Securities Fundamentals Synthesis

Securities Fundamentals, Unit 8 of 8

This synthesis ties together the Securities Fundamentals units to help you identify security types, analyze their characteristics, and match them to investor needs on the exam.

Step 1: Identify the Security Category

If the question mentions Discount, T-bill, 270 days, money market, one year or less, You're dealing with Cash equivalents

If the question mentions Coupon, maturity, par value, yield, bond, You're dealing with Fixed income securities

If the question mentions Voting rights, dividends, EPS, shares, You're dealing with Equity securities

If the question mentions IPO, S-1, underwriter, SPAC, prospectus, lock-up, You're dealing with Equity public offering

If the question mentions P/E ratio, DCF, DDM, moving average, support/resist, You're dealing with Equity valuation methods

Step 2: Narrow Down the Specific Security

Cash Equivalents Identification

Backed by U.S. government, 4 to 52 weeks: Treasury bills

$1 NAV (government, retail), liquid: Money market fund

$100,000+ minimum, negotiable, bank-issued: Negotiable CD (jumbo)

Unsecured corporate IOU, 270 days or less: Commercial paper

International trade, bank guarantee: Banker's acceptance

Overnight lending, collateralized: Repurchase agreement

Fixed Income Identification

Full faith and credit, safest, no default: Treasury securities

GNMA, FNMA, prepayment risk, mortgage pool: Agency securities

Debenture, secured, convertible, corporate: Corporate bonds

Tax-exempt, GO, revenue, muni: Municipal bonds

Yankee, Eurodollar, sovereign risk: Foreign bonds

Below BBB-/Baa3, higher yield, speculative: High-yield bonds

Equity Identification

Voting, residual claim, preemptive rights: Common stock

Fixed dividend, no voting, interest rate sensitive: Preferred stock

Bargain element, vesting, exercise price: Employee stock options

Restricted-stock resale rule, holding period, affiliate, control: Restricted / Control stock

Foreign company, U.S. bank, currency risk: ADRs

Equity Public Offering Identification

First time public, S-1 filing, cooling-off period: Initial public offering

New shares after IPO, dilutive, proceeds to company: Primary (follow-on) offering

Existing shares sold, non-dilutive, proceeds to sellers: Secondary offering

Shell company, blind pool, 18-24 month deadline: SPAC

Equity Valuation Methods Identification

Charts, trends, moving averages, support/resistance: Technical analysis

P/E, EPS, book value, financial statements, top-down: Fundamental analysis

V = D/r, Gordon Growth Model, V = D1/(r-g), r > g: Dividend discount model

Free cash flow, discount rate, terminal value, present value: Discounted cash flow

Step 3: Match to Investor Objective

Safety / Capital preservation: Best Security Types T-bills, money market funds, Treasury bonds

Current income: Best Security Types Corporate bonds, preferred stock, municipal bonds

Tax-free income: Best Security Types Municipal bonds (especially for high tax brackets)

Growth / Capital appreciation: Best Security Types Common stock, growth stocks

Inflation protection: Best Security Types TIPS, common stock, I Bonds

Liquidity / Emergency fund: Best Security Types Money market funds, T-bills, negotiable CDs

Step 4: Assess Risk Profile

Risk Spectrum (Low to High)

Lowest: T-bills, money market funds, FDIC-insured deposits

Low: Treasury bonds, agency securities

Moderate: Investment-grade (high-grade) corporate bonds, blue-chip stocks, preferred

Moderate-High: High-yield bonds, small-cap stocks, ADRs

High: Penny stocks, emerging market bonds, non-investment grade

Risk Types by Security Category

Cash equivalents: Primary Risks Inflation risk, opportunity cost (low returns)

Treasury bonds: Primary Risks Interest rate risk, inflation risk

Corporate bonds: Primary Risks Credit/default risk, interest rate risk

Municipal bonds: Primary Risks Credit/default risk, interest rate risk, call risk, (AMT for private activity)

Common stock: Primary Risks Market risk, business risk

Preferred stock: Primary Risks Interest rate risk (like bonds), dividend risk

Exam Tip: Gotchas

Preferred stock acts like a bond. Price moves inversely with interest rates.

T-bills have no interest rate risk (too short-term) but Treasury bonds do.

Municipal bonds are not risk-free. They have interest rate risk and potential default risk.

Tax Treatment Summary

Treasury securities: Federal Tax Treatment Taxable federally, exempt from state/local

Municipal bonds (GO/Revenue): Federal Tax Treatment Exempt from federal, often state if in-state

Private activity munis: Federal Tax Treatment May trigger AMT

Corporate bonds: Federal Tax Treatment Fully taxable (interest = ordinary income)

Dividends on common stock: Federal Tax Treatment Qualified dividends taxed at capital gains rates

Dividends on preferred stock: Federal Tax Treatment Usually qualified dividend treatment

Capital gains: Federal Tax Treatment Held one year or less = ordinary; held more than one year = preferential

Zero-coupon bonds: Federal Tax Treatment Phantom income taxed annually (no cash received)

Series EE/I Bonds: Federal Tax Treatment Tax-deferred until redemption; may be tax-free for education

Exam Tip: Gotchas

Zero-coupon = phantom income. You pay tax on imputed interest each year even though you receive nothing until maturity.

Treasury = federal taxable, state exempt. Munis are the opposite (federal exempt).

Dividends are double-taxed. Corporate profits are taxed, then dividends to shareholders are taxed again.

Liquidity Comparison

Most Liquid: Money market funds; Least Liquid: Savings bonds (1-year hold)

Most Liquid: T-bills; Least Liquid: Restricted stock (6-month/1-year hold)

Most Liquid: Exchange-traded stocks; Least Liquid: Thinly traded bonds

Most Liquid: Negotiable CDs; Least Liquid: Private placements

Key Characteristics: Stocks vs. Bonds

Best for: Common Stock Growth; Preferred Stock Current income; Bonds Income and safety

Voting rights: Common Stock Yes; Preferred Stock Usually no; Bonds No

Fixed payments: Common Stock No (variable dividends); Preferred Stock Yes (fixed dividend); Bonds Yes (interest)

Maturity date: Common Stock None; Preferred Stock Usually none; Bonds Yes

Bankruptcy priority: Common Stock Last; Preferred Stock After debt, before common; Bonds First

Price sensitivity: Common Stock Business performance; Preferred Stock Interest rates; Bonds Interest rates

Growth potential: Common Stock Unlimited; Preferred Stock Limited; Bonds None (return of principal)

Inflation hedge: Common Stock Good; Preferred Stock Poor; Bonds Poor (except TIPS)

Bond Pricing Relationships

Premium, Par, and Discount

Premium: Market Price vs. Par Above par; YTM vs. Coupon YTM < Coupon; Issuer Likely to Call? Yes (to refinance)

Par: Market Price vs. Par Equals par; YTM vs. Coupon YTM = Coupon; Issuer Likely to Call? Maybe

Discount: Market Price vs. Par Below par; YTM vs. Coupon YTM > Coupon; Issuer Likely to Call? No

Yield Ranking (Critical)

Discount bonds: Nominal < CY < YTM < YTC

Premium bonds: Nominal > CY > YTM > YTC

Par bonds: Nominal yield, current yield, and YTM are equal; YTC is calculated separately if the bond is callable.

Exam Tip: Gotchas

Focus on YTM for discount bonds (issuer won't call). Focus on YTC for premium bonds (issuer likely to call to refinance at lower rates).

Key Formulas

Fixed Income Formulas

Current Yield = Annual Interest divided by Market Price

Tax-Equivalent Yield (Municipal Bonds): TEY = Municipal Yield divided by (1 - Tax Bracket)

Conversion Ratio (Convertible Bonds): Conversion Ratio = Par Value divided by Conversion Price

Parity Price (Parity Stock Price): Parity Stock Price = Bond Price divided by Conversion Ratio

Parity Bond Price (Conversion Value): Parity Bond Price = Stock Price x Conversion Ratio

Equity Formulas

Dividend Yield = Annual Dividend divided by Current Market Price

Total Return = (Capital Gain + Dividends) divided by Initial Investment

Stock Split Adjustment:

2-for-1 split: Shares double, price halves

Reverse split (1-for-10): Shares decrease, price increases

Total value unchanged

Valuation Formulas

Dividend Discount Model (DDM):

V = D / r (zero growth); V = D1 / (r - g) (Gordon Growth)

V = stock value

D = annual dividend per share; D1 = next year's expected dividend (Gordon Growth)

r = required rate of return

g = constant annual dividend growth rate

Price-to-Earnings Ratio: P/E = Market Price per Share divided by Earnings per Share (EPS)

Exam Question Framework

When you see a securities fundamentals question, ask:

1. What category of security is this? (Cash equivalent, fixed income, equity, or public offering)

2. What is the specific security type? (Use identification tables above)

3. What is the investor's objective? (Safety, income, growth, tax efficiency)

4. What are the key risks? (Interest rate, credit, market, inflation)

5. What is the tax treatment? (Federal taxable, state exempt, tax-free)

6. If a bond: is it trading at premium, par, or discount? (Determines yield focus)

7. If a valuation question: which method applies? (Technical, fundamental, DDM, or DCF)

8. If a public offering question: who gets the proceeds? (Company vs. selling shareholders)

Think of it this way: The exam tests whether you can match the right security to the right investor. Master the identification tables and risk/objective matching, and you'll be able to eliminate wrong answers quickly.

What's Next

The next chapter, Advanced Securities, builds on these fundamentals by covering:

Pooled investments (mutual funds, ETFs, UITs, REITs)

Derivative securities (options, futures)

Alternative investments (hedge funds, private equity, commodities)

Insurance products (annuities, life insurance)

Those products are more complex, but they all use the same core concepts of risk, return, and suitability that you learned in this chapter.