StockTicker - Learn about Stocks, Bonds, and Investing

Tuesday, March 22, 2005


Securities are a type of transferrable interests representing financial value. Traditionally securities have been categorised between debt and equity securities, and between bearer and registered securities.

The uses that are made of securities have changed over time, both for the issuer and for the holder. Though the purpose of capital raising has sometimes been taken to be a defining characteristic of securities, its uses have expanded greatly in modern times.

They are often represented by a certificate. They include shares of corporate stock or mutual funds, bonds issued by corporations or governmental agencies, stock options or other options, other derivative securities, limited partnership units, and various other formal "investment instruments." Banknotes, checks, and some bills of exchange do not fall into this category. Commodities like Oil, Food grains can also be referred to as Securities. One can enter into contracts to buy or sell various quantities of such commodity securities in various commodity exchanges.

Concept of "security"Originally the term "securities" was used to denote security interests (such as mortgages and charges) supporting the payment of a debt or other obligation. In Early modern Europe, companies and government agencies began to raise capital from the public using secured debt oligations, which came to be known as "securities". As shares became more readily transferrable from the Victorian era, their functional similarity to debt securities became clearer, and both forms of investment became known as "securities". More recently, the term has also been extended to include units in investment funds and other forms of readily transferrable investment.

The concept of "securities" should be distinguished from "interest in securities". The latter are the assets of a client from whom an intemediary holds securities on an unallocated basis, commingled with the interests in securities of other clients. The distinction between securities and interests in securities is often overlooked in practice, although it is a source of legal risk.

Uses of securities

For the issuer
Issuers of securities include commercial companies, government agencies, local authorities and international and supranational organisations (such as the World Bank). Debt securities issued by government (called sovereign debt) generally carries a lower interest rate than corporate debt issued by commercial companies. Repackaged securities are usually issued by a company established for the purpose of the repackaging - called a special purpose vehicle (SPV).

New capital: Commercial enterprises have traditionally used securities as a means of raising new capital. Securities are an attractive option relative to bank loans, which tend to be relatively expensive and short term. Another disadvantage of bank loans as a source of financing is that the bank may seek a measure of control over the business of the borrower via financial covenants. Through securities, capital is provided by investors who purchase the securities. In a similar way, government will raise capital from securities (see government debt) if taxation and other income are insufficient to meet public expenditure. This will result in a budget deficit.

Repackaging: In recent decades securities have been issued to repackage existing assets. In a traditional securitisation, a financial institution may wish to remove assets from its balance sheet in order to achieve regulatory capital efficiencies or to accelerate its receipt of cash flow from the original assets. Alternatively, an intermediary may wish to make a profit by acquiring financial assets and repackaging them in a way which makes them more attractive to investors.

For the holder
Investors in securities may be retail, i.e. members of the public investing other than by way of business. The greatest part in terms of volume of investment is wholesale, i.e. by financial institutions acting on their own account, or on behalf of clients. Important institutional investors include investment banks, insurance companies, pension funds and other managed funds.

Investment: The traditional economic function of the purchase of securities is investment, with the view to receiving income and/or achieving capital gain. Debt securities generally offer a higher rate of interest than bank deposits, and equities may offer the prospect of capital growth. Equity investment may also offer control of the business of the issuer.

Collateral: The last decade has seen an enormous growth in the use of securities as collateral. Where A is owed a debt or other obligation by B, A may require B to deliver property rights in securities to A. These property rights enable A to satisfy its claims in the event that B becomes insolvent. Collateral arranagments are divided into two broad categories, namely security interests and outright collateral transfers. Commonly, commercial banks, investment banks and government agencies are significant collateral takers.

Types of securities
Securities are traditionally divided into debt securities and equities.

The holder of a debt security is owed a debt by the issuer and is entitled to the payment of principal and interest, together with other personal rights under the terms of the issue, such as the right to receive certain information. Debt securities are generally issued for a fixed term and redeemable by the issuer at the end of that term.

Treasury bonds are medium or long term debt securities issued by sovereign governments or their agencies. Typically they carry a lower rate of interest than corporate bonds. In addition to serving as a source of finance for governments, treasuries are used to manage the money supply in the money market operations of central banks.

Money market instruments are short term debt instruments, such as certificates of deposit, commercial paper and certain bills of exchange. They are highly liquid and are sometimes referred to as "near cash".

Eurosecurities are securities issued internationally outside their domestic market. They include eurobonds and euronotes. Eurobonds are characterically underwritten, and not secured, and interest is paid gross. A euronote may take the form of euro-commercial paper (ECP) or euro-certificates of deposit.
  • Bond
  • Debenture
  • Mortgage Backed Securities

An equity is an ordinary share in a company. The holder of an equity is a shareholder, owning a share, or fractional part of the issuer.

  • Stock


Hybrid securities combine some of the characteristics of both debt and equity securities.

Preference shares form an intermediate class of security between equities and debt. If the issuer is liquidated, they carry the right to receive interest and/or a return of capital in priority to ordinary shareholders.

Convertibles are bonds which can be converted, at the election of the bondholder, into another sort of security such as equities.

Equity warrants are contractual entitlements to purchase shares on pre-determined terms. They are often issued together with bonds or existing equities, but are detachable from them and separately tradeable.

Securities markets

Primary and secondary markets
The securities markets can be divided into the primary markets and the secondary markets. Primary markets (also known as capital markets) comprise of new securities to their first holders. The issue of new securities is commonly known as an Initial Public Offering (IPO). Issuers usually retain investment banks to assist them in finding buyers for these issues, and in many cases, to buy any remaining interests themselves. This arrangement is known as underwriting. In recent years the business of managing or underwriting issues of securities has been concentrated in the hands of a small number of investment banks, the most prominent of which are Goldman Sachs, Morgan Stanley and Merrill Lynch. The International Primary Markets Association (IPMA) is the trade association of banks and other investment institutions who are active in the primary markets.

Transferrability is an essential characteristic of securities. This trading is called the aftermarket or secondary market. Secondary markets often consist of what is called an exchange to facilitate the meeting of buyers and sellers. They are often referred to as stock exchanges, even though there are exchanges such as the Chicago Board of Options Exchange, where no stocks are traded. The International Securities Market Association (ISMA) is the trade association for the banks and other investment institutions that are active in the secondary markets.

Public offers and private placements
In the primary markets, securities may be offered to the public in a public offer. Alternatively, they may be offered privately to a limited number of persons in a private placement. Often a combination of the two is used. The distinction between the two is important to securities regulation and company law.

Another category, sovereign debt, is generally sold by auction to a specialised class of dealers.

Listing and OTC dealing
Securities are often listed in a stock exchange, an organised and officially recognised market on which securities can be bought and sold. Issuers may seek listings for their securities in order to attract investors, by ensuring that there is a liquid and regulated market in which investors will be able to buy and sell securities.

Growth in informal electronic trading systems has challenged the traditional business of stock exchanges. Large volumes of securities are also bought and sold "over the counter" (OTC). OTC dealing involves buyers and sellers dealing with each other by telephone or electronically on the basis of prices that are displayed electrionically, usually by commercial information vendors such as Reuters and Bloombergs.

There are also eurosecurities, which are securities that are issued outside their domestic market into more than one jurisdiction. They are generally listed on the Luxembourg Stock Exchange or admitted to listing in London. The reasons for listing eurobonds include regulatory and tax considerations, as well as the investment restrictions.

International debt markets
London is the centre of the eurosecurities markets. There was a huge rise in the eurosecurities market in London in the early 1980s. Settlement of trades in eurosecurities is currently affected through two European computerised systems called Euroclear (in Belgium) and Clearstream (formerly Cedelbank in Luxembourg).

Derivative products

  • Cash (Spot)
  • Future
  • Option
  • Swap
  • Trust-preferred
In the United States, the offer and sale of securities is either registered pursuant to a registration statement that is filed with the Securities and Exchange Commission (SEC) or are offered and sold pursuant to an exemption therefrom. Dealing in securities is heavily regulated by both the federal authorities (chiefly SEC) and state authorities. In addition the industry is heavily self policed by Self Regulatory Organizations (SRO's), such as the NASD or the MSRB.

Due to the difficulty of creating a general definition that covers all securities, the SEC attempts to define "securities" exhaustively (and not very precisely) as: "any note, stock, treasury stock, security future, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a "security"; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker's acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited." - Section 3a item 10 of the 1934 Act.

Friday, March 18, 2005

Mutual Funds

A mutual fund enables investors to pool their money and place it under professional investment management. The portfolio manager trades the fund's underlying securities, realizing a gain or loss, and collects the dividend or interest income. The investment proceeds are then passed along to the individual investors. There are more mutual funds than there are individual stocks.

"Open" or "closed"
Most mutual funds are open-end funds. This means that at the end of every day, the investment management company sponsoring the fund issues new shares to investors and buys back shares from investors wishing to leave the fund. A mutual fund can also be a closed-end fund. The sponsor of a closed-end fund registers and issues a fixed number of shares at the initial offering, similar to a common stock. Investors then can buy or sell these shares through a stock exchange. The sponsor does not redeem or issue shares after a closed-end fund is launched, so the investor must trade them through a broker.

Exchange-traded fund
A new innovation, the exchange traded fund (ETF) combines characteristics of both open and closed end mutual funds. An ETF usually tracks a stock index, like an index fund, but can be redeemed on demand for its underlying holdings, eliminating the discounts and premiums that are common with closed-end funds and forcing prices to remain very close to the net asset value (NAV). ETFs are traded throughout the day on a stock exchange, just like closed-end funds.

Net asset value
The net asset value, or NAV, is a fund's value of its holdings, usually expressed as a per-share amount. For most funds, the NAV is determined daily, after the close of trading on some specified financial exchange, but some funds update their NAV multiple times during the trading day. Open-end funds sell and redeem their shares at the NAV, and so only process orders after the NAV is determined. Closed-end funds may trade at a higher or lower price than their NAV; this is known as a premium or discount, respectively. If a fund is divided into multiple classes of shares, each class will typically have its own NAV, reflecting differences in fees and expenses paid by the different classes.

Some mutual funds own securities which are not regularly traded on any formal exchange. These may be shares in very small or bankrupt companies; they may be derivatives; or they may be private investments in unregistered financial instruments (such as stock in a non-public company). In the absence of a public market for these securities, it is the responsibility of the fund manager to form an estimate their value when computing the NAV. How much of a fund's assets may be invested in such securities is stated in the fund's prospectus.

Share class
Many mutual funds divide their assets up among multiple classes of shares. All of the assets of each class are effectively pooled for the purposes of investment management, but classes typically differ in the fees and expenses paid out of the fund's assets. These differences are supposed to reflect different costs involved in servicing investors in various classes; for example, one class may be sold through brokers with a front-end load, and another class may be sold direct to the public with no load but a "12b-1 fee" included in the class's expenses. Still a third class might have a minimum investment of $10,000,000 and only be open to financial institutions (a so-called "institutional" class). In some cases, by aggregating regular investments by many individuals, a retirement plan (such as a 401(k) plan) may qualify to purchase "institutional" shares (and gain the benefit of their typically-lower expense ratios) even though no members of the plan would qualify individually.

Turnover is a measure of the amount of securities that are bought and sold, usually in a year, and usually expressed as a percentage of net asset value. It shows how actively managed the fund is.

A caveat is that this value is sometimes calculated as the value of all transactions (buying, selling) divided by 2; i.e., the fund counts one security sold and another one bought as one "transaction". This makes the turnover look half as high as would be according to the standard measure.

Turnover generally has tax consequences for a fund, which are passed through to investors. In particular, when selling an investment from its portfolio, a fund may realize a capital gain, which will ultimately be distributed to investors as taxable income. The very process of buying and selling securities also has its own costs, such as brokerage commissions, which are borne by the fund's shareholders.

The Dalbar Inc. consultancy studied mutual fund stock returns over the period from 1984 to 2000. Dalbar found that the average stock fund returned 14 percent; during that same period, the typical mutual fund investor had a 5.3 percent return. This finding has made both "personal turnover" (buying and selling mutual funds) and "professional turnover" (buying mutual funds with a turnover above perhaps 5%) unattractive to some people.

A front-end load or sales charge is a commission paid to a broker by a mutual fund when shares are purchased, taken as a percentage of funds invested. The value of the investment is reduced by the amount of the load. Some funds have a deferred sales charge or back-end load which is paid to the broker out of the proceeds when shares are redeemed. (This is distinct from a redemption fee, which is also paid out of proceeds, but is kept by the fund. Many funds charge redemption fees when shares are sold a short time after they are purchased, to discourage investors from market timing.) Load funds are sold through financial intermediaries such as brokers, financial planners, and other types of registered representatives who charge a commission for their services.

It is possible to buy many mutual funds directly from the fund sponsor, without paying a sales charge. These are called no-load funds. Some discount brokers will sell no-load funds, sometimes for a flat transaction fee or even no fee at all. (This does not necessarily mean that the broker is not compensated for the transaction; in such cases, the fund may pay brokers' commissions out of "distribution and marketing" expenses rather than a specic sales charge.)

United States
Mutual funds can invest in many different kinds of securities. The most common are cash, stock, and bonds, but there are hundreds of sub-categories. Stock funds, for instance, can invest primarily in the shares of a particular industry, such as high technology or utilities. These are known as sector funds. Bond funds can vary according to risk (high yield or junk bonds, investment-grade corporate bonds), type of issuers (government agencies, corporations, or municipalities), or maturity of the bonds (short or long term). Both stock and bond funds can invest in primarily US securities (domestic funds), both US and foreign securities (global funds), or primarily foreign securities (international funds). By law, mutual funds cannot invest in commodities and their derivatives or in real estate. (However, there do exist real estate investment trusts, or REITs, which invest solely in real estate or mortgages, and mutual funds are allowed to hold shares in REITs.) A mutual fund may restrict itself in other ways. These restrictions, permissions, and policies are found in the prospectus, which every open-end mutual fund must make available to a potential investor before accepting his or her money.

Most mutual funds' investment portfolios are continually adjusted under the supervision of a professional manager, who forecasts the future performance of investments appropriate for the fund and chooses the ones which he or she believes will most closely match the fund's stated investment objective. This is called active management, in contrast to indexing, in which a fund's assets are managed to closely approximate the performance of a particular published index. Because the composition of an index changes less frequently than the condition of the market, an index fund manager makes fewer trades, on average, than does an active fund manager. For this reason, index funds generally have lower expenses than actively-managed funds, and typically incur fewer capital gains which must be passed on to shareholders. The majority of actively managed funds usually only match the performance of the index fund, but since they have higher costs they then underperform the index funds. Three fourths of all mutual funds underperform the S and P 500 index. This means the majority of the professional managers can't execute a better stock picking strategy then simply buying the 500 S&P companies equally. For this reason, many advisors strongly suggest avoiding mutual funds.

Mutual funds are corporations under US law, but they are subject to a special set of regulatory, accounting, and tax rules. Unlike most other types of corporations, they are not taxed on their income as long as they distribute substantially all of it to their shareholders. Also, the type of income they earn is often unchanged as it passes through to the shareholders. Mutual fund distributions of tax-free municipal bond income are also tax-free to the shareholder. Taxable distributions can either be ordinary income or capital gains, depending on how the fund earned it.

Picking a mutual fund from among the thousands offered is not easy. The following is just a rough guide, with some common pitfalls.
  • Unless you are in the highest tax bracket, you probably don't need a tax-exempt fund.
  • Match the term of the investment to the time you expect to keep it invested. Money you may need right away should be in a money market account. Money you will not need until you retire in 30 years should be in longer-term investments, such as stock or bond funds.
  • There are some funds that invest in both stocks and bonds called "balanced funds." These are not generally as good an idea as a do-it-yourself balance of a stock fund and a bond fund, simply because you get to control the mix yourself. More stock is more aggressive, more bond is more conservative.
  • Expenses matter over the long term, and of course, cheaper is usually better. You can find the expense ratio in the prospectus. Expense ratios are critical in index funds, which seek to match the market. Actively managed funds need to pay the manager, so they usually have a higher expense ratio.
  • Sector funds often make the "best fund" lists you see every year. The problem is that it is usually a different sector each year (internet funds, anyone?). Avoid making these a large part of your portfolio.
  • Closed-end bond funds often sell at a discount to the value of their holdings. You can sometimes get extra income by buying these in the market. Hedge fund managers love this trick. This also implies that buying them at the original issue is usually a bad idea, since the price will often drop immediately.
  • Mutual funds often make their distributions near the end of the year. If you get the money, you will have to pay taxes on it. Check the fund company's website to see when they plan to pay the dividend, and wait until afterwards if it is coming up soon.
  • Do your homework. Read the prospectus, or as much of it as you can stand. It should tell you what these strangers can do with your money, among other vital topics. Check the performance of a fund against its peers with similar investment objectives, and against the index most closely associated with it. Be sure to pay attention to performance over both the long-term and the short-term. A fund that gained 53% over a 1-yr. period (which is impressive), but only 11% over a 5-yr. period should raise some suspicion, as that would imply that the returns on four out of those five years were actually very low (if not straight losses).
  • Diversification is the best way to reduce risk. Most people should own some stocks, some bonds, and some cash. Some of the stocks, at least, should be foreign. You might not get as much diversification as you think if all your stock funds are with the same management company, since there is often a common source of research and recommendations. Too many funds, on the other hand, will give you about the same effect as an index fund, except your expenses will be higher.
  • The compounding effect is your best friend. A little money invested for a long time equals a lot of money later.
In September 2003, the US mutual fund industry was beset by a scandal in which major fund companies permitted and facilitated "late trading" and "market timing".

United Kingdom
In the United Kingdom the term "mutual fund" may be confusing due to the existence of building societies and mutual life companies which in law are owned by their members and which have no share holders to distribute profits to and consequently are referred to as "mutuals". Collectively managed funds are referred to by type, and the following are the principal ones are available:

  • investment trusts which are themselves quoted companies, often with a fixed life. The quoted price of the company may trade at a discount (lower) or premium (higher) than the value of the investments it holds at any point in time, giving rise to more volatility and risk as well as opportunities. Investment trusts may also be split into different types of shares to appeal to different types of investor. These are known as split capital trusts.
  • Unit Trusts are traditional arrangements set up as a trust rather than a company and are open ended. The fund is divided into units rather than shares that build in trading and management costs through the canceling of units meet management charges and by way of a dual pricing policy of units to meet trading costs. Units have a bid (buying) and offer (selling) price at a given time and the difference is known as the bid-offer spread.
  • OEICs (pronounced "OIKS") is an acronym for "Open Ended Investment Companies" which a rapidly diplacing Unit Trusts which operate under, what is considered to be, archaic rules. Additionally OEICs are easily marketed overseas and are seen as a way of developing the collectively managed fund market. A major difference is that OEICs have shares (but unlike Investment Trusts they reflect asset value like the units in a unit trust) and these are traded with a single price (any initial charges are levied explicitly by reducing capital).
  • ICVCs' (Investment Companies with Variable Capital) an alternative name for OEICs.

Tax favoured products such as Pensions or Individual Savings Accounts may include any of the above, although separate Pension funds and (subject to involved differences) Life Insurance funds exist with their own legislative control and tax treatment.

Wednesday, March 16, 2005

Stock Market

A stock market is a market for the trading of publicly held company stock and associated financial instruments (including stock options, convertibles and stock index futures).

Traditionally such markets were open-outcry where trading occurred on the floor of an exchange. These days increasingly the markets are cyber-markets with buying and selling occurring via online real-time matching of orders placed by buyers and sellers.

Many years ago, worldwide, buyers and sellers were individual investors and businessmen. These days markets have generally become "institutionalized"; that is, buyers and sellers are largely institutions whether pension funds, insurance companies, mutual funds or banks. This rise of the institutional investor has brought growing professionalism to all aspects of the markets.

The character of markets around the world varies, for example with the majority of the shares in the Japanese market being closely held (by financial companies and industrial corporations) compared with the structures of ownership in the USA or the UK.

International markets
There are stock markets in most developed economies, with the world's biggest markets being in the USA, China, Japan, and Europe. There are global stock-market indices that, because they delineate the global universe of stock opportunities, shape the choices and distribution of funds of institutional investors.

Stock index
The movements of the prices in a market or section of a market are captured in price indices called Stock Market Indices, of which there are many, e.g., the Standard and Poors Indices and the Financial Times Indices. Such indices are usually market-capitalisation weighted.

Derivative instruments
An option is a contract that gives an investor the right to buy or sell a security such as a stock or index at an agreed-upon price during a specified period with no obligation.

A future is a contract that gives an investor the obligation to buy or sell a security at an agreed-upon price during a specified period.

An option buyer who believes that the price of a stock will rise can enter a contract known as a "call" which gives him the right to buy another's stock at a date three to nine months in the future. He pays a fee to the owner of the stock and will forfeit it if he does not exercise the option. But if the stock price rises enough, he can exercise the option and buy the stock at the fixed price, and then resell it for a higher price to recover his premium and make a profit.

Someone who thinks that the price of a stock is about to fall can buy a "put" contract with someone else who agrees to buy the stock at a fixed price. He does not have to own the stock at the time the contract is made. Again, he pays a premium. But if the stock price does fall, he can buy the stock at a low price on the market and then sell it for an agreed-upon higher price.

Option contracts are traded like stocks, often by people who have no intention of exercising them. Although there is a guaranteed loss of the premium when an option is not exercised, there is enormous potential profit from trading the option itself--its price rises or falls with the price of the underlying stock. Someone who has a guaranteed buyer for 10,000 shares of stock at $35 has a contract of enormous value if the price of the stock falls to $10. He may not want to invest $100,000 to fulfill the contract and earn $350,000 (for example, he may not have that much cash on hand). But someone will want to buy the contract from him for more than he paid for it.

There are also two sorts of trades involving cash or stock not actually owned, short selling and margin buying.

Short selling
In short selling, someone sells stock that they don't actually own, hoping for the price to fall. They must eventually buy back the stock. Exiting a short position by buying back the stock is called "covering a short".

Margin Buying
In margin buying, someone borrows money to buy the stock and hopes for it to rise. Most industrialized countries have regulations that require that if the borrowing is based on collateral from other stocks, it can be at only a certain percentage of those other stocks' value. Other rules include a prohibition of freeriding; that is, putting in an order to buy stocks without paying initially, and then selling them and using part of the proceeds to make the original payment.

Stock Market Regulation
Before 1929, there were few regulations governing trades. In the 1920s there were many abuses in the sale and trading of securities. State Blue Sky laws were easy to evade by making security sales across state lines. After holding hearings on the abuses Congress passed The Securities Act of 1933. It regulates the interstate sales of securities and made it illegal to sell securities into a state without complying with the state law. It requires companies which want to sell securities publicly to file a registration statement with the Securities & Exchange Commission. The registration statement provides a lot of information about the company and is a matter of public record. The SEC does not approve or disapprove the issue, but lets the statement "become effective" if it provides sufficient required detail, including risk factors. Then the company can begin selling the issue, usually through investment bankers.

The next year Congress passed the Securities Exchange Act of 1934 which regulates the secondary market trading of securities. Initially it applied only to stock exchanges and listed companies as its name implies. In the late 1930s it was amended to provide regulation of the over-the-counter market also. In 1964 it was amended to apply also to companies traded in the over-the-counter market.

Corporate Bonds

In finance and economics, a bond or debenture is a debt instrument that obligates the issuer to pay to the bondholder the principal (the original amount of the loan) plus interest. Thus, a bond is essentially an I.O.U. (I owe you contract) issued by a private or governmental corporation. The corporation "borrows" the face amount of the bond from its buyer, pays interest on that debt while it is outstanding, and then "redeems" the bond by paying back the debt. A mortgage is a bond with a lien on a real estate.

Bonds are securities but differ from shares of stock in that stock is an ownership interest (termed "equity"), but bonds are merely "debt": Therefore a shareholder is an owner, but a bond-holder is merely a creditor.

Each country sets its own rules for issuing and redeeming short and long-term debt and stock. In the U.S. (for example):
  • Bonds are long-term loans secured by property rather than short-term loans secured merely by the debtor's promise to pay.
  • Interest paid to bondholders receives preferential tax treatment compared to dividends paid to shareholders.
  • In bankruptcy, bondholders are paid before short term creditors (including workers who are owed wages) and all creditors must be paid in full before owners receive anything.

Issuing Bonds

Bonds are issued by governments or other public authorities, credit institutions, and companies, and are sold through banks and stock brokers. They enable the issuer to finance long-term investments with external funds. The term total volume refers to the number of individual bonds in a bond issue.

Features of bonds

The most important features of a bond are:

  • Initial value, known as the "par value"
  • maturity date - Bond maturity tells when investors should expect to get the principal back and how long they can expect to receive interest payments. The maturity of a bond can be any length of time, although typical bond maturities range from one year to 30 years. There are three groups of bond maturities: Short-term bonds (notes): Maturities of 1-4 years Medium-term bonds (notes): Maturities of 5-10 years Long-term bonds: Maturities of 10-30 years (Some bonds have been issued with maturities of up to 100 years. These are considered 'Long-term' although they are quite uncommon)
  • the "coupon" or "nominal yield," effectively the interest rate
  • whether the interest rate is fixed or floating
  • whether the borrower can pay back the bond at any time before the maturity date. The rights of a particular bond issue are specified in a written document, usually called an "indenture". In the U.S. federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. Those terms may be changed while the bonds are outstanding, but amendments to the governing document often require approval by a majority vote of the bondholders.

Interest is paid on the first "coupon date" and subsequently on coupon dates at regular intervals, assuming the issuer has the money to make the payments on those dates. If all interest ("coupon") payments have not been made when due, and so are in arrears, the issuer must also pay those back-due amounts when it redeems the bond, in addition to the principal ("face") amount.


The bond may have a "call" provision that allows the issuer to pay back the debt (redeem the bond) before its nominal maturity date. When there is no such provision requiring a holder to let the issuer redeem a bond before its maturity date, the issuer may offer to redeem a bond early, and its holder may accept or reject that offer.

There are three broad categories of callable bonds.

  • A "European callable", one with a European-style contract, can only be called on a certain date.
  • A "Bermudan callable" can be called until a certain date.
  • A "US" or "American callable" can only be called after a certain date. Bonds can also carry "put options", which allow the investor to sell the bonds back to the issuer at a date specified when the bonds are sold to the investor.

Preferred Stock

A preferred stock, also known as a preferred share or simply a preferred, is a share of stock carrying additional rights above and beyond those conferred by common stock.

Such rights may include:
  • a dividend amount that never changes, if the dividend is paid at all. The dividend is usually specified as a percentage of the initial investment and/or a stock symbol letter, such as Pacific Gas & Electric 6% Preferred A. Variable preferreds are rare exceptions: their changing dividends depend on prevailing interest rates, or nowadays on ratings.
  • precedence over shares of common stock when it comes to the distribution of profits and the liquidation proceeds of a stock corporation
  • superior voting rights generally, or special voting rights to approve certain extraordinary events (such as the issuance of new shares or the approval of the acquisition of the company) or to elect directors, many preferred shares provide no voting rights
  • anti-dilution provisions that prevent the issuance of additional shares at prices below those of the preferred shares
  • right of first refusal with respect to the issuance of new shares dividend rights or cumulative
  • dividend rights (cumulative dividend rights accumulate during periods when they are not paid).
  • when a company goes bankrupt and has to liquidate assets the preferred stockholders get paid first, if possible.
The above list, although including several customary rights, is far from comprehensive. Preferred shares, like other legal arrangements, may specify nearly any right conceivable.

Preferred shares are more common in private companies, where it is more useful to distinguish between the control of and the economic interest in the company. Also, government regulations and the rules of stock exchanges discourage the issuance of publicly traded preferred shares.

A single company may issue several classes of preferred stock. For example, a company may undergo several rounds of financing, with each round receiving separate rights and having a separate class of preferred stock; such a company might have "Series A Preferred", "Series B Preferred", "Series C Preferred" and common stock.

Common Types
There are various types of preferred stocks that are common to many corporations:
  • Cumulative Preferred Stock - This type of stock is almost like a corporate bond in the sense that the company is obligated to pay the dividend if it makes a profit. In the case of a loss, the dividend will accumulate and has to be paid in future years.
  • Non-cumulative Preferred Stock - Dividend for this type of preferred stock will not accumulate if it is unpaid.
  • Convertible Preferred Stock - This type of preferred stock carries the option to convert in to a common stock.
  • Participating Preferred Stock - This type of preferred stock allows the possibility of additional dividend above the stated amount under certain conditions.

Capital Loss

In finance, a capital loss is a financial loss incurred when an asset is sold for less than its original purchase price. Capital losses are most often incurred in stock and bond investments.
In taxation in the United States, capital gains are subject to capital gains tax, but if a taxpayer has suffered from capital losses in the same year, he can offset the gains with the losses to reduce his tax. If the losses exceed the gains for an individual, he can take up to a $3,000 tax deduction to correspond with the losses.

Normal depreciation of the value of an asset is not considered a capital loss, so if a taxpayer purchases a car for $30,000 and sells it a year later for $15,000 and this is a reasonable price for a year-old used car of that type, no tax deduction may be taken.

Capital Gains Tax

In many jurisdictions, including the United States and the United Kingdom, a capital gains tax or CGT is charged on capital gains, that is the profit realised on the sale of an asset that was previously purchased at a lower price. The most common capital gains are realized from the sale of stocks, bonds, and property.

In the United States, individuals and corporations pay income tax on the net total of all their capital gains just as they do on other sorts of income, but the tax rate is lower for "long-term capital gains", which are gains on assets that had been held for over one year before being sold. The tax rate on long-term gains was reduced in 2003 to 15%, or to 5% for individuals in the lowest two income tax brackets. Short-term capital gains are taxed at a higher rate: the ordinary income tax rate. In 2013 these reduced tax rates will "sunset", or revert back to the rates in effect before 2003, which were generally 20%.

Technically, a "cost basis" is used, rather than the simple purchase price, to determine the taxable amount of the gain. The cost basis is the original purchase price, adjusted for various things including additional improvements or investments, taxes paid on dividends, certain fees, and depreciation.

Exemptions from capital gains taxes (CGT) in the United States include:

Every two years, an individual can exclude up to $250,000 ($500,000 for a married couple) of gains on the sale of their primary residence. If an individual or corporation realizes both capital gains and capital losses in the same year, the losses cancel out the gains in the calculation of taxable gains. For this reason, toward the end of each calendar year, there is a tendency for many investors to sell their investments that have lost value. For individuals, if losses exceed gains in a year, the losses can be claimed as a tax deduction against ordinary income, up to $3,000 per year.

Capital Gain

In finance, a capital gain is profit that is realized from the sale of an asset that was previously purchased at a lower price. The most common capital gains are realized from the sale of stocks, bonds, and property. (If the sale of the asset had yielded a loss rather than a profit, this loss would be called a capital loss.)

Capital gains are often exempt from income tax, in which case it may be important to distinguish capital gains (or losses) realised on the sale of fixed assets (long-life assets that form part of the structure of a business, such as real property) from trading profits or losses realised on the sale of trading stock (short-life assets that are quickly sold on).

In many jurisdictions, including the United States and the United Kingdom, capital gains are subject to a capital gains tax.

Retained Earnings

In accounting, retained earnings are profits that were not paid to a company's shareholders as dividends.

They are reported in the ownership equity section of a firm's balance sheet. The decision of whether a firm should retain profits or disburse them as dividends depends on at least two things: the firm's judgement of its own investment opportunities relative to those available in the market and any difference in tax treatment of dividends paid now and capital gains expected to result from investing retained earnings.


Par value in Finance is the Face value of a security

Balance Sheet

In formal bookkeeping and accounting, a balance sheet is a statement of the financial value (or "worth") of a business or other organisation (or person) at a particular date, usually at the end of its "fiscal year," as distinct from a profit and loss statement ("P&L," also known as an income statement), which records income and expenditures over some period. Therefore a balance sheet is often described as a "snapshot" of the company's financial condition at that time. Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time, instead of a period of time.

The balance sheet has two parts: assets on the left-hand ("debit") side or at the top and liabilities on the right-hand ("credit") side or at the bottom. The assets of the company -- money ("in hand" or owed to it), investments (including securities and real estate), and other property -- are equal to the claims for payments of the persons or organisations owed -- the creditors, lenders, and shareholders. This standard format for balance sheets is derived from the principle of double-entry bookeeping.

Equity Valuation

Equity, which is the shareholders' interest ("net worth"), may not reflect the company's true value, since assets are normally shown ("carried") on the balance sheet at what the company paid for them, without any adjustment for increases (write up) or decreases (write down) in their value since then.

Treasury Stock

In finance, a treasury stock or reacquired stock is stock which is bought back by the issuing company. It reduces the amount of outstanding stocks on the open market ("open market" including insiders holdings). On the balance sheet, treasury stock is listed under shareholder equity as a negative number. Sometimes, companies do this when they feel that their stock is undervalued on the open market. Other times, companies do this to provide a "bonus" or incentive compensation plans for employees. Rather than receive cash, the recipient would get an asset that might appreciate in value faster than cash saved in a bank account.

Limitations of treasury stock include:
  • Treasury stock does not pay dividend
  • Treasury stock has no voting rights
  • Total treasury stock can not exceed 5% of total capitalization
After buyback, the company can either retire the shares or hold the shares for later resell. Buying back stocks reduces the number of outstanding shares, thus it can cause the value of outstanding shares to appreciate. In addition, it can serve as a signal to investors.

One way of accounting for treasury stock is with the cost method. In this method, the paid-in capital account is reduced in the balance sheet when the treasury stock is bought. When the treasury stock is sold back on the open market, the paid-in capital is either debited or credited if is sold for more or less than the initial cost respectively.


A shareholder or stockholder is an individual or company (including a corporation), that legally owns one or more shares of stock in a joint stock company. Companies listed at the stock market strive to enhance shareholder value. The shareholder concept is the theory that a company only has responsibilities to its shareholders and owners, and should work solely to benefit these people.

Stockholders are granted special privileges depending on the class of stock, including the right to vote (usually one vote per share owned) on matters such as elections to the board of directors, the right to share in distributions of the company's income, the right to purchase new shares issued by the company, and the right to a company's assets during a liquidation of the company. However, stockholder's rights to a company's assets are subordinate to the rights of the company's creditors. This means that stockholders typically receive nothing if a company is liquidated after bankruptcy, although a stock may have value after a bankruptcy if there is the possibility that the debts of the company will be restructured.

Stockholders or shareholders are considered by some to be a partial subset of stakeholders, which may include anyone who has a direct or indirect equity interest in the business entity or someone with even a non-pecuniary interest in a non-profit organization. Thus it might be common to call volunteer contributors to an association, such as a hypothetical online open content encyclopedia, stakeholders, even though they are not shareholders.


A dividend is the distribution of profits to a company's shareholders.

The primary purpose of any business is to create profit for its owners, and the dividend is the most important way the business fulfills this mission. When a company earns a profit, some of this money is typically reinvested in the business and called retained earnings, and some of it can be paid to its shareholders as a dividend. Paying dividends reduces the amount of cash available to the business, but the distribution of profit to the owners is, after all, the purpose of the business.

Some companies pay "stock dividends" rather than cash dividends, in which case shareholders receive additional stock shares.

The amount of the dividend is determined every year at the company's annual general meeting, and declared as either a cash amount or a percentage of the company's profit; see The dividend decision. The dividend is the same for all shares of a given class (that is, preferred shares or common stock shares). Once declared, a dividend becomes a liability of the firm.

When a share is sold shortly before the dividend is to be paid, the seller rather than the buyer is entitled to the dividend. At the point at which the buyer is not entitled to the dividend if the share is sold, the share is said to go ex-dividend. This is usually two business days before the dividend is to be paid, depending on the rules of the stock exchange. When a share goes ex-dividend, its price will generally fall by the amount of the dividend.

The dividend is calculated mainly on the basis of the company's unappropriated profit and its business prospects for the coming year. It is then proposed by the Executive Board and the Supervisory Board to the annual general meeting. At most companies, however, the amount of the dividend remains constant. This helps to reassure investors, especially during phases when earnings are low, and sends the message that the company is optimistic with respect to its future performance.

Some companies have dividend-reinvestment plans. These plans allow shareholders to use dividends to systematically buy small amounts of stock often at no commission. Dividends are not yet paid in gold certificates although this idea has been discussed by mining companies such as Goldcorp.

Companies have often avoided paying dividends for several reasons:
Company management and the board believe that it is important for the company to take advantage of opportunities before it, and reinvest its recent profits in order to grow, which will ultimately benefit investors more than a dividend payout at present. This reasoning is sometimes right, but is often wrong, and opponents of this reasoning (such as Benjamin Graham and David Dodd, who complained about the practice in the classic 1934 reference Security Analysis) usually note that this comprises company management dictating to the business's owners how to invest their own money (i.e. the profit of the business). When dividends are paid, shareholders in many countries, including the United States, suffer from double taxation of those dividends: the company pays income tax to the government when it earns any income, and then when the dividend is paid, the individual shareholder pays income tax to the government on the dividend payment. This is often used as justification for retaining earnings, or for performing a stock buyback, in which the company buys back stock, thereby increasing the value of the stock left outstanding. The shareholder pays no income tax on this transaction. Microsoft is an example of a company who has historically been a proponent of retaining earnings; it did so from its IPO in 1986 until 2003, when it declared it would start paying dividends. By this point Microsoft had accumulated over $43 billion in cash, and there had been increasing irritation from stockholders who believed this large pile of cash should lie in their hands and not in the company's. Originally, the official reason to amass this large sum was to create a reserve for Microsoft's legal battles; since then, Microsoft appears to have changed tactics such that the reserve is not as necessary.

In the United States, credit unions generally use the term "dividends" to refer to interest payments they make to depositors. These are not dividends in the normal sense and are not taxed as such; they are just interest payments. Credit unions call them dividends because, technically, credit unions are owned by their members, and the interest payments are therefore payments to owners.

The name comes from the arithmetic operation of division: if a / b = c then a is the dividend, b the divisor, and c the quotient.

Some Important Verbage

A stock, also referred to as a share, is commonly a share of ownership in a corporation.

The first company that issued shares is considered to be the Stora Kopparberg, in the 13th century.

The owners and financial backers of a company may want additional capital to invest in new projects within the company. If they were to sell the company it would represent a loss of control over the company.

Alternatively, by selling shares, they can sell part or all of the company to many part-owners. The purchase of one share entitles the owner of that share to literally a share in the ownership of the company, including the right to a fraction of the assets of the company, a fraction of the decision-making power, and potentially a fraction of the profits, which the company may issue as dividends. However, the original owners of the company often still have control of the company, and can use the money paid for the shares to grow the company.

In the common case, where there are thousands of shareholders, it is impractical to have all of them making the daily decisions required in the running of a company. Thus, the shareholders will use their shares as votes in the election of members of the board of directors of the company. However, the choices are usually nominated by insiders or the board of the directors themselves, which over time has led to most of the top executives being on each other's boards. Each share constitutes one vote (except in a co-operative society where every member gets one vote regardless of the number of shares they hold). Thus, if one shareholder owns more than half the shares, they can out-vote everyone else, and thus have control of the company.

Shareholder rights
Although owning 51% of shares does mean that you own 51% of the company and that you have 51% of the votes, the company is considered a legal person, thus it owns all its assets, (buildings, equipment, materials etc) itself. A shareholder has no right to these without the company's permission, even if that shareholder owns almost all the shares. This is important in areas such as insurance, which must be in the name of the company not the main shareholder.

In most countries, including the United States, boards of directors and company managers have a fiduciary responsibility to run the company in the interests of its stockholders. Nonetheless, as Martin Whitman writes, " can safely be stated that there does not exist any publicly traded company where management works exclusively in the best interests of OPMI [Outside Passive Minority Investor] stockholders." Instead, there are both "communities of interest" and "conflicts of interest" between stockholders and management. "It would be naive to think that any management would forego management compensation, and management entrenchment, just because some of these management privileges might be perceived as giving rise to a conflict of interest with OPMIs." [Whitman, 2004, 5]

Means of Financing
Financing a company through the sale of stock in a company is known as equity financing. Alternatively debt financing (for example issuing bonds) can be done to avoid giving up shares of ownership of the company.

There are several types of shares, including common stock, preferred stock, treasury stock, and dual class shares. Preferred stock, sometimes called preference shares, have priority over common stock in the distribution of dividends and assets, and sometime have enhanced voting rights such as the ability to veto mergers or aquistions or the right of first refusal when new shares are issued (i.e. the holder of the preferred stock can buy as much as they want before the stock is offered to others). A dual class equity structure has several classes of shares (for example Class A, Class B, and Class C) each with its own advantages and disadvantages. Treasury stock are shares that have been bought back from the public.

A stock option is the right (or obligation) to buy or sell stock in the future at a fixed price. Stock options are often part of the package of executive compensation offered to key executives. Some companies extend stock options to all (or nearly all) of their employees. This was especially true during the dot-com boom of the mid- to late- 1990s, in which the major compensation of many employees was in the increase in value of the stock options they held, rather than their wages or salary. Some employees at dot-com companies became millionaires on their stock options. This is still a major method of compensation for CEO's.
The theory behind granting stock options to executives and employees of a corporation is that, since their financial fortunes are tied to the stock price of the company, they will be motivated to increase the value of the stock over time.