Canadian Securities Exam Fast-Track Study Guide, 4th Edition

TABLE OF CONTENTSAcknowledgements viIntroduction: How to Use this Book vii

Chapter 1: The Capital Market 1Introduction 1Suppliers and Users of Investment Capital 1The Role of Financial Instruments 4Financial Markets 5Chapter 1 Review Questions 8

Chapter 2: The Canadian Securities Industry 11An Overview of the Canadian Securities Industry 11The Role of Financial Intermediaries 11The Canadian Securities Industry 12Chartered Banks 14Other Intermediaries 16Chapter 2 Review Questions 18

Chapter 3: The Canadian Regulatory Environment 21

Regulatory Organizations 21Arbitration 24Regulation and Investor Protection 24The Ethics of Trading 26Takeovers and Insider Trading 28Chapter 3 Review Questions 29

Chapter 4: Economic Principles 33Overview of Economics 33Measuring the Economy 34Labour Markets 36Interest Rates 37Money and Inflation 38International Economics 39Chapter 4 Review Questions 41

Chapter 5: Economic Policy 45Economic Theories 45Fiscal Policy 46Monetary Policy 46Chapter 5 Review Questions 49

Chapter 6: Fixed-income Securities: Features and Types 53

Overview and Terminology 53Bond Features 54Government Securities 56Corporate Bonds 57Chapter 6 Review Questions 61

Chapter 7: Fixed-income Securities: Pricing and Trading 67

Bond Pricing Principles 67The Term Structure of Interest Rates 71

Delivery, Regulation, and Settlement 72Bond Indexes 73Chapter 7 Review Questions 74

Chapter 8: Equity Securities: Common and Preferred Shares 79

Introduction 79Common Shares 79Preferred Share Characteristics 81Stock Indices and Averages 87Chapter 8 Review Questions 89

Chapter 9: Equity Securities: Equity Trading 95Cash and Margin Accounts 95Short Sales 97Equity Transactions 98Chapter 9 Review Questions 99

Chapter 10: Derivatives 105Introduction 105Options 106Futures and Forwards 112Rights and Warrants 115Chapter 10 Review Questions 118

Chapter 11: Financing and Listing Securities 123Basic Forms of Business Organization 123The Incorporation Process 125Government and Corporate Financing 127The Financing Procedure 130The Listing Process 133Chapter 11 Review Questions 135

Chapter 12: Corporations and Their Financial Statements 139

Understanding Financial Statements 139Statement of Financial Position 139Statement of Comprehensive Income 143Other Components 145Chapter 12 Review Questions 146

Chapter 13: Fundamental and Technical Analysis 151Overview 151Fundamental Macroeconomic Analysis 152Industry Analysis 153Fundamental Valuation Models 155Technical Analysis 158Chapter 13 Review Questions 160

Chapter 14: Company Analysis 165Fundamental Company Analysis 165Interpreting Financial Statements 166Assessing Preferred Share Investment Quality 174Chapter 14 Review Questions 176

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Chapter 15: Introduction to the Portfolio Approach 183Introduction 183Risk and Return 183Portfolio Risk and Return 187The Portfolio Management Process 189Chapter 15 Review Questions 191

Chapter 16: The Portfolio Management Process 197Developing an Asset Mix and Selecting

Investment Styles 197Implementing the Asset Mix 200Monitoring the Economy, the Markets,

the Portfolio, and the Client 201Evaluating Portfolio Performance 202Chapter 16 Review Questions 203

Chapter 17: Evolution of Managed and Structured Products 209

Managed versus Structured Products 209Chapter 17 Review Questions 211

Chapter 18: Mutual Funds: Structure and Regulation 213

Introduction 213The Structure of Mutual Funds 214Labour-sponsored Venture Capital Corporations

(LSVCCs) 217Regulation of Mutual Funds 219Chapter 18 Review Questions 223

Chapter 19: Mutual Funds: Types and Features 227Types of Mutual Funds 227Fund Management Styles 229Redeeming Mutual Fund Units or Shares 229Comparing Mutual Fund Performance 231Chapter 19 Review Questions 233

Chapter 20: Segregated Funds and Other Insurance Products 237

Key Features of Segregated Funds 237Maturity Guarantees and Benefits 238Fees and Expenses 241Tax Considerations 242Regulation 245Other Insurance Products 247Chapter 20 Review Questions 247

Chapter 21: Hedge Funds 251Overview of Hedge Funds 251Hedge Fund Indexes 253Benefits and Risks of Hedge Funds 253Due Diligence 254Hedge Fund Strategies 255Funds of Hedge Funds 257Chapter 21 Review Questions 257

Chapter 22: Exchange-listed Managed Products 261Closed-end Funds 261Income Trusts 262Exchange-traded Funds 263Chapter 22 Review Questions 264

Chapter 23: Fee-based Accounts 267Fee-based Accounts 267Chapter 23 Review Questions 269

Chapter 24: Structured Products 271Principal Protected Notes (PPNs) 271Index-linked Guaranteed Investment Certificates

(GICs) 272Split Shares 272Asset-backed Securities (ABS) 273Mortgage-backed Securities (MBS) 274Chapter 24 Review Questions 274

Chapter 25: Canadian Taxation 277Taxes and Taxation Issues 277Taxation of Investment Income 278Tax Deferral Plans 281Basics of Tax Planning 284Chapter 25 Review Questions 285

Chapter 26: Working with the Retail Client 289The Process of Financial Planning 289Financial Planning Aids 291Ethics and the Financial Advisor 292Case Studies 294Chapter 26 Review Questions 296

Chapter 27: Working with the Institutional Client 299Who Are Institutional Clients? 299Suitability Requirements for

Institutional Investors 300Roles and Responsibilities in

the Institutional Market 301Chapter 27 Review Questions 301

Answers to End-of-Chapter Review Questions Chapter 1 304Chapter 2 304Chapter 3 304Chapter 4 305Chapter 5 305Chapter 6 305Chapter 7 306Chapter 8 307Chapter 9 308Chapter 10 309Chapter 11 309

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Chapter 12 310Chapter 13 310Chapter 14 311Chapter 15 312Chapter 16 313Chapter 17 314Chapter 18 314Chapter 19 314Chapter 20 315Chapter 21 315Chapter 22 315Chapter 23 316Chapter 24 316

Chapter 25 316Chapter 26 317Chapter 27 317

CSC Practice Examination #1: Chapters 1–12 319CSC Practice Examination #2: Chapters 13 –27 341

Answers to Practice Exam #1: Chapters 1–12 363Answers to Practice Exam #2: Chapters 13 –27 369

ACKNOWLEDGEMENTSI would like to thank my wife, Grace, my children, Jason, Brennan, Brigid, and Siobhan, and my parents, Bill and Beryl, for their support. I would also like to acknowledge the support and direction provided by the Wiley editorial team, with special acknowledgement to Karen Milner and Lindsay Humphreys.

c h a p t e rTHE CAPITAL MARKET

CSC EXAM SUGGESTED GUIDELINES:

15 questions combined for Chapters 1–3

1

INTRODUCTION

The vital function served by financial markets is the transfer of wealth from those who have extra wealth to those who need capital. In other words, financial marketsdrive economic growth by transforming savings into investments.

•The three components of this process of wealth transfer are

1. financial instruments;

2. financial markets; and

3. financial intermediaries.

SUPPLIERS AND USERS OF INVESTMENT CAPITAL

Investment Capital

Capital incorporates the savings of individuals, corporations, governments, and other entities. It is scarce and valuable; however, it is only economically significant when it is properly utilized.

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2 Canadian Securities Exam Fast-Track Study Guide

Capital can be utilized through

1. direct investment in real assets that generate wealth directly (e.g., land, buildings, equipment, human capital); or

2. indirect investment in financial assets (e.g., stocks, bonds, treasury bills), which allows issuers of these securities to invest funds directly in wealth gen-erating assets.

Capital is mobile, scarce, and sensitive—efficient allocation promotes economic growth, while inefficient allocation can constrain economic growth. As a result of these characteristics, capital is selective and tends to flow toward attractive economic environments.

•Capital tends to flow into and out of countries in response to several variables, such as

° the political environment;

° economic trends;

° fiscal policy;

° monetary policy;

° investment opportunities and risk-return opportunities; and

° labour force characteristics.

•The availability of capital is critical to any nation. It is necessary to promote eco-nomic output, improve productivity, encourage innovations, and improve the competitive position of a nation in general.

Sources of Capital

Investors, both retail and institutional, provide investment capital. Retail refers to investors who invest for their own account, while institutional investors are organi-zations such as pension funds or mutual funds that buy and sell securities on behalf of the underlying entity—which in turn is set up to serve its plan members, unit holders, etc.

• Individuals represent a significant source of investment capital in Canada.

•Corporations tend to retain a large portion of their earnings to finance operations and growth and are not an important source of capital.

•Canadian governments have generally been net borrowers in recent years to fund their deficits.

• Foreign investment has grown in importance in Canada and has been necessary to fund deficits and growth. The benefit of this fact is that it helps to expand our international trading relationships, while the cost is that this may take long-term cash flows out of the country. It is an issue that will be debated for some time to come.

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CHAPTER 1 • The Capital Market 3

•Nonresidents can invest in Canada through Canadian firms (which may be located at home or abroad), or through bonds or stocks that are listed on foreign ex-changes or over-the-counter markets (such as the NASDAQ stock market in the United States).

•The two main categories of international bond issues are

1. foreign bonds: which are offered and denominated in the currency of a country other than the borrower; and

2. Eurobonds: which may be denominated in one of several currencies and are sold in countries other than the currency in which they are denominated.

Users of Capital

• Individuals use capital primarily for consumption purposes, with the funds usually being obtained through personal loans, mortgage loans, or charge accounts.

•Businesses use capital to finance day-to-day operations, to maintain and upgrade plant and equipment, and to finance growth. A large proportion of funds are financed internally (through reinvested earnings), with the remainder coming from bank loans and through the issue of securities such as money market, bond, and equity instruments.

•Canadian governments have a long history of deficits, a situation that requires them to borrow to finance their expenditures.

•The federal government finances its debt using

1. treasury bills (T-bills);

2. marketable short- and long-term bonds (debentures); and

3. Canada Savings Bonds and Canada Premium Bonds (which can be sold only to Canadian residents).

T-bills and marketable bonds may be purchased by foreign investors.

• Prior to 1995, the yields on the Government of Canada’s debt were generally higher than on U.S. government debt. Since then, our yields have been lower than those in the United States. This change reflects the improved financial position of the federal government in recent years, as the government reduced, then eliminated, its federal budget deficit.

• Provincial governments may issue non-marketable bonds to the federal govern-ment or borrow funds from the Canada Pension Plan (CPP) assets (or QPP for Quebec firms). They may also issue marketable bonds, T-bills, or provincial ver-sions of savings bonds.

•Municipal governments borrow to provide local services such as streets, sewers, waterworks, and police and fire protection. They often do so in the form of serial or installment debentures (which will be discussed in Chapter 6).


THE ROLE OF FINANCIAL INSTRUMENTS

•The broad categories of financial instruments available are discussed below, and they are elaborated upon in subsequent chapters. The role of these instruments is to enable the transfer of capital from suppliers to users. The financial markets provide the environment that allows this transfer to take place, as discussed in the section below.

Financial Instruments

These are legal, formal documents that set out the rights and obligations of the par-ties involved. The major categories are described below.

DEBT

•Represents a legal obligation to repay borrowed funds at a specified maturity date and provide interim interest payments as specified in the agreement.

•Examples include bank loans, commercial paper, treasury bills, mortgages, bonds, debentures, as well as many other instruments.

EQUITY

•Represents part-ownership of a company.

•Common shares usually provide holders with voting privileges, and holders may receive dividends (however, they are not obligatory).

• Preferred shareholders typically receive a fixed dividend amount that must be paid before any dividends are paid to common shareholders.

INVESTMENT FUNDS

•An investment fund is a company that manages investments for its clients. The most common form is the open-end fund, which is known as a mutual fund.

DERIVATIVE PRODUCTS

•Derivatives are so called because they derive their value from the price of another underlying asset, such as a stock, stock or bond index, commodity price, etc.

•They are suitable for hedging or speculative purposes by more sophisticated investors.

OTHER INVESTMENT PRODUCTS

• Income trusts and exchange-traded funds are recent innovations that have become very popular investments. Both trade on stock exchanges, and both will be dis-cussed in later chapters.

PRIVATE EQUITY

• Financing can be equity or debt, or a combination of the two.


• Several types include

1. leveraged buyouts;

2. growth capital;

3. early stage venture capital (VC);

4. late stage VC; and

5. distressed debt.

•Higher risks/higher returns for providers—also lower liquidity than typical invest-ments.

•Typical providers include

° pension plans;

° endowments;

° foundations;

° wealthy individuals/families.

FINANCIAL MARKETS

•The benefits of investment products depend on the existence of efficient mar-kets for buying and selling these instruments. An efficient market should allow for fast and low-cost transactions, and maintain a high degree of liquidity. Obviously, proper regulation of these markets is essential.

•Primary markets involve the sale of securities by the issuer to the market for the first time, and money flows to the issuer. They may be in the form of seasoned offerings or initial public offerings (IPOs). Secondary markets involve the sale of previously issued securities. No funds go the issuer. Secondary markets facilitate the primary markets by making securities transferable.

• Financial intermediaries improve the efficiency of markets by facilitating the trad-ing or movement of the financial instruments that transfer capital between sup-pliers and users (including corporate, government, private, and global entities).

•Examples of financial intermediaries include the Bank of Canada, chartered banks, trust and mortgage companies, credit unions, insurance companies, pen-sion funds, investment dealers/bankers, venture capital firms, mutual funds, leas-ing companies, sales finance companies, and factors.

Auction Markets (Stock Exchanges)

Auction markets are those where all transactions converge to one location.

•Canadian stock exchanges have undergone significant changes in recent years. At the start of 1999, there were five stock exchanges in Canada: the Toronto Stock Exchange (TSX—formerly called the TSE), the Montreal Exchange (ME), the Vancouver Stock Exchange (VSE), the Winnipeg Stock Exchange (WSE),

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and the Alberta Stock Exchange (ASE). A complete overhaul of that structure occurred during 1999 and 2000, and as a result of this restructuring, there are three remaining stock exchanges in Canada—the TSX, the newly created TSX Venture Exchange (which replaced the Canadian Venture Exchange in 2001), and the Canadian National Stock Exchange (CNSX) which gained recognition as a stock exchange in 2004 (as an alternative for emerging companies to the TSX Venture Exchange). The first two exchanges are owned by the TMX Group Inc., which became the first North American exchange (under its previous name the TSX Group Inc.) to become publicly listed, in November 2002. Trading operations for both the TSX and the TSX Venture Exchange are conducted by TSX Markets, also a member of the TMX Group.

• In May 2008, the TSX Group and the ME merged to form the TMX Group.

•Today, the TSX is the official exchange for trading of Canadian senior stocks—big companies with solid histories of profits. The TSX accounts for the majority of both the volume of shares traded in Canada and the dollar value of share trades.

• There are over 80 exchanges in 60 countries, and the TSX was the 8th largest exchange in the world in 2009, based on market capitalization. The New York Stock Exchange is the largest in the world, followed in order by Tokyo, NASDAQ, NYSE Euronext, and London.1

• Since March 2000, the Montreal Exchange (or Bourse de Montreal) assumed its role as the Canadian national derivatives market, and now carries on all trading in financial futures and options that previously occurred on the TSX, the ME, and the now-defunct Toronto Futures Exchange.

•The only other Canadian exchange is ICE Futures Canada (formerly the Winnipeg Commodity Exchange), which handles futures trading in commodities and is dis-cussed in Chapter 10 along with the ME.

•Traditionally, exchanges were not-for-profit organizations. Under this arrangement, stock exchange memberships (in the form of stock exchange “seats”) are sold to individuals, which permits them to trade on the exchange. These seats are valuable assets that may be sold, subject to certain exchange conditions. However, today most exchanges are “for-profit,” and are owned by the shareholders, and firms (called Participating Organizations or Approved Participants) do not have to be owners to have access to exchange trading.

•Member firms must be publicly owned, they must maintain capital adequacy requirements, and key personnel must complete required courses of study.

•Exchanges are governed by bodies that consist of at least one permanent exchange official (e.g., the president), plus members of the board of directors who are selected from member firms, as well as two to six highly qualified public governors appointed or elected from outside the brokerage community.

•Exchanges are financed by transaction fees, initial listing fees, sustaining listing fees, fees paid by companies with respect to capital structure changes, and through the sale of historic and market information.

1Source: World Federation of Exchanges (www.world-exchanges.org).


•Over the past decade, several trends have emerged in response to increased global trading and the resulting competition, as well as to the availability of enhanced technology. These include the dominance of electronic trading systems over physi-cal locations, increasing mergers and alliances (the number of exchanges has decreased from over 200 to fewer than 100), and the move to the for-profit corpo-rate structure.

• Future trends expected to continue are the move to for-profit structures, addi-tional mergers, increased focus on niche markets, and easier trading between exchanges.

•Exchanges have the power to suspend the trading or listing privileges of an indi-vidual security, either temporarily or permanently.

Dealer Markets: The Unlisted Market

Dealer markets or Over-the-counter (OTC) markets comprise a network of dealers that trade directly with each other over the phone or through a computer network. They are negotiated networks, which maintain bid and ask quotations received from the dealers acting as market makers in given securities. Market makers execute trades from their inventories.

Almost all bonds and debentures are sold through dealer markets (about 14 times the volume that is conducted for unlisted equities); however, the volume of unlisted equity trading is much smaller than the volume of exchange-traded equity transac-tions.

• It is important to note that this market does not set listing requirements.

•Unlisted trades need not be reported except in Ontario, where the Ontario Secu-rities Commission (OSC) requires such trades to be reported on the Canadian Unlisted Board Inc. (CUB) automated system.

•The first Canadian quotation and reporting system, the Canadian Trading and Quotation System Inc. (CNQ), was launched in July 2003. These Quotation and Trade Reporting Systems (QTRS) are stock markets that operate similarly to exchanges—by providing users with the means to post quotations and report trades. They provide an alternative market for small-cap emerging companies, since the requirements to trade on these markets are less stringent than those required to trade on organized exchanges, such as the TSX Venture Exchange. In Canada, it is regulated by the Investment Industry Regulatory Organization of Canada (IIROC).

Alternative Trading Systems

•Alternative Trading Systems (ATS) are computerized systems that execute orders outside traditional exchange facilities by matching orders from their own invento-ry or by matching buy and sell orders from outside parties. Sometimes, they permit buyers and sellers to contact each other directly to negotiate trades. These systems are privately owned, often by individual brokerage firms or groups of firms. Most of their customers are institutional investors, who are able to reduce their transac-

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tions costs through the use of such a system. In addition, since these systems can operate when exchanges are closed, they are ideal for the trading of securities on a global basis.

•Concern has mounted over the growth of ATS trading because the details of such trades are not available to the general public, there is the ever-present threat of technological problems, and potential issues can arise from trading across country borders. In response to such concerns, both Canada and the United States have recently introduced legislation to regulate ATS trading activities. Trading activity of Canadian ATS is governed by IIROC.

•Three recently launched electronic trading systems handle much of the bond and money market OTC trades in Canada. They are

1. CanDeal: A joint venture among Canada’s six largest investment dealers, and a member of IIROC. Handles federal government bonds and plans to expand to provincials, corporate debt, and commercial paper. Handles over 80% of market transactions.

2. CBID: IIROC member and ATS. Maintains retail and institutional market places, dealing with more than 2,500 debt instruments.

3. CanPX: Joint venture of Investment Industry Association of Canada (IIAC) and IIROC member firms. Deals in government bonds and T-bills, and some corporate bonds.

Chapter 1 Review Questions

1. Private equity is characterized by:

a) low returns

b) low liquidity

c) low risk

d) many small investors

2. Which of the following represent a source of capital?

a) individuals

b) businesses

c) governments

d) all of the above

3. All of the following represent an indirect investment EXCEPT for:

a) the purchase of common shares

b) the purchase of T-bills

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c) the purchase of new land

d) all of the above are indirect investments

4. Which of the following exchanges trades all financial and equity futures and options?

a) Toronto Stock Exchange

b) TSX Venture Exchange

c) Bourse de Montreal

d) ICE Futures Canada

5. All of the following are characteristics of a liquid market EXCEPT:

a) frequent sales

b) big price fluctuations from sale to sale

c) narrow price spread between bid and offering prices

d) thousands of orders from all parts of the country and overseas

6. Which of the following are privately owned computerized networks that match orders for securities outside of recognized exchanges?

a) CNQ

b) ATS

c) RS

d) UMIR

Bonus Questions

7. Retail investors:

a) generally trade in large volumes of securities

b) buy and sell securities for another company or organization

c) buy and sell securities for their own personal account

d) are an insignificant source of investment capital in the marketplace

8. Which of the following statements concerning foreign investment is FALSE?

a) Foreign investment generally leads to long-term outflows of interest and dividend payments.

b) Foreign investors only supply capital to the Canadian market, and are not consumers of capital.

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c) Over the past 20 years, government policy in Canada has tended to favour the protection of Canadian businesses from foreign investment.

d) Foreign investment is an important source of investment capital.

9. Canada’s stock exchanges are markets.

a) physical dealer

b) electronic dealer

c) electronic auction

d) physical auction

10. If the government estimates its revenue to be $100 and its expenses to be $80 for a given year, then:

a) the budget deficit is $20

b) the national debt is $20

c) the budget surplus is $20

d) the national surplus is $20

11. Which of the following statements concerning financial markets is true?

a) The ask is the lowest price a seller will accept for a security.

b) The bid is the highest price that a buyer will pay for a security.

c) A liquid market is characterized by a narrow bid-ask spread, frequent sales, and small price changes from sale to sale.

d) All of the above statements are true.

12. Institutional investors:

a) are organizations that buy and sell securities

b) are government owned and operated on behalf taxpayers

c) are high-risk investment vehicles

d) All of the above are true.

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( )

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Documents

Canadian Securities Exam Fast-Track Study Guide, 4th Edition