Canadian Investment Funds Course - Unit 5: Types of Investments PDF

Canadian Investment Funds Course Unit 5: Types of Investments Introduction As a Dealing Representative, it is essential that you have in-depth knowledge about the different types of investments that are available in the financial markets, so that you can effectively match clients with suitable inves...

Canadian Investment Funds Course Unit 5: Types of Investments Introduction As a Dealing Representative, it is essential that you have in-depth knowledge about the different types of investments that are available in the financial markets, so that you can effectively match clients with suitable investments. In this unit, you will learn about fixed income and money market instruments, equities and derivatives. You will also learn about how each investment type is used within mutual funds. This unit takes approximately 2 hours and 10 minutes to complete. Lessons in this unit: Lesson 1: Building Blocks of Mutual Funds Lesson 2: Fixed Income Securities Lesson 3: Bonds Lesson 4: Equities Lesson 5: Derivatives © 2021 IFSE Institute 157 Unit 5: Types of Investments Lesson 1: Building Blocks of Mutual Funds Introduction Mutual funds are collections of different types of investments. The holdings within a given mutual fund are intended to achieve one of a number of different investment objectives. As a Dealing Representative, your clients will expect you to have an understanding of the different investment types held within mutual funds. In this lesson you will learn about the general structure of mutual funds, and the different investment objectives they are intended to meet. This lesson takes approximately 10 minutes to complete. By the end of this lesson you will be able to: describe the concept of a mutual fund distinguish between the different investment objectives describe who issues securities and why 158 © 2021 IFSE Institute Canadian Investment Funds Course The Building Blocks of Mutual Funds Mutual funds are investments that hold a collection of different securities such as equities and bonds. Collectively, the securities in a mutual fund are called holdings. A typical mutual fund can hold dozens or hundreds of different securities. The investment goal of a mutual fund determines which securities are included in the fund’s holdings, as each security plays a unique part in helping the fund reach its goal. Therefore, to understand the different categories and types of mutual funds, we need to first understand the different securities that form the building blocks of the funds. Knowledge of the building blocks will help you understand how the underlying securities affect the performance and return of a mutual fund. As a Dealing Representative this will help you manage your clients’ expectations and recommend suitable mutual funds. Investment Objectives A mutual fund’s investment objectives determine the various types of securities that are held in a given fund. There are three main investment objectives: Safety of Principal Income Growth Safety of Principal Mutual funds for which the investment goal is safety of principal strive to protect investors from losing any of their original investment. In other words, investors expect to get back at a minimum the amount of money they put into the investment. Example Bob has $50,000 that he plans to use to purchase a home in one year. Joe, his Dealing Representative, recommends a mutual fund that provides safety of principal and some income. This way, Bob will likely get back all the money he put into the mutual fund along with some income. © 2021 IFSE Institute 159 Unit 5: Types of Investments Income Mutual funds with a primary investment objective of income provide investors with a regular source of income over the course of their investment time horizon. Income-oriented investments are typically fixed income securities, which are essentially debt issued by corporations or governments. The corporations or governments are the borrowers, and they must make regular payments to the lenders, i.e. the investors. Compared to investments that offer safety of principal, income investments will experience greater price fluctuations. Depending on the situation, investors may find that their investments have either grown or declined in value compared to their original principal. Example Jane, 65, has just retired and needs additional income of to meet her cash-flow needs. Ryan, her Dealing Representative, recommends that Jane invest in a bond fund that makes monthly distributions to unitholders. Jane's original investment is $35,000 into the bond fund. Later that year, Jane notices that the value of her investment is now only $34,800. A few months later, Jane notices that the value of her bond fund has rebounded and is now worth $35,040. Growth Securities with an investment objective of growth have the potential to appreciate over time. Investors purchase growth investments in the hope that the market price of the securities when they sell their investments will be higher than the original purchase price. Growth investments typically include equity securities that represent ownership in a corporation. The value of an investors' equity investment is tied to the prospects of the corporation. If the corporation is profitable or has the potential to do well, equity investors will benefit. If the corporation does poorly or is perceived to be doing poorly, equity investors will suffer. Therefore, equity investors will experience greater price fluctuations than safety-of-principal or income investors. Example Stan has some money available to invest and does not require it until he retires in 30 years. Rinaldo, his Dealing Representative, recommends that Stan invest in a Canadian equity mutual fund. Stan's original investment is $25,000. The value of Stan's portfolio increases and at the end of the year Stan's investment is now worth $26,400. At the end of the following year, there is bad news released about a couple of companies in the mutual fund portfolio. This negatively affects Stan, and the value of his investment drops to $24,000. 160 © 2021 IFSE Institute Canadian Investment Funds Course Why Governments and Corporations Issue Securities Governments and corporations each issue securities as a means of raising capital. This section looks at the reasons why each type of organization issues securities. Governments From time to time, governments may need to raise money in order to pay for spending commitments such as health care, defense, or deficit financing. Governments can borrow money from the public by issuing fixed income securities, as follows: Security Type Description Short-term Generally, these securities mature (i.e. expire) within five years or less. They include treasury bills, and provincial or municipal short-term papers. Medium-term These are securities with a maturity timeline of five to ten years. Examples are federal, provincial or municipal bonds. Long-term These are fixed income securities that mature in ten years or more, such as Government of Canada bonds. Corporations One of the ways in which corporations can raise money to grow their businesses is to divide ownership into smaller parts and sell those parts to the public in the form of shares. In exchange for a share, a corporation receives the money it needs, and investors have an opportunity to share in the corporation’s earnings. Corporations can issue two types of shares, as follows: Common shares—Share ownership that entitles investors to a portion of the company’s earnings and some control of the corporation. Preferred shares—Share ownership that entitles investors to receive a fixed amount of the company’s earnings on an ongoing basis. This type of share ownership typically does not give investors control of the corporation. If a corporation wants to maintain its current division of ownership, rather than issuing shares, the corporation can borrow from the public and issue fixed income securities such as bonds. This way, the corporation receives money without increasing the number of owners in the corporation. The company can issue the following types of fixed income securities: money market securities, including both bankers’ acceptances and commercial papers medium- and long-term bonds A corporation can also borrow money from a bank. However, interest payments required by banks can be very high, which is why some corporations choose to raise funds by issuing either shares or fixed income securities. © 2021 IFSE Institute 161 Unit 5: Types of Investments Lesson 2: Fixed Income Securities Introduction Fixed income securities are a form of loan in which investors act as lenders, with the borrowers being organizations such as governments or corporations, which need to raise capital. As a Dealing Representative it is very important that you are familiar with the different types of fixed income securities, and how they are bundled in mutual funds to meet various investment objectives. This lesson takes approximately 25 minutes to complete. By the end of this lesson you will be able to: describe characteristics of fixed income securities describe the major features of the following money market instruments: - treasury bills provincial and municipal short-term papers bankers' acceptances commercial papers discuss how money market instruments are used in mutual funds 162 © 2021 IFSE Institute Canadian Investment Funds Course Fixed Income Securities: Key Concepts As mentioned, when governments or corporations need money, they can borrow money from the public by issuing fixed income securities. Fixed income securities are essentially loans provided by investors. The debt security includes a contractual obligation stating that the issuing government or corporation must pay interest and return the principal (i.e. the investment amount) to the investor (i.e. lender) by the maturity date (i.e. the bond’s expiry date). Investors tend to purchase fixed income securities with the objectives of safety of principal and stable, regular income. Some key concepts when dealing with fixed income securities are: Concept Definition Term-to-maturity The term-to-maturity or lifespan refers to the length of time between the current date and the maturity date. Fixed income securities have a finite life and expire on a specified date called the maturity date. On that date, interest payments cease and the principal must be repaid in full to the investor. Term Term refers to one of three term-to-maturity categories of fixed income securities: Short-term securities, which typically mature within five years. Medium-term securities, which usually mature at a fixed time, somewhere between five and ten years. Long-term securities, which typically mature after ten years or longer. NOTE: The number of years for each term category will vary but not by a significant amount. Some corporations define short term as a period that is less than two years while others see it as a period under five years. Par value Also referred to as the face value or face amount, this is the value of a fixed income security. It is the amount of the original principal investment, which must be fully repaid to the investor when the security matures. Typically, the par value is denominated in multiples of $1,000 (e.g. $5,000 or $10,000). Coupon rate The coupon rate is used to calculate the regular interest payments paid by a bond, which is also referred to as the coupon payment. The coupon rate is fixed throughout the life of the fixed income security. © 2021 IFSE Institute 163 Unit 5: Types of Investments Money Market Securities Money market securities are fixed income investments that typically have a maturity of under a year. The short maturity makes money market securities very liquid, which means they can be converted into cash very quickly and easily. The price of money market securities does not fluctuate a great deal. This fact, added to the short maturity of the securities makes them a relatively stable and safe investment. Money market securities meet the investment objectives of safety of principal and stable income. They are also very low-risk investments. Types of Money Market Securities There are several types of money market securities. Each type of security involves a different level of risk and corresponding level of return. Generally, investments with higher levels of risk compensate investors with the potential for higher return – why else would a rational investor choose a higher risk investment. There are four different types of money market securities, as follows: treasury bills provincial and municipal short-term papers bankers’ acceptances commercial papers Treasury Bills Treasury bills (T-bills) are fixed income securities issued by the Canadian government to finance their shortterm cash needs. T-bills do not pay periodic interest to investors. Instead, T-bills are sold at a discount, and then at maturity the government pays the investor the face value. The interest income is the difference between the face value and the price the investor paid for the T-bill. For T-bills, the investment objectives are safety of principal and income. T-bills are very low-risk investments since they are guaranteed by the Government of Canada. Example Gary bought a 120-day T-bill with a face value of $10,000, for $9,950. When the T-bill matures after 120 days, the government will pay Gary $10,000, the face value. Gary will receive interest income of $50 on his investment. This amount represents the difference between the face value and the purchase price, calculated as ($10,000 - $9,950). 164 © 2021 IFSE Institute Canadian Investment Funds Course T-bills in the Primary and Secondary Markets T-bills are issued and exchanged in both the primary and secondary markets. The primary market is where new T-bills are issued and sold. The secondary market is where investors can sell their T-bills before the maturity dates. T-bills in the Primary Market The Bank of Canada issues T-bills on behalf of the Government of Canada. The Bank of Canada conducts an auction on a two-week cycle where T-bills are sold in large denominations to banks and investment dealers. The terms of maturity offered at the auction are 98, 182, and 364 days. T-bills in the Secondary Market There is a secondary market run by investment dealers where individuals and institutions can buy and sell Tbills. In the secondary market, T-bill prices change in relation to interest rates. When rates increase, T-bill prices decrease. Conversely, when interest rates decrease, T-bill prices increase. If investors sell their T-bills for a higher price than the original purchase cost, they will make a profit. This form of income, from a sale that incurs a profit, is called a capital gain. If investors sell their T-bills for a lower price than the original purchase cost, they will lose money. This form of income loss from a sale is called a capital loss. Example Monica buys a 6-month T-bill for $9,850, which will mature at a face value of $10,000. After three months, the interest rate drops and the current market price of Monica’s T-bill rises to $9,950. Monica sells her T-bill in the secondary market for $9,950 and realizes interest earned of $75 and a capital gain of $25. The interest earned is calculated as [($10,000 -$9,850) x 3 months/6 months]. The capital gain is calculated as ($9,950 - $9,850 -$75). On the other hand, if interest rates increase and the current market price of her T-bill after 3 months falls to $9,800, she would realize interest earned of $75 and a capital loss of $125, calculated as ($9,800 $9,850-$75), if she then sells her T-bill. T-bill Return Calculation In order to determine the rate of return for a T-bill, you must calculate the quoted yield. The quoted yield is expressed as a percentage. The formula is as follows: Quoted Yield = {[(Face value – Price) ÷ Price] x (365 ÷ Term to Maturity)} x 100 © 2021 IFSE Institute 165 Unit 5: Types of Investments Example Sue purchased a 91-day T-bill with a face value of $1,000, for $990.13. we can calculate the rate of return on her T-bill as follows: Using the quoted yield formula, [(((1,000 – 990.13) ÷ 990.13)) x (365 ÷ 91)] x 100 = 4% The rate of return on her investment is 4%. Provincial and Municipal Short-Term Papers Provincial and municipal short-term papers are debt securities issued by the provincial or municipal government, in order to raise money to pay for capital spending. Similar to T-bills, these securities are sold at a discount and pay the face value at maturity. The investment objective of short-term papers is safety of principal and income. Provincial and municipal short-term papers offer slightly higher interest income than T-bills, but the risk level is also higher. Example The town of Milton, a municipality, wants to raise $10,000,000 for a new sewer. The town hires an investment dealer to underwrite and sell their debt securities. The investment dealer establishes an interest rate based on the credit rating of the municipality, and then sells the securities to investors. Bankers’ Acceptances Bankers’ Acceptances (BAs) are fixed income securities that are issued by corporations but guaranteed by a commercial bank. A corporation may find that it wants to borrow money in the short term (typically one to three months), but it finds that by itself, its borrowing costs are too high. However, if the corporation can rely on the credit rating of a major bank, its borrowing costs will fall, meaning it can pay less interest on its debt. If the bank agrees, it advances the corporation the funds. For a stamping fee, the bank guarantees the corporation's debt and is ultimately responsible to repay investors if the corporation defaults on its payments. Similar to T-bills, BAs are bought at a discount, and the difference between the face value and purchase price is considered interest income. However, BAs typically pay higher interest rate than T-bills due to their higher risk. In other words, there is a greater chance of default by the bank than by the government. The investment objectives of BAs are safety of principal and income. Example BIZ Corporation is expecting payments from its customers, but in the interim needs to make payroll and other critical payments. To get the money to make these payments while they are waiting for cash from their customers, BIZ may issue bankers’ acceptances to get the short-term loan they need. 166 © 2021 IFSE Institute Canadian Investment Funds Course Commercial Papers Commercial papers (CPs) are issued by corporations seeking to get short-term loans to fund short-term cash shortages. Similar to other money market securities, CPs are purchased at a discount, and at maturity the issuer pays the face value to the investor. The interest income is the difference between the face value and purchase price. CPs typically pay higher rates and are considered higher risk than T-bills and BAs because they are not guaranteed by the government or a commercial bank. Instead, the issuing corporation borrows money under its own name and credit rating. The interest rate will depend on how stable the corporation is, and the likelihood of it repaying the loan. The investment objectives are safety of principal and income. Risks and Returns of Money Market Investments Each type of money market security has its own risk and return level as shown in the graph. Money Market Securities and Mutual Funds Portfolio managers use money market securities in their mutual fund portfolios either to meet their primary objective of safety of capital, like in a money market fund, or as a short-term placeholder for cash. Quite often referred to as cash equivalents, money market securities provide a relatively safe and flexible alternative to cash. Portfolio managers require this flexibility to meet redemption requests or to park cash while they are making decisions for longer term investments. © 2021 IFSE Institute 167 Unit 5: Types of Investments Lesson 3: Bonds Introduction Bonds are a type of fixed income security, with a maturity period of greater than one year. As a Dealing Representative, your clients will expect you to understand the structure of bonds, and how they can help investors to meet their financial goals. In this lesson, you will learn about the different types of bonds available to investors. You will also learn about bond yield curves, and how bond mutual funds are structured. This lesson takes approximately 40 minutes to complete. By the end of this lesson you will be able to: describe the features of a bond and how it works describe how the bond market facilitates the new issuance of a bond and the subsequent trading on the secondary market list the different types of bonds, and explain the differences between them explain the inverse relationship between interest rates and bond prices differentiate between current yield and yield-to-maturity describe what the yield curve illustrates and the main types of yield curves discuss the main types of risk associated with investing in bonds describe the role of credit rating agencies discuss how bonds are used in mutual funds 168 © 2021 IFSE Institute Canadian Investment Funds Course Bonds Bonds are fixed income securities with a maturity of greater than one year. Newly issued bonds typically sell at their par value. Bond issuers promise to pay regular coupon payments to the investor, also referred to as the bondholder. Bonds have a finite life which means they mature on a pre-determined date. The investment objectives of bonds are regular income and stability of principal. The risk and return of bonds varies based on a number of factors, including the credit worthiness of the issuer, among other considerations. Bonds issued by corporations with good credit ratings typically involve lower risk. On the other hand, corporations with poor credit ratings involve higher risk and as such, pay higher coupon rates to attract investors and to compensate them for the higher risk. Click on the Issuer, Par Value, Coupon Rate and Maturity Date on the diagram to view more information. Term Definition Issuer (Government of Canada Treasury Bond) This is the borrower. The issuer is either a government body or corporation. The issuer is responsible for all the coupon payments and repayment of principal. Coupon Rate (5.25%) The coupon rate is the rate of interest that will be paid to the bondholder. It is a nominal annual interest rate and is expressed as a percentage of the par value. The coupon payment is the interest payment calculated using the coupon rate and the par value. Although the coupon rate is expressed as an annual percentage, most bonds pay interest semi-annually. © 2021 IFSE Institute 169 Unit 5: Types of Investments Term Definition Par Value ($1,000) Also known as face value, face amount or principal, this is the amount that was originally lent to the issuer and is to be repaid at maturity. Par value is usually denominated in multiples of $1,000. Maturity Date (the fifteenth day of November two thousand twenty four) This is the date the bond will expire, at which point the last coupon payment is made and the principal is repaid to the bondholder. When bonds are issued, the maturity date is usually the same day (e.g. May 9) but in a future year. Coupon payments are paid on the anniversary of this day and the semi-annual anniversary day (e.g. May 9 and November 9). The Bond Market When government or corporations want to raise money through a new bond issue, they hire an investment dealer to help them with the process. This first step where the money raised from investors goes directly to the issuer is known as the primary distribution. Bond prices are quoted in relation to $100. When a bond price is $100, it is referred to as par. Typically primary distributions of bonds are priced at par. Example Rakesh purchases $10,000 par value of a 5-year Government of Canada bond. Because it is a new issue, the price of the bond is $100. Rakesh pays $10,000 for his bond, calculated as (($100 ÷ $100) x $10,000). After the primary distribution, investors can sell their bonds to other investors in the bond market. Unlike the stock market, which has a central place to trade stocks such as the Toronto Stock Exchange (TSX), the bond market does not have a central trading place. Instead, the majority of bonds trade in the over-the-counter market, a computerized network where investment dealers transact directly with each other. A small number of bonds do trade on an exchange. In the bond market, the price of a bond can change from par due to several factors such as interest rate changes. Bonds that are priced above par are said to be trading at a premium, while bonds that are priced below par are said to be trading at a discount. 170 © 2021 IFSE Institute Canadian Investment Funds Course Example If in the bond market, Rakesh's bond is discounted to a price of $99, then he would have to accept $9,900 if he wants to sell his bond, calculated as (($99 ÷ $100) x $10,000). In this situation, Rakesh incurs a capital loss. If his bond is trading at a premium of $101, then he would receive $10,100 if he sells it, calculated as ($101 ÷ $100) x $10,000). Here, Rakesh incurs a capital gain. Globally, the bond market is significantly larger than the stock market, since this type of security is very important in maintaining well-functioning governments and corporations. Types of Bonds There are two classes of bonds: coupon bonds, which provide regular payments to investors, and zero-coupon bonds, also called strip bonds, which make a lump sum payment to investors upon maturity. Coupon Bonds Historically, bondholders were given a bond certificate showing they loaned money to the issuer. Attached to each certificate were a number of coupons which entitled the bondholder to receive regular coupon payments. When it was time to receive a coupon payment, the bondholder would cut out the coupon from the bond certificate and redeem it at the bank. With coupon bonds there is a built-in contract that states the issuer’s legal obligation to provide coupon payments, usually semi-annually or annually, and return of principal. If the issuer defaults on the coupon payments or principal, the bondholder can force the issuer into bankruptcy to sell their assets and use the proceeds to repay the bondholders. While bondholders no longer receive physical certificates, coupon bonds are still obligated to make regular coupon payments. At maturity, the issuer must make one final coupon payment and return the bondholder’s principal. The coupon payments for coupon bonds are calculated as follows: Coupon Payment = [(face value x coupon rate) ÷ number of payments per year] © 2021 IFSE Institute 171 Unit 5: Types of Investments Example Karen invests $10,000 in a new 3-year ABC bond issued on February 1, Year 1. The coupon rate of ABC bond is 6% and the coupon payments are made semi-annually. Karen's coupon payment is $300, calculated as [($10,000 x 6%) ÷ 2]. The following illustrates Karen's payment schedule. Date Payment Type of Payment August 1, Year 1 $300 Interest February 1, Year 2 August 1, Year 2 February 1, Year 3 $300 $300 $300 Interest Interest Interest August 1, Year 3 $300 Interest February 1, Year 4 $300 Interest February 1, Year 4 $10,000 Principal Investment Profile of Coupon Bonds The investment objective of coupon bonds is stability of income, with a higher level of return than money market securities. The expected return for coupon bonds is both income, and the potential for an additional return in the form of capital gains due to changes in interest rates, if the coupon bonds are traded on the secondary market. The risk level of coupon bonds ranges from low to medium. Regular coupon payments, and the promise to repay the principal, give these bonds a stable quality. However, their price sensitivity to interest rate changes increases the risk level. Debentures Debentures operate the same way as bonds, but they differ by how they are secured. Bonds are secured by specific assets of the issuer such as property, inventories, equipment, or other securities. Debentures are not secured by real assets or collateral. Instead, they are backed by the reputation and credit worthiness of the issuer. Investment Profile of Debentures Debentures offer a higher level of income than regular secured bonds. Debentures are considered medium risk because they are not secured by any real assets, and they have lower priority than bondholders for the company’s assets in the event that the company goes bankrupt. Convertible Bonds Convertible bonds are a type of coupon bond that offer investors the option to convert the bonds into common shares, which confer ownership interest in the company issuing the bonds. This option is at a pre-set 172 © 2021 IFSE Institute Canadian Investment Funds Course price, within a specified time frame. In exchange for the conversion option, the bond issuer usually offers a lower coupon rate than that offered with other bond types. Example Cheryl is considering investing in common shares of BIZ Corporation, but she is uncertain about how well the company will perform in the future. She buys a BIZ convertible bond, which offers her the option to convert her bond into common shares at $40 per share at a specific date in the future. If BIZ common shares rise in value to $45 per share, Cheryl can make the conversion within the allowable time and convert her bond into common shares at the lower price of $40. However, if the common share price falls to $30, she does not have to convert her bond. She can continue to hold the bond and collect the coupon payments until the bond matures. Investment Profile of Convertible Bonds Convertible bonds appeal to investors who want the stability offered by bonds and the option to own common shares. Compared to regular bonds, convertible bonds are higher risk because they have lower priority for the issuer’s assets in the event of bankruptcy. Bonds with Additional Features Coupon bonds can also have additional features that may be triggered either at the issuer's option or the bondholder's option. Callable or Redeemable Bonds With a callable bond, the issuer (borrower) reserves the right to buy back, or call, the bond from the bondholder within a specified time period and at a specified price, usually at a premium to face value. This makes sense if interest rates drop and the borrower can issue bonds at a lower interest rate. Investors demand a higher rate of interest on callable bonds because they may have to sell the bond back at a disadvantageous time. Extendible Bonds If a bond has an extendible feature, it allows the investor to extend the term of the bond within specified limits. This is an attractive feature if the bond is close to maturity, and is paying higher interest than current rates. Investors accept a lower rate of interest to obtain this feature. © 2021 IFSE Institute 173 Unit 5: Types of Investments Retractable Bonds These bonds allow the bondholder to redeem a bond at par before the maturity date. A bondholder may choose to redeem early if the coupon rate is lower than current interest rates, and invest the proceeds elsewhere. Zero-Coupon Bonds Zero-coupon bonds, also called strip bonds do not provide coupon payments. These bonds are sold at a discount and redeemed at maturity for their face value. The interest income constitutes the difference between the face value of the zero-coupon bond, and purchase price. Example Jean buys a zero-coupon bond for $9,500 that will mature in 3 years with a face value of $10,000. With this zero-coupon bond Jean will earn interest income of $500, over a period of 3 years, calculated as $10,000 $9,500. Zero-coupon bonds are created when an investment dealer takes a regular coupon bond and strips its coupon payments. In doing so, the investment dealer creates separate bonds for each coupon payment and the principal. Zero-Coupon Bonds Characteristics With zero-coupon bonds, the face value at maturity is pre-determined so investors know exactly how much interest income they will receive. Zero-coupon bonds are typically held in registered accounts such as Registered Retirement Savings Plans (RRSPs). Interest income generated by securities is taxed annually. Although strip bonds do not pay interest annually, the interest accrues, or builds up, each year. Subsequently, investors are required to pay taxes on the accrued annual interest income even though they do not receive any interest income until the bond matures. By putting strip bonds in a registered account where interest income is sheltered, investors are not required to calculate the annual accrued interest income or pay taxes on this amount. If a strip bond is held in a nonregistered account, investors are required to pay taxes each year on the accrued interest income, which is interest that accumulates but has not been paid. Investment Profile of Zero-Coupon Bonds The investment objectives of zero-coupon bonds are income and stability of principal (if held to maturity). Income is derived from interest, as well as the potential for capital gains if the zero-coupon bonds are sold before maturity in the secondary market. 174 © 2021 IFSE Institute Canadian Investment Funds Course Zero-coupon bonds have a higher risk than coupon bonds because no payments are received until the bonds mature. Generally, payments received sooner are considered to be safer than payments received at a later time because there is greater uncertainty in the future. For example, the issuer can go bankrupt or interest rates may rise. Mortgage Bonds Mortgage bonds are fixed income securities that invest in a pool of mortgages. These bonds offer bondholders regular interest income and safety of principal. Canada Mortgage Bonds (CMBs) are invested in a pool of mortgage-backed securities, which are a collection of mortgages that are packaged into a security and sold to investors. CMB holders are paid the interest and principal from the mortgage-backed securities. CMBs are guaranteed by the Canada Mortgage and Housing Corporation (CMHC), a government-owned home insurance provider. They are also backed by the Government of Canada. Investment Profile of Mortgage Bonds The investment objectives of mortgage bonds are stable income, and safety of principal (if held to maturity). Income is derived from interest, as well as the potential for capital gains if the mortgage bonds are sold before maturity in the secondary market. Mortgage bonds are considered to be low risk because they are backed by real assets (buildings and houses) that can be sold to repay the bondholders. In the case of CMBs they are backed by CMHC and the government of Canada. Bond Prices and Interest Rates Bond Prices Interest Rates © 2021 IFSE Institute Bond Prices Interest Rates The relationship between interest rates and bond prices is important for bonds that trade on the secondary market. That is, the bonds have not matured and bondholder wants to sell them. Since the terms of an existing bond, such as the coupon rate and maturity date are fixed, the only component that can be adjusted is the price. Therefore, bondholders will be subject to the current market conditions, in this case interest rates, when they sell their bonds. 175 Unit 5: Types of Investments There is an inverse relationship between bond prices and interest rates. What that means is, when prevailing interest rates rise, the price of existing bonds generally falls. Conversely, when prevailing interest rates fall, bond prices generally rise. When prevailing interest rates rise, the price of existing bonds generally falls. Example Bonds are issued with a fixed coupon rate. Last year, Yolanda purchased a bond for $1,000 with a coupon rate of 7%. She will receive a coupon payment of $70 a year, calculated as ($1,000 x 7%). This year, interest rates have increased to 8%. Dominic bought a bond for $1,000 with a coupon rate of 8%, which means that he will receive $80 a year, calculated as ($1,000 x 8%). Because the new bond pays a higher coupon rate (8%) than the existing bond (7%), the new bond is more attractive, and a rational investor would choose to buy the newly issued bond with a higher coupon payment. Therefore, the bond seller must reduce the price of the 7% bond to attract investors, since the coupon rate is fixed, and cannot be changed. Conversely, when prevailing interest rates fall, bond prices generally rise. Example Last year, Marta purchased a bond for $1,000 with a coupon rate of 7%. This year, the prevailing interest rate dropped to 6%. Liam purchases a new bond with a face value of $1,000. He will only receive a coupon payment of $60 per year. Since the 7% bond is now a more attractive investment, the increased demand will raise the price of the 7% bond in the secondary market. Bond Return Calculations As a Dealing Representative, it is very important that you understand how the return on investment for bonds is calculated. Two common calculations to determine the return or yield of a bond are: current yield and yieldto-maturity. Current Yield The current yield formula calculates the potential return on investment for bondholders, based on the current market price of the bond and the stated coupon payment. The current yield formula is: 176 © 2021 IFSE Institute Canadian Investment Funds Course Current Yield = (Coupon Payment ÷ Market Price) x 100 Example Luther purchases a bond with a par value of $1,000 and a coupon rate of 6%. He pays $980 for the bond, which is the market price. The coupon payment is $60, calculated as (6% x $1,000). The current yield of Luther's bond is 6.12%, calculated as (($60 ÷ $980) x 100). Yield-to-Maturity A limitation of the current yield formula is that it provides only the annual yield, and does not calculate the overall return from the reinvestment of interest, called compounding. It also does not take into account any capital gains or capital losses resulting from a discount or premium on the bond price. Since the current yield is based on the current market price of bonds, the yield may change from year to year, when the market price of a bond changes. The yield-to-maturity (YTM) is the annual return an investor earns if the bond is held to maturity. This return is considered a more accurate measure of a bond’s return than the current yield, because it factors in the coupon and principal payments, the timing of the payments, the bond’s price and the time to maturity. Unlike the current yield, it assumes all coupons are reinvested at the same rate. The YTM calculation is complex. Bond tables, calculators, and computer programs have been developed to determine the YTM of a bond. For this course you are not required to calculate the YTM. Bond Prices, Interest Rates, and Yields The reason it is important to understand the inverse relationship between bond prices and interest rates is these factors affect bond yield, or return. Before delving more deeply into how bond prices and interest rates affect yield, it is essential to understand two characteristics of a rational bond investor. All things being equal: Bond investors prefer higher coupon payments. Bond investors tend to invest in bonds primarily for the steady coupon payments. Therefore, bond investors will be attracted to bonds that pay higher coupon payments. Bond investors prefer lower purchase prices. Like any rational investors, bondholders do not want to pay high prices for a bond. © 2021 IFSE Institute 177 Unit 5: Types of Investments When Bond Prices Fall, the Yield Rises The relationship between bond prices, interest rates and yield looks like this: Yield Bond Prices An investor who paid less than par is said to have purchase his or her bond at a discount. Bonds that are purchased at a discount have a higher yield than the coupon rate. Interest Rates Remember the bond’s coupon rate and coupon payments are fixed. When interest rates increase, prices of existing bonds decrease. As a result, investors shopping for bonds can buy the bond at a lower price and receive the same coupon payments as those who purchased the bonds at par. Example James bought a bond at a par value of $1,000 with a coupon rate of 10%, which means that James gets a coupon payment of $100 each year, calculated as ($1,000 x 10%). A year later, interest rates rise and the market value of James’s bond falls to $800. James sells his bond to Margaret for $800. At a price of $800, Margaret is able to get the same $100 yearly coupon payment at a lower market price, a discount price. Margaret’s yield is 12.5%, which is higher than the return James got on the bond. James’s current yield is 10%, calculated as (($100 ÷ $1,000) x 100). Margaret’s current yield is 12.5%, calculated as (($100 ÷ $800) x 100). Interest rates have increased and the bond price has decreased, therefore the bond yield has increased. When Bond Prices Rise, the Yield Falls Now let’s see what happens to the bond’s yield when bond prices go up. When interest rates decrease, they cause the price of existing bonds to increase. As a result, investors shopping for bonds will pay more for existing bonds because they pay a higher coupon payment than newly issued bonds. This will raise the market price of existing bonds. 178 © 2021 IFSE Institute Canadian Investment Funds Course Bond Prices The relationship between bond prices, interest rates and yield looks like this: Yield Interest Rates An investor who paid more than par value for a bond is said to have purchased his or her bond at a premium. Bonds that are purchased at a premium have a lower yield than the coupon rate. Example James bought a bond at a par value of $1,000 with a coupon rate of 10%, which means that James gets a coupon payment of $100 each year, calculated at ($1,000 x 10%). A year later, interest rates fall and the market value of James’s bond rises to $1,200. James sells his bond to Margaret for $1,200. At a price of $1,200, Margaret gets the same $100 yearly coupon payment, but at a higher market price. Margaret’s yield is 8.33%, which is lower than the return that James got on the bond. James’s current yield is 10%, calculated as (($100 ÷ $1,000) x 100). Margaret’s current yield is 8.33%, calculated as (($100 ÷ $1,200) x 100). Relationship Between Bond Prices and Interest Rates The chart below summarizes the inverse relationship between bond prices and interest rates: Direction of Interest Rates Bond Price Current Yield Stable or no change $100 or trading at “par” Current Yield equal to Coupon Rate Increase trading at a “discount”, less than par value Current Yield greater than Coupon Rate Decrease trading at a “premium”, greater than par value Current Yield less than Coupon Rate Yield Curves The yield curve is a graph that shows the relationship between the yield-to-maturities of the same class of bonds with different maturities. Bonds within the same class are those that have the same credit quality. © 2021 IFSE Institute 179 Unit 5: Types of Investments Yield curves are an important tool in fixed income investing and it is often used in forecasting the direction of interest rates and bond pricing. To get a better understanding of yield curves, we’ll look at the three types of yield curves: Yield Curves Types Yield Curve Type Normal Yield Curve Inverted Yield Curve Flat Yield Curve Example Description Upward sloping curve shows that longer term bonds have higher yields than shorter term bonds due to the higher risk of long-term bonds. The higher yield reflects investors’ expectation that rates will rise in the future. This downward sloping curve shows yield on short-term bonds to be higher than long-term bonds that suggests that investors expect rates to decline. This can be a sign that a recession is forthcoming. A flat yield curve shows that short and long-term bonds are receiving almost the same return. It usually indicates the market is in transition trying to determine the direction of interest rates. When the curve moves from normal to flat this can signal an economic slowdown. Portfolio managers will use the shape of the yield curve to develop a bond investing strategy. They can refer to it to select the term to maturity of bonds that will provide the optimal yield. 180 © 2021 IFSE Institute Canadian Investment Funds Course Risks of Investing in Bonds There are six main types of risk associated with investing in bonds: inflation risk interest rate risk reinvestment risk liquidity risk sovereign risk default risk Inflation Risk Also known as purchasing power risk, inflation risk arises when the return of a bond does not keep up with the inflation rate, representing the increase in the costs of goods and services. The inflation rate reduces the actual rate of return of the bond. As a result, the purchasing power of the bondholder’s coupon payments is eroded. The dollar value of the coupon payments will buy fewer goods because general prices have gone up. Example Clive purchases a bond with a coupon rate of 5%, but the inflation rate is 3%. Therefore, Clive’s purchasing power has only increased by approximately 2%, not 5%. Given the inflation rate, Clive’s real rate of return, also called the actual return, is approximately 2%. Interest Rate Risk This is the risk that the price of existing bonds will decline due to a rise in interest rates. Recall that as interest rates rise the price of existing bonds declines, and when interest rates fall bond prices go up. Reinvestment, Liquidity, Sovereign, and Default Risk Reinvestment Risk This is the risk that coupon payments from a bond will be reinvested at a lower interest rate than the rate on the original investment. Example Bonnie purchased a 10-year bond with a coupon rate of 5%. After two years, the prevailing interest rate fell to 3%. Subsequently, Bonnie’s coupon payment can only be reinvested at 3% and not 5%. © 2021 IFSE Institute 181 Unit 5: Types of Investments Liquidity Risk This is the risk that a bond investor cannot find a buyer for his or her bond when he or she wants to sell it. This is often the case in thin bond markets, where demand for bonds may be low due to economic uncertainty. Sovereign Risk This is the risk that a government, or an agency backed by the government, may be unable to make interest payments or return the investor’s principal amount. The government may be unable to pay due to unfavourable economic conditions. Default Risk Also referred to as credit risk, this is the risk that the bond’s issuer may run into financial problems and will not be able pay bondholders their scheduled coupon payments. In a worst-case scenario, their principal will not be re-paid. However, in the event the issuer defaults on coupon payments, the investor may still be able to recover some of their investment. Role of Credit Rating Agencies Credit rating agencies rate the credit quality of bond issuers. These companies use their professional judgment and other analytical tools to create a series of ratings on corporate and government bond issues. Investors will refer to the rating assigned to a bond issuer to gauge its default risk. In Canada, credit rating agencies must apply to securities regulators to become a designated rating organization. They are required to abide by the rules regarding conflicts of interest, proper compliance and reporting requirements. The Standard & Poor’s Rating Services is one of the major global credit rating agencies. According to its rating system, bonds can range from the highest quality, rated AAA, to the lowest quality, rated D. Investment grade bonds, those that have low risk of default, range from between AAA to BBB-. Conversely, high yield bonds (i.e. high-risk bonds) usually have a rating of BB or lower and are commonly referred to as “junk bonds”. Bonds and Mutual Funds Since there is a contractual obligation from issuers to pay regular coupon payments, bonds are usually used in mutual fund portfolios to provide an income stream that can be distributed to investors. Furthermore, issuers must repay the principal amount; this offers mutual fund portfolios some stability. Because of this fact, portfolio managers may invest a portion of their portfolio in bonds to lower the overall risk of their mutual fund. Portfolio managers do need to consider the credit quality of the issuer and the term of the bond since these factors affect the level of risk of the bond. Depending on the investment objective of the mutual fund, portfolio managers will select bonds accordingly. 182 © 2021 IFSE Institute Canadian Investment Funds Course Lesson 4: Equities Introduction Equities are shares of a corporation that investors can buy as part of their portfolio. Equities provide investors with partial ownership in a corporation, which entitles investors to the corporation’s net assets and profits, but also exposes them to any risks or losses incurred by the corporation. In this lesson you will learn about the different types of shares that companies can issue. You will also learn about the risks and potential returns of equity investments, and about how mutual funds use equities in their portfolios. This lesson takes approximately 30 minutes to complete. By the end of this lesson you will be able to: describe the concept of share ownership differentiate between common and preferred shares discuss the investment profiles of common and preferred shares describe the different types of preferred shares explain how mutual funds use equities © 2021 IFSE Institute 183 Unit 5: Types of Investments Equities All corporations need money to start up or to grow their business. One of the ways corporations can raise money is to divide their ownership into smaller units and sell the units to the public. Each unit of a company is called a share or equity because it represents an ownership share in the corporation, which entitles investors to the corporation’s net assets and profits. But as part-owners, investors will also be affected by any risks and losses experienced by the corporation. A company’s shares are first made available through an initial public offering (IPO). A company will hire an investment dealer to help them bring their shares to market. After the IPO, shares are traded in a secondary market through a centralized exchange such as the Toronto Stock Exchange (TSX). Investors who purchase the shares become shareholders of the company, and as such gain a proportionate ownership of the company according to the number of shares they hold. As shareholders, they are entitled to certain rights and benefits. Common and Preferred Shares When corporations issue shares, they fall into two general types: common shares and preferred shares. Both types of shares represent ownership in the corporation that entitles investors to the corporation’s earnings and assets. However, common and preferred shares have different entitlements and rights. Common Shares Common shares entitle shareholders to a share of a corporation’s profit and net asset value, as well as a share in the control of the corporation through voting rights on certain matters regarding the company’s operations. Some of the matters on which shareholders are entitled to vote include electing the members of the Board of Directors, the people chosen to control the activities of the corporation. Common shareholders are typically given one vote per share. The price of common shares reflects expectations of a company’s future profitability, and the demand for the shares. Shareholders benefit from common shares that appreciate in price and can realize a capital gain when the shares are sold. However, share prices can also fall and incur capital losses if share are sold. Investors purchase common shares with the anticipation that they will get a return in the form of capital gains. Preferred Shares Preferred shares are considered a hybrid of equity and fixed income securities. Like bonds, they are issued at par value, e.g. $25, and typically provide a regular income stream. Common and Preferred Shares Entitlements Preferred shareholders are entitled to receive a portion of the corporation’s profits in the form of dividends. The dividends are typically fixed and paid regularly. However, a company has no contractual obligation to pay 184 © 2021 IFSE Institute Canadian Investment Funds Course dividends. If dividends are paid, preferred shareholders will receive their dividends before common shareholders. Preferred shares are considered to be lower risk than common shares because preferred shareholders rank before common shareholders for the company’s assets in the event of bankruptcy. In exchange for the priority they have over common shareholders, preferred shares typically do not come with voting rights. Therefore, preferred shareholders do not have control over the corporation. The table below highlights the characteristics of common and preferred shares. Entitlement Common Shares Preferred Shares Dividends Yes. The amount and frequency will depend on the company’s earnings and what the Board of Directors decides. Yes. Preferred shareholders have priority over common shareholders for dividends. Dividend amount is fixed and frequency of payment is consistent. Voting Rights Yes. No. Some preferred shares will have special voting rights, but the votes will be more restrictive than those of common shares (i.e. can only vote on specific items). Claim on corporation’s assets if the company goes bankrupt Yes. But common shareholders are last in line for the corporation’s assets. They are paid after preferred shareholders. Yes. Preferred shareholders are paid before common shareholders. Benefits and Risks of Common Shares Benefits Compared with other investment assets such as bonds, common shares produce higher average long-term returns. If the common shares are from a profitable corporation, the price of the common share can appreciate over time. Eventually, shareholders may sell the common shares for a higher price than the purchase price and realize a profit. Risks As common shareholders are part-owners of the corporation, whatever affects the corporation’s earnings will eventually have an impact on the shareholders. If a business is not doing well for any number of reasons such as poor management decisions, slow economic growth, or competitor products, dividend payments may be © 2021 IFSE Institute 185 Unit 5: Types of Investments reduced or cut. Shareholders also face the risk that a company may go bankrupt, in which case they may also lose some or all of their investment money. However, shareholders are not liable for the debts incurred by a company, nor are they personally liable for any actions undertaken by the corporation. Prices of common shares reflect the company’s profitability as well as investors’ demand for the shares. Common shares involve more risk than preferred shares because of their price volatility and the uncertainty of the future share price. Example Shi-woo purchases 400 shares of Treatwell Medical Devices Inc. at a price of $40 per share. Her original investment is $16,000, calculated as (400 x $40). The company announces that it has plans to aggressively expand into Asia where there are enormous opportunities. The share price rises to $55 based on this news and Shi-woo's investment is now worth $22,000, calculated as (400 x $55). A few months later, the expansion plan stalls because Treatwell is unable to obtain the necessary regulatory approvals to operate in the target countries. The share price falls to $26 and Shi-woo's investment drops to $10,400, calculated as (400 x $26). The following year, the company begins to experience financial difficulty as a result of an economic slowdown and their failure to move into the Asian market. By the end of the year, Treatwell files for bankruptcy. Shi-woo has lost her entire investment of $16,000. Benefits and Risks of Preferred Shares Benefits Since preferred shares can be redeemed back to the issuer for par value, they usually trade around that price. This offers relative price stability. They also provide fixed dividends on an on-going basis. Risks Similar to common shareholders, preferred shareholders are affected by the performance of the corporation. If a company performs badly, it may miss dividend payments. Preferred shareholders are also subject to loss of their original investment if the company declares bankruptcy. Preferred shares are typically redeemable. The issuer may exercise its right to call the preferred share at an inopportune time for the preferred shareholder. In a low interest rate environment, existing preferred shares might be paying a higher yield than the market. This is good for the investor, but expensive for the dividendpaying company. Most would prefer to pay the expense of calling in the shares, rather than pay a high fixed dividend yield on them. 186 © 2021 IFSE Institute Canadian Investment Funds Course Example In the fall of 1997, the Bank of Nova Scotia had an outstanding issue of preferred shares that were callable on October 29, 1997, at their par value of $25 per share. Just prior to the call date the shares were trading at $26.85, a $1.85 per share premium to their par value, calculated as ($26.85 - $25.00). At the time, the prime rate in Canada was 6.25%. From the Bank of Nova Scotia's perspective, letting the preferred shares remain outstanding and paying the fixed dividend of 9.25% for any longer than necessary would not have made good business sense. Consequently, the company redeemed the shares on the October 29th call date. The Bank of Nova Scotia preferred shares were trading at $25 on October 29th. The $1.85 premium on the shares disappeared once the shares were called. Dividends After a corporation sells its products and deducts its costs, it is left with either a profit or a loss. When there is a profit, the corporation can reinvest the money in their business. Some corporations will use the profits to grow their business and invest the profits in research and development. Others may use the money to buy machinery or invest in technology to increase production. A company may also allocate a portion of the profits to be shared with common and preferred shareholders in the form of dividends. Dividends are the portion of the corporation’s profit that is not reinvested in the business, but is instead distributed to shareholders. The decision about how profit is to be used rests with the Board of Directors. If the Board believes a portion of the profits should be distributed to the shareholders, then the corporation will make a public announcement that it will distribute dividends. The date on which the dividend is authorized and announced to the public is called the declaration date. The announcement will include details about the dividend amount that will be allocated to each share. The date of record will also be indicated. Investors who own the shares as of the date of record are entitled to dividends. Types of Common and Preferred Shares To attract investors, corporations can add different features to their common and preferred shares. Some corporations may issue two types of common shares which are denoted as Class A and Class B shares. The differences between the two shares usually relate to voting rights and dividend entitlements. Typically, Class A shares offer more votes per share. Preferred shares may also come with different features that appeal to the different needs of investors and the corporation. The following are some of the different features that can be added to preferred shares. © 2021 IFSE Institute 187 Unit 5: Types of Investments Preferred Share Type Characteristics Convertible Preferred Shares Gives the shareholder the option to convert shares into a fixed number of common shares at a predetermined price within a specified period. Participating Preferred Shares Offers the opportunity to receive additional dividends if the company's profit exceeds a stated level. May also have provision that entitles investors to receive an additional amount of the company's assets if the company is liquidated. Cumulative Preferred Shares Requires that unpaid dividends accrue and be paid in full before dividends are paid to common shareholders. Non-cumulative dividends do not carry forward missed payments (dividends may be missed if the company does not make a profit). Callable (Redeemable) Preferred Shares Allows the issuer to redeem the preferred shares at a pre-determined price within a defined period. Retractable Preferred Shares Entitles the shareholder to sell the shares back to the issuer at a pre-determined price and time in the future. Investment Profile of Common and Preferred Shares The table below summarizes the investment profile of common and preferred shares. Common Share Preferred Share Investment Objective Long-term capital appreciation and potentially income Stable dividend income Expected Return Capital gain and potentially dividend income Dividend Income Risk Level Moderate to high Low to moderate Potential Gain Unlimited Limited, usually trades around par value Potential Loss Up to 100% of capital invested Up to 100% of capital invested Equities and Mutual Funds Portfolio managers consider investing in equities to provide potential growth in their portfolios. Since common shares can provide unlimited price appreciation, more aggressive mutual funds tend to hold equities that do not pay dividends but rather retain their earnings to reinvest in the business. The primary objective of these mutual funds is capital gains. 188 © 2021 IFSE Institute Canadian Investment Funds Course Mutual funds where the objective is moderate growth may select common shares from large, stable companies. These companies provide more price stability and perhaps dividend income. Portfolio managers consider investing in preferred shares primarily for the dividend income since the opportunity for price appreciation is limited. Since dividends provide a tax-efficiency income stream for investors, this type of mutual fund is appropriate for non-registered accounts. Investment Risk and Return This chart depicts the risk-return relationship for the different building blocks of mutual funds. Investments that are lower risk offer lower returns. Investments that offer higher potential return also come with greater risk. The chart below depicts the risk-return relationship for the different building blocks of mutual funds. Investments that are lower risk offer lower returns. Investments that offer higher potential return also come with greater risk. The chart below depicts the risk-return relationship for the different building blocks of mutual funds. Investments that are lower risk offer lower returns. Investments that offer higher potential return also come with greater risk. © 2021 IFSE Institute 189 Unit 5: Types of Investments Lesson 5: Derivatives Introduction Derivatives are financial instruments that get their value from one or more underlying assets, such as commodities, stocks, bonds, interest rates or currencies. In this lesson you will learn about the different types of derivatives. This lesson takes approximately 25 minutes to complete. By the end of this lesson you will be able to: differentiate between hedging and speculating describe the main features of: - call options - put options describe the main features of futures contracts and forward contracts explain how derivatives are used in mutual funds 190 © 2021 IFSE Institute Canadian Investment Funds Course Derivatives Derivatives are financial instruments that get their value from one or more underlying assets. The most common underlying assets include: commodities, stocks, bonds, interest rates, and currencies. The derivative itself is a contract between two parties, which specifies the conditions under which a transaction is to be made. Derivatives can be used to hedge risk of unexpected price changes, or in speculative trading. Almost all derivatives have a finite lifespan. At some time, the investor must fulfill the terms of the derivative and buy or sell the underlying asset, or allow the derivative to expire. The main types of derivatives include the following: options future contracts forward contracts Hedging Hedging is a strategy used to reduce the risk of unfavourable price changes. Investors hedge their investments when they are uncertain about the direction of the market and want to protect their asset against adverse price movements. A hedge usually involves taking an offsetting position, such as entering into an agreement with another party to sell or buy an asset at a predetermined price to prevent loss. Example Joe is a soy bean farmer. He wants to ensure that he can sell his crop at a particular price to cover all his costs and to allow him to make a profit. Instead of waiting until he harvests his crop, Joe enters into a derivative contract now to sell his crop at a specified price on a specified date. By entering the contract, Joe guarantees the price he will receive for his crop. Speculation Speculation is a strategy intended to increase profit. It involves executing very high-risk financial transactions that have a potential of providing high returns. Trading on the basis of speculation is called speculative trading. This strategy is the opposite of a buy-and-hold strategy, where someone invests in an investment for a long period with the objective of gaining long-term return. Speculative trading involves buying and selling an asset to make a substantial gain in a short period. Someone who engages in speculative trading is called a speculator. © 2021 IFSE Institute 191 Unit 5: Types of Investments Example Indira is a speculative trader. She enters into derivative contracts to buy corn but does not ever intend to purchase the corn or take delivery. She is betting that the price of corn will appreciate substantially over the next few weeks. Before the contracts expire, she must enter into offsetting contracts to close out the transaction so that she does not have to fulfil the purchase and delivery requirements of the contracts. Mutual funds are intended for long-term investors and are not suited for speculative trading. Options Options are derivative contracts that give an investor the right to buy or sell a pre-determined amount of an underlying security at a set price for a set period of time. There are two parties involved in an option transaction: the option buyer and the option seller. The option buyer, also known as the holder, has the right to buy or sell the underlying security. The option seller, also known as the writer, has the obligation to buy or sell the underlying security if the buyer decides to exercise the option. The option buyer must pay the option seller a price for this right, called a premium. There are options on many different securities, such as stocks, bonds, and indexes, but the most common are stock options. There are two types of options: Call options allow the option buyer the right to buy an underlying security at a pre-determined price. They are used when an investor believes the security price will go up in the future. Put options allow the option buyer the right to sell an underlying security at a pre-determined price. They are used when an investor believes the security price will fall in the future. Type of Contract Option Buyer Option Seller Call Right to buy an underlying security Obligation to sell an underlying security Put Right to sell an underlying security Obligation to buy an underlying security 192 © 2021 IFSE Institute Canadian Investment Funds Course Example Joyce has been following the news about ROBO Co. and she believes the common share price will go up very soon. ROBO’s share price is currently $20. She buys a call option at a $2 premium per share, from a seller who is willing to sell the shares for $23 within the next six months. If the share price goes up to $30, Joyce can exercise her option and buy the shares for $23 and the seller must sell it to her at $23. However, if Joyce’s forecast is wrong and the share price actually falls below $23, she has the right not to buy the share. Her loss would be only the premium she paid to buy the option. Example Sam owns ROBO common shares, which he purchased for $25. Unlike Joyce, he thinks the price will fall so he buys a put option. This gives him the right to sell his shares for a specific price within a specific period. He buys put options at $2 per share, which gives him the right to sell the shares for $20 within the next nine months. If the price drops to $15, Sam can exercise his option to sell his shares for $20. If the price goes up to $25, Sam will not exercise his option and only lose the premium for the put options. Futures Contracts Futures contracts are intended to solve the basic business risk of future price uncertainty. With futures contracts, investors can control as much of the future as possible, in that the contract can set a predetermined price for a good that is to be delivered at a specific time in the future. Futures contracts differ from options because there is a legal obligation to buy or sell the underlying asset. Example Wheat prices change daily, which affects the profits that wheat farmers can make. If prices go up, farmers can enjoy a large profit but if prices drop, their profits shrink. Frank is a wheat farmer. Frank can protect himself from a loss by entering into a futures contract with another party, to sell his wheat at $8 per bushel, to be delivered in three months. This way, even if the price drops to $7 a bushel within the next three months, Frank is protected. He has already secured his selling price ahead of time using a futures contract, therefore hedging the risk that wheat prices will fall. On the other hand, if the price of wheat increases to $9 per bushel, the buyer will benefit, since he or she is able to buy wheat from Frank at the agreed upon price of $8. © 2021 IFSE Institute 193 Unit 5: Types of Investments The futures market is where producers and users of commodities such as wheat, meats, currency, interest rates, and securities buy and sell contracts. Note that the definition of commodities has been expanded from physical goods to include financial assets. Buyers of futures are considered to be “long” on the commodity, meaning the commodity will belong to the buyer at a defined time for a specific price. Whereas the seller is said to be “short” on the commodity because they agree to deliver the commodity at a pre-determined price and date and will be short of the commodity after its delivery. Forward Contracts A forward contract is an agreement that allows a buyer to purchase an underlying asset such as stocks, bonds, or currency, from a seller for a pre-set price at a specific future date. The provisions of the contract, including the price and sale date, are customized by the seller and buyer. Forward contracts are similar to futures contracts because there is a legal obligation to buy or sell the underlying asset. Example Jerome is a pension fund portfolio manager. He has finalized a deal to fund an infrastructure project in Germany. The agreement stipulates that he make three lump sum instalments: one in six months, the second in a year, and the third in three years. Jerome can enter into a forward contract that will lock in the Canadian-Euro exchange rate at those three points in time. By doing so, Jerome is assured the exchange rate now that he will have to pay in the future. Differences Between Forward and Futures Contracts As you can see, forward contracts and futures contracts have the same function. However, they differ from each other in several key ways, as follows: Forward Contracts Futures Contracts not traded on a centralized exchange, but through a broker-dealer traded on the futures exchange customized contracts, negotiated between buyers and sellers through broker-dealers standardized contracts no clearinghouse, therefore it is possible that buyers and sellers may default on contracts has a clearinghouse that ensures buyers and sellers follow through on the contract 194 © 2021 IFSE Institute Canadian Investment Funds Course Derivatives and Mutual Funds Derivatives such as options, forward and futures contracts are used in the management of mutual funds to reduce risk and to maximize profits. One of the ways derivatives are used in mutual funds is with hedging currency exchange fluctuations. For instance, Canadian mutual funds are mostly denominated in Canadian dollars. However, mutual funds that invest outside of Canada will require foreign currency to purchase securities of corporations based outside of Canada. Within a mutual fund, foreign currency must be converted back into Canadian dollars. As a result, exchange rate changes will affect the return of the mutual fund. Generally, if the Canadian dollar is weak and depreciates, the value of foreign assets will increase after their conversion into Canadian currency, which increases the return of the mutual fund. However, if the Canadian dollar is strong and appreciates, the value of the foreign asset will fall after it is converted into Canadian dollars, which will reduce the mutual fund’s return. Derivatives can help manage any downside risk. Example Geraldine is a portfolio manager of a U.S. equity mutual fund. She plans to use a forward contract to eliminate the risk of a strong Canadian dollar. The exchange rate for Canadian dollars (CAD) is currently $0.80 U.S. dollars (USD), which means that she can exchange $0.80 USD for $1.00 CAD. If the Canadian dollar appreciates to $0.85 USD, then she must exchange $0.85 USD for $1.00 CAD, which is $0.05 more per Canadian dollar. Geraldine can sell a USD forward contract that allows her to lock in an exchange rate of $0.80 USD in the future. In the next year, if the Canadian dollar appreciates such that the exchange rate is $0.85 USD, she will benefit from having used a future contract as a currency hedge. As a result, the return of her fund will not be negatively affected by the change in currency rate. The provincial securities commission regulates the use of derivatives in mutual funds. The rules are stated in National Instrument (NI) 81-102. © 2021 IFSE Institute 195 Unit 5: Types of Investments Summary Congratulations, you have reached the end of Unit 5: Types of Investments. In this unit you covered: Lesson 1: Building Blocks of Mutual Funds Lesson 2: Fixed Income Securities Lesson 3: Bonds Lesson 4: Equities Lesson 5: Derivatives Now that you have completed these lessons, you are ready to assess your knowledge with a 10-question quiz. To start the quiz, return to the IFSE Landing Page and click on the Unit 5 Quiz button. 196 © 2021 IFSE Institute