark of the overall stock market performance. This index provides a broad
snapshot of the overall U.S. equity market.

d. The S&P 500 is often cited as an index of ___________-cap stocks.

6. The S&P 500 index is a market-value-weighted index or market-capitalization-weighted

index.
a. Market value is also called capitalization or market cap.
1. How to find the market value of each firm?

2. Each stock’s importance on the index is based on relative total market value instead
of relative per-share price.
b. What are top 3 holdings of SPDR S&P 500 ETF Trust (SPY) according to the link
below?
https://finance.yahoo.com/quote/SPY/holdings/
c. Are all of those three stocks included in the DJIA?

7. Check your knowledge:

a. Use Alphabet Inc. as a real-life case to confirm what you have learned from this class so
far. Please refer to the article: “Google stock forecast and price prediction”, USA today,
9-29-2023
1. When was Google founded?
2. When did the company go public?
3. When was the company added to the S&P 500 index?
4. Does Google's stock pay dividends?
 1998. 2004. Google was added to the S&P 500 index in March 2006.
No. Alphabet has never paid dividends to investors. Alphabet has authorized $140 billion in share
buybacks in 2022 and 2023 combined, but the company said its primary use for capital is reinvesting in its
long-term growth.
b. Use Nvidia as another real-life case. Please refer to the article: “If Nvidia CEO Jensen
Huang had a chance to do it all again, he wouldn't”, The Street, 10-22-2023:
https://www.msn.com/en-us/money/topstocks/if-nvidia-ceo-jensen-huang-had-a-chance-
to-do-it-all-again-he-wouldn-t/ar-AA1iEurd?
ocid=entnewsntp&cvid=aaf0f9828f2942bab62c32fd9ad9811e&ei=48.
1. When was Nvidia founded?
2. When did the company go public?
3. Does Nvidia's stock pay dividends? Look it up at
https://finance.yahoo.com/quote/NVDA?p=NVDA&.tsrc=fin-srch.

8. What is the key issue/problem with market value-weighted averages?

(a) High-market-value stocks carry more weight than low-market-value stocks.

(b) Each stock’s weight in the Index is proportionate to its market value.
(1) Apple is the world’s most valuable company that has the biggest influence on the
S&P 500 index. As of August 2, 2022, Apple is the world’s largest company by stock
market value, according to the article “Apple Rules the S&P 500 With Highest
Weighting for Any Company Since 1980,” Barron's,

9. S&P MidCap 400 Index:

a. 400 firms.
b. Stocks with market caps of $1.5 to $10 billion.
c. This index is often cited as an index of mid-cap stocks.

10. S&P SmallCap 600 Index:

a. 600 firms.
b. Average market cap of $600 million.
c. This index is often cited as an index of small-cap stocks.

Nasdaq Indexes
https://indexes.nasdaqomx.com/ Tab “Indexes” Choose “Equity: U.S.”
Click “DASDAQ” under Director located on the right hand side to find a list of NASDAQ indexes.
1. Nasdaq Composite Index: Symbol: COMP
https://indexes.nasdaqomx.com/Index/Overview/COMP
(a) All common stocks listed on the Nasdaq Stock Market
(b) Market value-weighted

2. Nasdaq 100 Index: Symbol: NDX

(a) Largest 100 firms on the Nasdaq Stock Market
(b) Large stock index, but technology oriented.
(c) Explore the equity securities included in NASDAQ-100 at
https://indexes.nasdaqomx.com/Index/Weighting/NDX.
 (1) Is Amazon.com Inc. (AMZN) included as one of the securities of this underlying
index?
(2) Is NETFLIX, INC. (NFLX) included as one of the securities of this underlying index?
(3) Is TESLA, INC. (TSLA) included as one of the securities of this underlying index?
(4) Is Microsoft Corporation (MSFT) listed included as one of the securities of this
underlying index?

3. In summary, investors should use the correct index for the purpose of benchmarking.
What indexes can be used to measure how well large-cap stocks are doing?

Russell Indexes
http://www.russell.com/indexes/americas/default.page
Tab “Indexes” Choose “Russell 3000” from “Popular Indexes”
1. Russell 3000 uses the largest 3,000 U.S. companies, representing _____of the investable
US equity.
98%.

2. Russell 1000 uses the 1,000 largest U.S. companies.

(a) Represents ____of the investable US equity.
92%.
(b) The Russell 1000 Index is closely correlated with the ______________.
S&P 500.
(c) The Russell 1000 is often cited as an index of __________-cap stocks.
Large cap.

3. Russell 2000 uses the 2,000 smallest companies in the Russell 3000.
(a) These “small cap” have an average market capitalization of about $200 million compared
to $4 billion for the Russell 1000.
(b) The Russell 2000 is often cited as an index of _________-cap stocks.

Wilshire Indexes
http://wilshire.com/ Tab “Indexes” Wilshire's families of indexes.
1. Wilshire 5000 Total Market Index is the broadest index for the U.S. equity market.
https://wilshire.com/indexes/wilshire-5000-family/wilshire-5000-total-market-index
(a) The Wilshire 5000 was created in 1974.
Please note that the S&P 500 index was created in 1957, and DJIA was started in 1896.
(b) The Wilshire 5000 Total Market Index represents the broadest index for the U.S. equity
market, measuring the performance of all U.S. equity securities with readily available
price data.
(c) The index was named after the nearly 5,000 stocks it contained when it was originally
created, but it has grown to include over 5,000 issues, reflecting the growth in U.S. equity
issues as a whole.

2. Wilshire US Real Estate Indexes

Global Stock Indexes

1. Major Local Stock Market Index
e.g., Nikkei, Dax, FTSE
2. Morgan Stanley Capital International Indexes

Chapter 5 – How securities are traded

Brokerage Operations
1. Revenues:
(a) Commissions on executed trades
(b) Sales loads on mutual funds
(c) Profits from securities sold from inventory
(d) Underwriting fees and administrative account fees

2. Fees and Costs:

(a) Brokerage commissions differ by security, broker, and investor.
(b) Institutional investors have the greatest negotiating power.
(c) Dividend reinvestment plans permit reinvestment of dividends in additional stock.

Investors Protection and Regulation

1. The SEC Act of 1934 created the Securities and Exchange Commission (SEC).
(a) Administers all securities law.
(b) Monitors public securities transactions.
(c) Requires issuer registration for public offers.
(d) Investigates indications of violations such as “insider trading.”

2. The SEC is the U.S. government’s securities regulator.

Interest Rates
1. Interest rates are used as a regulating device to control the flow of funds between
suppliers and demanders.
(a) The interest rate represents the cost of money (opportunity cost).
(b) What’s the federal regulatory body that governs interest rates?
The Federal Reserve (Fed; The Board of Governors of the Federal Reserve System)
(c) Who is the chair of the Federal Reserve?
- Jay Powell (since 2018)
- Janet Yellen, (2014-2018) Aims to curb unemployment
- Ben Bernanke (2006-2014) Designed the policy Yellen must now unwind
- Alan Greenspan (1987-2006) Heralded the era of easy money

2. When the economy slides into recession, what do you think the Fed would do?
(a) ____________ interest rates to stimulate economic growth.
(b) The Fed adopts easy-money monetary policies, known as quantitative easing or QE.
(c) Interest rates decline when the economy contracts.
(d) Low interest rates increase economic growth by encouraging borrowing and risk-taking.

3. When an economy is overheated and caused by an increase in demand for goods due to
low interest rates, what do you think the Fed would do?
 (a) The Fed may raise interest rates to control inflation when it senses a sustainable recovery is
in hand.
(1) Inflation is a key driver of interest hikes.
(2) Inflation measures the increase in prices year to year.
(3) That means borrowing costs across the economy will continue to rise, so mortgages and
loans will continue to get more expensive.
(b) Interest rates rise when the economy expands rapidly.
(c) The Federal Reserve set targets for the Federal funds rate—what banks pay for short-term
loans to one another.
(1) Not only do Fed rates have a ripple effect throughout the economy—such as by making
corporate debt or home loans cheaper or more expensive—they also change the relative
appeal of stocks vs. bonds.
(2) When rates are low, investors seek higher returns in riskier assets like stocks.
(3) All things being equal, lower borrowing costs are good news for the stock market—at
least in the short term.

4. Does the interest rate remain constant over time?

(a) There are cyclical trends in interest rates, and interest rates depend on the strength of the
economy.
(b) Recessions follow expansions like night following day.
(c) Since 1989, the average length of time between the last hike and first cut is 8.2 months.
(1) That's a great time to be an investor.
(2) The S&P 500 index rose 13% on average during those periods.
(3) In the six months after a rate cut, the S&P rose 6.6%.

Two Main Types of Brokerage Accounts

1. Cash account:
(a) Investor pays ________ percent of the purchase price for securities.
100%.
(b) Investors sell their own securities.

2. Margin account:
(a) This account allows investors to buy securities with money borrowed or sell securities
borrowed from a broker.
(1) Buying on margin
(2) Short selling.
(b) Securities can be bought on margin or sold short in a margin account.
(c) The investor with a margin account is no longer restricted to his or her wealth when
investing in risky assets.

Bull versus Bear

1. A bull market is referred to a prolonged period in which investment prices rise faster
than their historical average.
(a) Bull markets can happen as a result of an economic recovery, an economic boom, or
investor psychology.
 (b) Under the criteria used by Dow Jones Market Data and many other market watchers, a
20% rise from a recent low signals the start of a bull market, while a 20% fall signals the
start of a bear market.
(1) That means the market is always in either a bull or bear market.
(2) The market doesn’t hop into and out of either a bull or bear each time it crosses the
threshold again. It takes another 10% or 20% move in the opposite direction to
change the status.

2. A bear market is referred to a prolonged period in which investment prices fall,

accompanied by widespread pessimism.
(a) Bear markets usually occur when the economy is in a recession and unemployment is
high, or when inflation is rising quickly.
(b) If the period of falling stock prices is short and immediately follows a period of rising
stock prices, it is instead called a correction.
(c) Some recent examples of bear markets in U.S. history are as follows.
(1) the pandemic crisis in March 2020
(2) the financial crisis in 2008 and early 2009
(d) The term "bear" has been used in a financial context since at least the early 18th century.

Buying on Margin (Investors buy securities on margin)

1. Investors buy securities with money borrowed from a broker, with the understanding
that ___________________________ plus ______________ must later be paid back to
the broker.
(a) First investors purchase a security on credit. Later, the security is sold, and you pay off
the loan plus interest.
(b) Eventually, the security is sold and the position is closed out.
(c) Buying on margin is a risky technique involving the purchase of securities with borrowed
money, using the shares themselves as collateral.
(d) Buying on margin is done using a margin account at a brokerage.

2. What’s the rationale behind buying on margin?

(a) You are betting on the stock by using the simple rule of “buy low, sell high.”
(b) Investors expect the stock will _________________ in price.
(c) Investors buying securities on margin take a _______________ position.
(d) Investors are _______________ on the stock.

3. Buying on margin is a technique used by investors who try to profit from the
_____________ price of a stock.

Initial Margin versus Maintenance Margin

1. Margin represents the investor’s ____________ in a transaction.
(a) This is the part of the total value of the transaction that is not borrowed from the broker.
(b) Buying on margin is subject to fairly strict SEC regulations.
(c) Exchanges set minimum required deposit of cash or securities.

2. The initial margin percentage is defined as the ratio of an investor’s equity to the
market value of securities at the time of ______________.
 (a) The initial margin is referred to the amount an investor deposits to buy on margin.
(b) Please recall your memory on the balance sheet from FIN 303:
A firm’s equity or net worth = ____________ – _______________
(c) How to find an investor’s initial equity (margin) when buying securities on margin?
(1) An investor’s equity anytime = ____________ – _______________
Note: Ignore transaction costs and interest fees.
The market value of the stock – the amount borrowed.
(2) An investor’s initial equity = ____________________ × _______________________
The market value of the stock × Initial margin %
(d) How much can this investor borrow from the broker?
Market value of stock × (1 - Initial margin %)

3. Assume Mary would like to buy 200 shares of a $50 stock on margin. The initial margin
is set at 60%.
(a) What’s the cost of purchase?
(b) How much should she deposit in her margin account to buy on margin? (That is, what’s
her equity at the time of purchase?)
(c) How much can she borrow from the broker?

4. The minimum initial margin on securities has been set at _____ by the Federal Reserve
since 1974.
(a) At least 50% of the purchase price must be paid in cash, with the rest borrowed.
(b) A high initial margin makes it more costly to invest on margin.

5. Formula for the margin percentage:

Note: MV stands for the market value or current value of stock (= stock price × number of shares).
Equity MV of stock −Amount borrowed
Margin %= =
MV of Stock MV of stock

(a) Investor’s equity changes with price.

(b) Owner’s equity would become ______________ if the stock value < amount borrowed.
Negative. To avoid such a situation, the broker sets a maintenance margin.

6. The maintenance margin is the absolute amount of margin that an investor must have
in the account at all times.
(a) Actual margin at any time cannot go below the maintenance margin level.
(b) Brokers usually require the maintenance margin of 30% or more when investors buy
stocks on margin.

7. A margin call (also known as “maintenance call” or “house call”) will be issued when
the actual margin declines below the maintenance margin.
(a) Hence, the investor has to add cash or securities to the margin account.
(b) Otherwise, the broker may sell the securities from the account to restore the minimum
percentage margin.

Leverage (Financial Leverage) 101

1. A preface to this buzz word in corporate/personal finance.
(a) Let’s start off on the basis of physics. Are you aware of the laws of leverage that
phsyicists use? I bet you learned this concept in high school.
(b) These principles of leverage allow anybody to move almost anything. Scientists have
been postulated that if a long enough level with a fixed fulcrum point was extended into
space, the earth could be pried out of orbit.
(c) Who said the following quote?
“Give me a place to stand and I will move the earth.”

2. The term leverage refers to the use of debt in an investor’s investment (or in a firm’s
capital structure).
(a) Leverage measures the degree to which an investor (or business) is utilizing borrowed
money.
(b) The debt position of an investor (or a firm) indicates the amount of other people’s money
that has been used to generate profits.
(c) What are two basic sources of long-term funds for all businesses?
(d) True or False: Leverage measures the extent to which an investor (or a firm) uses equity
financing.
(e) Leverage measures the extent to which an investor finances his investment from sources
other than himself or to which a firm finances its assets from sources other than the
stockholders.

3. What are the benefits for firms that issue debts?

(a) Debt provides capital for firms as one type of fixed-cost financing.
(b) Are interest expenses tax-deductible for firms?
(c) As a result, this tax benefit causes firms to have a preference for financing with bonds.

4. What are the obligations for firms that issue debts?

(a) Firms have to repay their debts and make contractual interest payments (if any).
(b) What is the issue if a firm carries too much debt?
(c) What is the impact on a firm’s credit/reputation if it does not honor its obligations by
defaulting or falling behind on interest payments?

5. Analogy: The use of leverage is like a double-edged sword. Think of a car loan,
education loan, or a home mortgage for cues. Why?
(a) That is, using leverage can magnify the realized return, and often there are tax advantages
associated with borrowing for firms.
(b) Leverage isn’t inherently bad, of course, if a company’s (an individual’s) earnings are strong
enough.
 (1) Debt increases the returns to stockholders during good times and reduces the returns during
bad times.
(2) With more debt, a firm is subject to a higher risk of being unable to make contractual
interest payments.

6. To figure out whether a company’s debt load is manageable, it is recommended to check its
interest coverage ratio—revenue divided by interest payments—is at least 1.5 (Fortune.com,
May 1, 2019).

7. The more debt an investor (or a firm) uses, the higher his (or its) financial leverage, and
the greater his (or its) risk of default.
(a) The default risk is the risk that an investor (or a firm) will not be able to pay its debt as it
comes due.
(b) Investors (or companies) that are highly leveraged may be at risk of bankruptcy if they
are unable to make payments on their debt; they may also be unable to find new lenders
in the future.

Two Cases of Using Leverage via Buying on Margin

1. Assume Leo bought 200 shares at $40 per share ($8,000 total) with a 50% initial
margin. Use $4,000 of his money and borrow $4,000. Ignore transaction costs and
interest fees.
(a) What is his profit if the stock rose to $44 (a 10% increase) and he sold it at this price?
Note: For simplicity’s sake, we didn’t factor in transaction costs.
Profit ($) = ?

(b) What is his return on this investment?

Return (%) = ?

2. Suppose Kathy bought 200 shares at $40 per share ($8,000 total). Use $4,000 of her
money and borrow $4,000. Ignore transaction costs and interest fees.
(a) What is her loss if the stock fell to $34 (a 15% decline) and she sold it at this price?
Loss ($) = ?

(b) What is her return on this investment?

Return (%) = ?

3. Suppose Natalie bought 200 shares at $40 per share ($8,000 total). The initial margin is
60%, so she puts in $4,800 of her money and borrows the rest. Ignore transaction costs
and interest fees.
(a) What is her loss if the stock fell to $34 (a 15% decline) and she sold it at this price?
Loss ($) = ?

(b) What is her return on this investment?

 Return (%) = ?

Short Sales (i.e., Investors short-sell securities)

Figure 5-1 (p. 127) The short sale process. Read Exhibit 5-3 and 5-4 from text.
1. Check this phrasal verb “short-sell” in the screenshot below (Fortun.com, 2/24/2024):

2. Investors borrow a security from a broker and sell it, with the understanding that it must
later be bought back and returned to the broker.
(a) First, investors borrow stock from a broker. Later, the stock is repurchased and given
back to the broker.
(b) By executing a short sale, the investors sell stock that they do not own by borrowing it
from the brokerage.
(c) To profit from a falling stock, short sale investors borrow shares and sell them, assuming
those shares will be cheaper to buy back and return to lenders in the future.

3. What’s the rationale behind short selling?

(a) You are betting against the stock by reversing the simple rule of “buy low, sell high.”
(b) Investors expect the stock will _________________ in price.
(c) Investors are _______________ on the stock.
(d) As a result, purchasing the security to replace the one that was borrowed is called
____________ the short position.

4. Short-selling is a technique used by investors who try to profit from the ____________
price of a stock.

(a) Investors can capitalize on the down move of securities by ________________.

(b) Investors make investments that pay off when share prices decline.
(c) Is this technique dangerous? Please imagine the potential results for these two choices:
(1) buy a stock for $10 and (2) short a stock at $10.
(1) If you buy a stock for $10, the most you can lose is $10. A stock can't go any lower
than zero.
(2) But if you short a stock, you can lose a lot more. A $10 stock can shoot up to $50 or
$100 or $200. The more it goes up, the more you lose.

5. Margin:
(a) Short sellers are required to deposit cash (or collateral) for possible losses.
(b) Proceeds from short sales are kept on an account with the broker.
 Equity Stock Value when Sold +Required Deposit of Cash−Current Stock Value
Margin%= =
Current Stock Value Current Stock Value

Use the definitions we learned from Chapter 1 to get the formula below:
- S: number of shares
- P1 = the price of the asset at a later point in time
- P0 = the price of the asset at time zero

(P¿¿ 1× S )
Margin%=( P 0 × S)+[P¿¿ 0× S ×(1−initial margin %)]− ¿¿
( P¿ ¿1 × S) ¿

6. Short Interest ratio:

(a) The ratio of total shares sold short to average daily trading volume.
(b) The higher the ratio, the more bearish investors are.

Types of Orders
Order types. p. 118-119.
1. Market orders authorizes immediate transaction at the best available price.
(a) Investors use a market order to ensure the execution of the order, but the exact price is
not assured. For instance, “Buy 50 shares of Nike (NKE) at market price.
(b) Does this order guarantee the exact price at which the transaction occurs?

2. Limit orders are used to buy and sell at a specified or better price.
(a) Investors use a limit order to ensure a specified price or better, but the execution is not
assured. For instance, “Sell 100 shares of IBM at $82.70 or better”
(b) Does this order guarantee the execution of the transaction?
(c) Order expiration (or order term) :
(1) Fill or kill
(2) Day order [expired at end of day]
(3) Good ‘til canceled [good until cancelled]

3. Stop orders are used to buy and sell after a stock reaches a certain price level.
(a) A stop order specifies a certain price at which a ___________ order takes effect.
Market order.
(b) Therefore, a stop order can be viewed as a market order to buy or sell a certain quantity
of a certain security if a specified price (the stop price) is reached or passed.
(1) A buy stop order is placed above the current market price. For example, assume you
are betting against a stock, hoping that it will drop. First, you sell short 100 shares of
common stock. However, the outlook for the stock later becomes mixed. You don’t
want to buy the stock at the moment. As a result, you can place a buy stop order to
ensure the stock is purchased when the stock does not move in your expected
direction.
(2) A sell stop order is placed below the current price. For example, assume you already
own a stock, hoping that it will rise. However, the outlook for the stock later becomes
mixed. You don’t want to sell the stock at the moment. As a result, you can place a
 sell stop order to ensure the stock is sold when the stock does not move in your
expected direction.
(c) Stop loss orders:
(1) Place an order to sell when a stock falls to a specific price.
(2) Help you limit your losses.

Settlement
1. Most settlement dates are _______ business days after the trade date.
Three.

2. Transfer of securities and funds between exchange members is facilitated by a

clearinghouse.

Disadvantages of mutual funds

1. Mutual funds cannot short sell.
2. Governed by the SEC.
3. If the fund manager anticipates a drop in the share price, all (s)he could do is sell the share
and avoid the loss, but (s)he can’t capitalize on the down move.