2.1 Products

2.1.1 Equity Securities

• Types of equities

  • Common stock

    • Definition: Common stock represents ownership in a company and is the type of stock most people are familiar with. Holders of common stock exercise control by electing a board of directors and voting on company policy.

    • Characteristics:

      • Dividends: Common stockholders may receive dividends, but these are not guaranteed and may vary in amount.
      • Voting Rights: Typically, common stockholders have the right to vote on company matters, including mergers and board elections.
      • Residual Claim: In the event of liquidation, common stockholders have the last claim on assets after creditors, bondholders, and preferred stockholders.

  • Preferred stock

    • Definition: Preferred stock represents a higher level of ownership than common stock and usually doesn't come with the same voting rights.

    • Characteristics:

      • Dividends: Preferred stockholders usually receive dividends before common stockholders and at a fixed rate.
      • Priority in Liquidation: In the case of company liquidation, preferred stockholders are paid before common stockholders but after debt holders.
      • Convertible Feature: Some preferred stocks can be converted into common stock.

  • Rights

    • Definition: Rights give stockholders the option to buy more shares of a company's stock at a specific price, usually below market value, within a certain time frame.

    • Characteristics:

      • Preemptive Right: Allows existing shareholders to maintain their proportional ownership in the company, preventing dilution of their ownership when new shares are issued.

  • Warrants

    • Definition: A warrant provides the holder with the right, but not the obligation, to purchase a company's stock at a specific price within a specified time period.

    • Characteristics:

      • Longer Duration: Unlike rights, warrants usually have a longer exercise period, often several years or indefinitely.
      • Dilution: When a warrant is exercised, the company issues new shares, which can lead to dilution of existing shareholders' equity.

  • American Depositary Receipts (ADRs)

    • Definition: ADRs are certificates issued by U.S. banks representing shares in a foreign company. They allow U.S. investors to buy shares in foreign companies without the complexities of buying shares in foreign markets.

    • Characteristics:

      • Trading: ADRs trade on U.S. stock markets just like domestic equities.
      • Dividends: Dividends are paid in U.S. dollars, though they are earned in the foreign company's local currency.
      • Types: There are different levels of ADRs (Level I, II, and III) that dictate where they can be traded and whether the company needs to adhere to U.S. GAAP (Generally Accepted Accounting Principles) or other financial reporting standards.

• Knowledge of:

  • Ownership (e.g., order of liquidation, limited liability)

    • Ownership in a company through equity securities grants shareholders certain rights and responsibilities. Here are some key aspects related to ownership:

    • Order of Liquidation: In the event that a company is liquidated (i.e., sells off all its assets and winds up its business), there's a specific hierarchy determining which stakeholders get paid first:

      1. Secured Debt Holders: These are creditors who have specific assets pledged as collateral for the debt.
      2. Unsecured Debt Holders: These are bondholders and other lenders who don't have specific collateral backing their claims.
      3. Preferred Stockholders: If any assets remain after debt holders are paid, preferred shareholders receive their share.
      4. Common Stockholders: They are last in line. If there's anything left after all other claimants have been paid, common stockholders receive the remainder.

    • Limited Liability: Shareholders' liability is limited to their investment in the company. In other words, if the company goes bankrupt or faces lawsuits, the maximum that common shareholders can lose is the amount they invested in the stock. Their personal assets are not at risk.

  • Voting rights

    • Common Stockholders: Typically, common stockholders have the right to vote on various company matters, such as electing the board of directors, mergers, and company policies. Usually, they get one vote per share owned.

    • Preferred Stockholders: They often do not have voting rights. However, in some cases, if the company fails to pay dividends or breaches certain covenants, preferred stockholders might gain voting rights.

  • Convertible

    • Convertible Securities: These are securities (like convertible bonds or convertible preferred stock) that can be converted into a specified number of common shares. The conversion can be at the option of the holder or at a specific future date.

    • Benefits: Convertibility offers investors the potential for upside if the company's stock price rises, while also providing the stability and income of a bond or preferred stock.

  • Control and restrictions (e.g., SEC Rule 144)

    • SEC Rule 144: This rule stipulates the conditions under which restricted and control securities (securities acquired in unregistered, private sales or directly from an issuer) can be sold publicly. Some of its conditions include:

      1. Holding Period: Before selling, one must hold the securities for a certain period, typically six months for public companies and one year for non-public companies.
      2. Trading Volume: The number of equity securities that may be sold during any three-month period cannot exceed the greater of 1% of the outstanding shares of the same class or the average reported weekly trading volume during the four weeks preceding the sale.
      3. Manner of Sale: Sales must be handled in an "ordinary brokerage transaction" and brokers cannot solicit buyers.
      4. Notice to the SEC: If the sale of an insider exceeds 5,000 shares or $50,000 in value, the seller must notify the SEC.

    • Restrictions on Insider Trading: Insiders (like company executives and directors) have access to material non-public information. They face restrictions on when they can buy or sell their company's stock to prevent insider trading.

2.1.2 Debt Instruments

• Treasury securities (e.g., bills, notes, receipts, bonds)

  • Treasury securities are debt instruments issued by the U.S. Department of the Treasury to raise funds for various government activities.

  • Bills: Short-term securities that mature in one year or less. They don't pay interest but are sold at a discount to their face value and mature at par.

  • Notes: Intermediate-term securities that mature between one and ten years. They pay interest every six months.

  • Bonds: Long-term securities that mature in more than ten years. Like notes, they pay interest every six months.

  • Receipts: These are not direct Treasury issuances but are a type of derivative that represents beneficial ownership interests in separately traded interest and principal components of Treasury securities.

• Agency (e.g., asset-backed and mortgage-backed securities)

  • These are issued by government-sponsored entities (GSEs) and federal agencies.

  • Asset-Backed Securities (ABS): Debt securities backed by various types of financial assets, such as auto loans, credit card receivables, or student loans.

  • Mortgage-Backed Securities (MBS): These are backed by home loans. Investors receive periodic payments derived from homeowners' mortgage payments.

• Corporate bonds

  • Debt securities issued by corporations to raise capital. They come with varying terms, interest rates, and credit qualities.

• Municipal securities

  • General obligation (GO) bonds

    • General Obligation (GO) Bonds: Backed by the full faith and credit of the issuing municipality. They are secured by general tax revenues.

  • Revenue bonds

    • Revenue Bonds: Backed by specific revenue sources, like tolls or rents, rather than general tax revenue. They finance income-producing projects and are paid from the revenue generated by those projects.

  • Others (e.g., special type bonds, taxable municipal securities, short-term obligations)

    • Special Type Bonds: This can include bonds like zero-coupon bonds, which don't pay periodic interest but are issued at a significant discount to face value and mature at par.

    • Taxable Municipal Securities: Most municipal bonds are tax-exempt, but some municipal securities are taxable if the funds from the bond issuance don't benefit the public.

    • Short-Term Obligations: These include instruments like commercial paper, which are unsecured short-term corporate debt securities with maturities that can range from a few days to 270 days.

• Others (e.g., money market instruments, certificate of deposit (CD), bankers’ acceptance, commercial paper)

  • Money Market Instruments: Short-term debt securities with maturities less than one year.

  • Certificate of Deposit (CD): Time deposit offered by banks with a specific maturity date and fixed interest rate.
  • Bankers’ Acceptance: Short-term credit instrument used in international trade.
  • Commercial Paper: Unsecured, short-term debt issued by corporations.

•  

  Knowledge of:

   

  • Varying Maturities: The length of time until the debt instrument is due for repayment. Maturities can range from a day to several decades.

  • Generate Income: Debt instruments generate income for the holder, typically in the form of interest payments.

  • Coupon Value: The interest rate stated on a bond, representing the periodic interest payment to the bondholder.

  • Par Value: The face value of a bond, typically $1,000, which is returned to the bondholder at maturity.

  • Yield: The rate of return on a debt instrument, taking into account its purchase price, par value, coupon interest rate, and time to maturity.

  • Ratings and Rating Agencies: Debt instruments are rated based on their credit risk by rating agencies like Moody's, S&P, and Fitch. Ratings help investors assess the risk of default.

  • Callable and Convertible Features:

    • Callable: The issuer can redeem the bond before its maturity.
    • Convertible: Bondholders can convert the bond into a predetermined amount of the issuer's equity.

  • Short-term vs. Long-term Characteristics: Short-term debt instruments typically have lower yields and are less sensitive to interest rate changes than long-term instruments.

  • Relationship between Price and Interest Rate: Bond prices and interest rates move in opposite directions. When interest rates rise, bond prices fall, and vice versa.

  • Negotiated vs. Competitive Offerings via Underwriters and Syndicates:

    • Negotiated: The issuer negotiates terms with a single underwriter instead of a syndicate.
    • Competitive: Multiple underwriters or syndicates submit bids to issue the bond, and the best bid wins.

  • Auction: Some government securities, like U.S. Treasury securities, are sold through auctions where institutional and individual investors place bids.

2.1.3 Options

• Types of options

  • Puts and calls

    • Call Option: Gives the holder the right, but not the obligation, to purchase an asset (often stock) at a specified price (known as the strike price) on or before a specific date (expiration date). Investors buy call options when they anticipate a rise in the underlying asset's price.
    • Put Option: Gives the holder the right, but not the obligation, to sell an asset at the strike price on or before the expiration date. Investors buy put options when they anticipate a decline in the underlying asset's price.

  • Equity vs. index

    • Equity Options: These are options on individual stocks. The contract usually represents 100 shares of the underlying stock. When exercised, the holder of an equity call option will buy shares of the stock, and the holder of a put option will sell shares of the stock.
    • Index Options: These are options on stock market indices like the S&P 500 or the Dow Jones Industrial Average. Index options are cash-settled, meaning that no actual stocks are bought or sold. Instead, the difference between the closing value of the index and the strike price of the option is paid in cash. They're used to hedge, speculate, or generate income on a broad market or sector without buying or selling individual stocks.

• Knowledge of:

  • Hedging or Speculation:

    • Hedging: Using options to protect an existing position or portfolio from adverse price movements. For example, buying put options to protect against a decline in stock holdings.
    • Speculation: Using options to profit from anticipated price movements without owning the underlying asset. For example, buying call options if one expects a stock to rise.

  • Expiration Date: The last day an option can be exercised. After this date, the option becomes worthless.

  • Strike Price: The predetermined price at which the holder of an option can buy (for call options) or sell (for put options) the underlying asset.

  • Premium: The cost of the option or the price paid by the buyer to the seller for the rights granted by the option.

  • Underlying or Cash Settlement:

    • Underlying Settlement: Refers to the delivery of the actual underlying asset upon the exercise of the option.
    • Cash Settlement: Instead of delivering the underlying asset, the difference in value is settled in cash. Typically seen in index options.

  • In-the-money, Out-of-the-money:

    • In-the-money (ITM): An option with intrinsic value. Call options are ITM when the underlying asset's price is above the strike price. Put options are ITM when the underlying asset's price is below the strike price.
    • Out-of-the-money (OTM): An option with no intrinsic value. Opposite conditions of ITM for calls and puts.

  • Covered vs. Uncovered:

    • Covered: The writer (seller) of the option owns the corresponding amount of the underlying asset. For instance, selling a call option while owning the underlying stock.
    • Uncovered (or Naked): The writer does not own the underlying asset, leading to higher risk.

  • American vs. European:

    • American: Can be exercised any time before the expiration date.
    • European: Can only be exercised at the expiration date.

  • Exercise and Assignment:

    • Exercise: The action taken by the holder of the option to buy or sell the underlying asset at the strike price.
    • Assignment: The obligation of the option writer to fulfill the terms of the contract by selling or buying the underlying asset to or from the option holder.

  • Varying Strategies:

    • Long: Buying an option.
    • Short: Selling an option.

  • Special Disclosures:

    • Options Disclosure Document (ODD): A standardized document that explains the characteristics and risks of trading standardized options. It's provided by the broker to potential options traders.

  • Options Clearing Corporation (OCC) for Listed Options:

    • The world's largest equity derivatives clearing organization. The OCC ensures that the obligations of the contracts are honored and provides central clearing and settlement services for options.

2.1.4 Packaged Products

• Investment companies
  • Types of investment companies

    • Closed-end Funds:

      • Structure: Operate as publicly traded investment companies that have a fixed number of shares. These shares are not redeemable from the fund but are traded on stock exchanges.
      • Pricing: Their market price can fluctuate and may be different from their net asset value (NAV). The price is determined by supply and demand on the stock market.
      • Benefits: Can invest in a more concentrated portfolio and often use leveraging strategies.

    • Open-end Funds (Commonly known as Mutual Funds):

      • Structure: Continuously offer their shares to the public and stand ready to buy back their shares upon investor demand. This means the number of outstanding shares can vary daily.
      • Pricing: Shares are bought and sold at the NAV, calculated at the end of each trading day based on the total value of the fund's assets.
      • Benefits: Offers daily liquidity and diversification across a wide range of assets.

    • Unit Investment Trusts (UITs):

      • Structure: Investment firms offer these as a fixed portfolio of securities in a one-time public offering. They have a definite life term.
      • Pricing: Units can be sold back to the investment firm at NAV or can be sold on the secondary market.
      • Distinct Feature: Unlike mutual funds or closed-end funds, UITs do not have an active manager making investment decisions. They are passively managed, often tracking a specific index.

    • Variable Contracts/Annuities:

      • Nature: These are insurance products that also have investment characteristics. The insurance company guarantees a minimum payment, but the value of the annuity's contract can rise or fall based on the performance of the investment options chosen by the holder.
      • Phases: Typically has two phases – an accumulation phase, where you make purchase payments and earn returns based on the performance of investment options, and a payout phase, where the insurer makes periodic payments for a fixed period or life.
      • Benefits: Offers tax deferral on gains and a guaranteed stream of payments in retirement.

• Knowledge of:

  • Loads:

    • A load is essentially a sales charge or commission applied when buying or selling mutual fund shares.
    • Front-end Load: Paid when shares are purchased.
    • Back-end Load (or Contingent Deferred Sales Charge): Paid when shares are sold.

  • Share Classes:

    • Different classes of a mutual fund that come with varying fee structures, often differentiated by their load structures or distribution fees.
    • Common classes include Class A (often with a front-end load), Class B (often with a back-end load and higher ongoing fees), and Class C (level-load structure, often without a front-end or back-end load but higher ongoing fees).

  • Net Asset Value (NAV):

    • The per-share value of a mutual fund, calculated daily. It's the total value of the fund's assets minus its liabilities, divided by the number of outstanding shares.

  • Disclosures:

    • Information that funds are required to provide to investors. This includes the prospectus (which details the fund's objectives, strategies, risks, and costs) and shareholder reports.

  • Costs and Fees:

    • Expenses associated with mutual funds. They can include management fees, 12b-1 fees (used for marketing and distribution expenses), and other fund expenses.

  • Breakpoints:

    • Discounted fees offered by mutual funds when investors buy shares in large quantities. The more you invest, the lower the front-end load may be.

  • Right of Accumulation (ROA):

    • Allows investors to get breakpoint discounts based on the total amount of mutual funds they own with a particular fund family, including prior purchases and reinvested dividends.

  • Letter of Intent (LOI):

    • A written commitment by an investor stating they intend to invest additional amounts in a mutual fund within a certain time frame to qualify for breakpoint discounts.

  • Net Transactions:

    • The net of all purchase and redemption activity for a specific period. It provides insight into the flow of money in and out of the fund.

  • Surrender Charges:

    • Fees charged when withdrawing money from an investment before a specified period, often seen in variable annuities.

  • Sales Charges:
    • Costs paid by the investor when buying or selling mutual fund shares. These can be front-end (paid when purchasing) or back-end (paid when selling).

2.1.5 Municipal Fund Securities

• 529 Plans:

  • Tax-advantaged savings plans designed to encourage saving for future education costs.
  • Earnings in 529 plans are not subject to federal tax and, in most cases, state tax, so long as the withdrawals are used for qualified education expenses.
  • Two primary types:
    • Prepaid Tuition Plans: Allow one to purchase units or credits at participating colleges and universities for future tuition and mandatory fees at current prices.
    • Savings Plans: Investment grows based on market performance of the investments chosen.

• Prepaid Tuition:

  • As mentioned above, these are a subset of 529 Plans where you can lock in current tuition rates for future education.
  • Useful for hedging against the rising costs of education.
  • Typically state-sponsored and may have residency requirements.

• Savings Plans:

  • Another subset of 529 Plans.
  • These plans let you save money in an individual investment account.
  • Funds can be withdrawn tax-free when they're used for qualified education expenses, including tuition, room and board, and books.

• Local Government Investment Pools (LGIPs):

  • Pooled investment vehicles that are established by state or local governments.
  • Allow government entities to collectively invest their funds, often in money market instruments.
  • Often used for managing public funds more efficiently.

• ABLE Accounts (Achieving a Better Life Experience Accounts):

  • Tax-advantaged savings accounts for individuals with disabilities.
  • Funds can be used for qualified disability expenses without jeopardizing federal benefits.
  • Eligibility is generally restricted to individuals with significant disabilities with an onset before age 26.
  • Can be used for a variety of expenses, including education, housing, transportation, employment training, and health care.

• Knowledge of:

  • Municipal Fund Securities:

    • These are investment vehicles sponsored by states or municipalities, designed to address specific needs, like education or disability expenses. Examples include 529 Plans, Local Government Investment Pools (LGIPs), and ABLE accounts.

  • Owner vs. Beneficiary:

    • Owner: The person who establishes and controls the municipal fund account. They contribute money, decide on the investments, and can make withdrawals.
    • Beneficiary: The individual who will benefit from the account. For example, in a 529 Plan, the beneficiary is the student for whom the education savings are intended. The beneficiary can be changed to another member of the original beneficiary's family without incurring penalties or taxes.

  • Restricted Use of Plan Assets:

    • Funds in these accounts must be used for specific purposes to receive the full tax benefits. For example, 529 Plan distributions must be used for qualified education expenses, and ABLE account funds for qualified disability expenses.
    • Non-qualified withdrawals can result in taxes and penalties.

  • Tax Advantages:

    • Earnings in these accounts grow tax-deferred, meaning you won't pay taxes on the gains each year.
    • Withdrawals for qualified expenses are often tax-free at the federal level and possibly at the state level.
    • Some states offer tax deductions or credits for contributions to these accounts.

  • Direct or Adviser Sold:

    • Refers to how the municipal fund securities can be purchased.
      • Direct-sold Plans: Investors purchase directly from the plan provider, often through a website. These plans typically have lower fees as there's no middleman.
      • Adviser-sold Plans: Investors purchase through a financial advisor. These might have higher fees due to the inclusion of advisor commissions, but they come with the benefit of professional advice on choosing and managing investments.

2.1.6 Direct Participation Programs (DPPs)

• Direct Participation Programs (DPPs) are unique investment vehicles that allow investors to directly participate in the cash flow and tax benefits of the underlying investments, typically in real estate or energy-related ventures. They are non-traded, meaning they are not listed on national exchanges, and therefore may lack liquidity compared to other investments.

  Types of DPPs:

  • Limited Partnerships:

    • A type of partnership arrangement where there are one or more general partners and one or more limited partners.
    • General Partners (GPs): They are responsible for the day-to-day management and operation of the partnership. They have unlimited liability, meaning their personal assets can be used to satisfy partnership debts.
    • Limited Partners (LPs): They provide capital and share in the profits, losses, and tax benefits, but do not participate in the management of the partnership. Their liability is limited to their investment in the partnership. This is the role typically played by investors in a DPP.
    • These partnerships can be involved in various ventures, such as real estate development, oil and gas projects, and more.

  • Tenants in Common (TIC):

    • A type of co-ownership where multiple parties own distinct, undivided interests in real property.
    • Each tenant in common has an equal right to possess or use the entire property, even if their percentage of ownership differs.
    • TIC ownership allows investors to own a fractional interest in a property, benefiting from potential income, tax advantages, and appreciation.
    • Upon the death of one tenant in common, their interest can be passed to their heirs, rather than the other tenants in common.
    • TICs have become popular for 1031 exchanges, a tax strategy that allows investors to defer capital gains taxes by reinvesting sale proceeds from a property into another qualifying property.

• Knowledge of:

  • Pass-through tax treatment

  • Unlisted

  • Generally illiquid

2.1.7 Real Estate Investment Trusts (REITs)

• Types of REITs

  • Private REITs:

    • These are not registered with the SEC and are not publicly traded.
    • Typically limited to institutional investors due to their lack of liquidity and high investment minimums.

  • Registered, Non-listed REITs:

    • These are registered with the SEC but are not traded on national stock exchanges.
    • Offer more liquidity than private REITs but less than listed REITs.
    • They typically have higher fees and are sold through broker-dealers.

  • Listed REITs:

    • Publicly traded on national stock exchanges, making them the most liquid type of REIT.
    • Subject to SEC regulations and are required to disclose financial performance and other pertinent company information.
    • Can be bought and sold like other publicly traded stocks.
• Knowledge of:

  • Real Estate Equity or Debt:

    • Equity REITs: They own and manage income-producing real estate, such as apartment buildings, office buildings, shopping centers, and hotels. Investors earn income from the rent paid by tenants of these properties.
    • Mortgage REITs: They don’t own real estate directly. Instead, they finance real estate by purchasing or originating mortgages and mortgage-backed securities. Investors earn income from the interest on these mortgages.

  • Tax-Advantaged Income without Double Taxation:

    • REITs enjoy a special tax status. They are required to distribute at least 90% of their taxable income to shareholders annually in the form of dividends.
    • In return for meeting certain criteria, including the distribution requirement, REITs are not subject to federal corporate income tax on the income distributed to shareholders. This avoids the "double taxation" typically seen with corporations (where income is taxed at the corporate level and again when distributed to shareholders as dividends).
    • The dividends received by REIT shareholders are taxed as ordinary income, unless they qualify for a lower rate.

2.1.8 Hedge Funds

• Knowledge of:

  • Minimum Investment:

    • Hedge funds often require a substantial minimum investment, which can range from hundreds of thousands to millions of dollars. This high threshold ensures that participants are typically high-net-worth individuals or institutional investors.

  • Partnership Structure:

    • Most hedge funds are structured as limited partnerships (LPs) or limited liability companies (LLCs).
    • In a limited partnership structure, the hedge fund manager typically serves as the general partner, responsible for the day-to-day management of the fund. The investors are limited partners, contributing capital but not involved in daily operations. Their liability is limited to their investment.
    • This structure provides flexibility in investment strategies and allows for the alignment of interests between the fund manager and investors.

  • Private Equity:

    • While hedge funds and private equity funds are both alternative investment vehicles, they differ in their investment approach and time horizons.
    • Private equity involves directly investing in companies, often with the intention of taking a controlling interest and making operational improvements or facilitating growth, with a longer-term investment horizon.
    • Some hedge funds might engage in private equity-style deals, but typically, hedge funds focus on liquid markets and shorter-term strategies.

  • Generally Illiquid:

    • Hedge funds often have "lock-up" periods where investors cannot redeem their shares for a set amount of time after their initial investment.
    • Even after the lock-up period, there might be restrictions on redemptions, such as quarterly or annual redemption windows.
    • These liquidity constraints allow the fund manager to pursue longer-term strategies without the concern of sudden large redemptions.
    • It's crucial for investors to understand these liquidity terms before investing, as accessing invested capital can be limited.

2.1.9 Exchange-traded Products (ETPs)

•  Types of ETPs

  • Exchange-traded funds (ETFs):

    • ETFs are investment funds traded on stock exchanges. They hold a collection of assets like stocks, bonds, commodities, or a mix.
    • They aim to track and replicate the performance of a specific index, such as the S&P 500.
    • ETFs offer liquidity because they can be bought and sold throughout the trading day at market prices, unlike mutual funds, which are priced once a day after the market closes.

  • Exchange-traded notes (ETNs):

    • ETNs are unsecured debt securities issued by financial institutions.
    • Unlike ETFs, which hold underlying assets, ETNs do not own the assets they track. Instead, they promise to pay holders a return based on the performance of a specific index or benchmark.
    • Since they're debt instruments, they carry the credit risk of the issuing institution.

• Knowledge of:

  • Alternative Investments to Mutual Funds:

    • ETPs, especially ETFs, are often seen as alternatives to mutual funds because both offer diversified exposure to a basket of assets.
    • Key differences include intraday trading for ETPs and different fee structures.

  • Fee Considerations:

    • Generally, ETFs have lower expense ratios compared to mutual funds because most ETFs are passively managed.
    • However, when trading ETFs, investors might incur brokerage commissions, which can add to the cost.
    • ETNs might have fees tied to the performance of the underlying index in addition to other costs.

  • Active vs. Passive:

    • Passive ETPs: These aim to replicate the performance of a specific benchmark or index. They don't try to outperform the market but instead match its performance. Most ETFs fall into this category, leading to their typically lower fees.
    • Active ETPs: These are managed with the goal of outperforming an index, using active investment strategies. Active ETPs typically have higher fees due to the added costs of research and active management.

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2.2 Investment Risks

• Definition and Identification of Risk Types

  • Capital Risk:

    • Refers to the risk of losing the initial investment or principal. This is the fundamental risk associated with any investment. For instance, if you invest in a stock, and its price falls, you may lose part or all of your initial investment.

  • Credit Risk:

    • Also known as default risk. It's the risk that a borrower will not meet their obligations in terms of principal and interest payments. For bondholders, there's a risk that the issuer might default on its obligations.

  • Currency Risk:

    • Arises from changes in currency exchange rates. It's particularly relevant for investments in foreign assets. If the currency in which the investment is denominated depreciates against the investor's home currency, the value of the investment in the home currency may decrease.

  • Inflationary/Purchasing Power Risk:

    • The risk that the return on an investment will not keep pace with inflation, eroding the purchasing power of the invested funds. For instance, if the return on an investment is 4%, but inflation is 5%, the real return is effectively -1%.

  • Interest Rate/Reinvestment Risk:

    • Interest rate risk is the risk that the value of an investment will decrease due to rising interest rates. This is especially relevant for fixed-income securities like bonds.
    • Reinvestment risk is the risk that future proceeds will have to be reinvested at a potentially lower rate of return when current bonds or securities mature.

  • Liquidity Risk:

    • The risk that an investor might not be able to buy or sell an investment quickly without causing a significant movement in its price. Illiquid assets might not have many buyers or sellers at any given time.

  • Market/Systematic Risk:

    • Risk inherent to the entire market or a broad market segment. It's unpredictable and cannot be completely eliminated through diversification. Events like recessions, wars, or natural disasters can affect the entire market.

  • Non-Systematic Risk:

    • Also known as specific or unsystematic risk. It's unique to a particular company or industry. Examples include a company losing a vital contract or a sector being impacted by a regulatory change. Diversification can help mitigate this risk.

  • Political Risk:

    • Refers to the risks associated with changes in government policies or regulations. For instance, a change in leadership or geopolitical tensions can impact investments in a particular region or country.

  • Prepayment Risk:

  • Relevant mainly for fixed-income securities. It's the risk that a borrower will pay back the borrowed funds before the maturity date. This can affect the returns for investors, especially if they expected to receive a particular interest rate for a longer period.

• Strategies for Mitigation of Risk

  • Diversification:

    • Definition: Diversification involves spreading investments across various assets or asset classes to reduce exposure to any single asset or risk.
    • How it Mitigates Risk: By holding a mix of different investments, the poor performance of one or a few can potentially be offset by the better performance of others. For instance, while stocks might be declining, bonds or real estate might be performing well.
    • Example: Instead of investing all funds into tech stocks, an investor might choose to invest in a mix of tech stocks, healthcare stocks, bonds, real estate, and international equities.

  • Portfolio Rebalancing:

    • Definition: Portfolio rebalancing is the process of realigning the weightings of a portfolio's assets to maintain a desired asset allocation.
    • How it Mitigates Risk: Over time, some investments may perform better than others, causing the portfolio to drift from its original asset allocation. Rebalancing ensures that the portfolio does not become overly exposed to one asset class, thereby managing risk.
    • Example: If an investor initially had a 60% allocation to stocks and 40% to bonds, but due to strong stock performance, the allocation shifted to 70% stocks and 30% bonds, they might sell some stocks and buy bonds to return to the original allocation.

  • Hedging:

    • Definition: Hedging involves making an investment to offset potential losses from another investment. It's like insurance for investments.
    • How it Mitigates Risk: By holding investments that are expected to move in opposite directions, losses in one can be offset by gains in another. However, it's essential to note that hedging can also limit potential gains.
    • Example: An investor might own stock in an airline company. To hedge against potential losses due to rising oil prices (which can hurt airline profitability), they could also invest in oil futures. If oil prices rise, the loss from the airline stock might be offset by gains from the oil futures.

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Rules

FINRA Rules

• 2261 – Disclosure of Financial Condition
• 2262 – Disclosure of Financial Relationship with Issuer
• 2310 – Direct Participation Programs
• 2330 – Members’ Responsibilities Regarding Deferred Variable Annuities 2342 – “Breakpoint” Sales
• 2360 – Options

MSRB Rules

• D-12 – Definition of Municipal Fund Securities
• G-17 – Conduct of Municipal Securities and Municipal Advisory Activities G-30 – Pricing and Commissions
• G-45 – Reporting of Information on Municipal Fund Securities

CBOE Rule

• Rule 1.1 – Definitions

SEC Rules and Regulations

• Securities Exchange Act of 1934
  • 3a11-1 – Definition of the Term "Equity Security"
  • 10b-18 – Purchases of Certain Equity Securities by the Issuer and Others
• Investment Company Act of 1940
  • Section 3(a) – Definitions - “Investment Company”
  • Section 4 – Classification of Investment Companies
  • Section 5 – Subclassification of Management Companies
  • 12b-1 – Distribution of Shares by Registered Open-end Management Investment Company