SIE

Common Stock and Shareholder Characteristics

Common stock represents fundamental ownership, or equity, in a corporation. Shareholders who own common stock benefit primarily through capital appreciation and the potential receipt of dividends. The standard timeframe for the settlement of equity trades is known as regular way settlement, which occurs on a $T+1$ basis, meaning the trade settles one business day after the transaction date. Corporations may distribute dividends in two distinct forms: cash dividends, which are typically paid on a quarterly basis, and stock dividends. Stock dividends involve the issuance of additional shares to existing shareholders; while this increases the total number of shares held, it simultaneously reduces the value of each individual share.

Corporate actions such as stock splits also alter the number of shares outstanding without changing the total market value of a shareholder’s position. In a $2:1$ forward stock split, a shareholder receives twice the amount of shares, but the price per share is reduced by half ($50\%$). Conversely, a reverse stock split reduces the number of shares outstanding while increasing the price per share; for instance, a $1:10$ reverse split would consolidate $10$ shares into a single share. To protect existing shareholders from dilution, companies may offer preemptive rights, also known as subscription rights, which allow them to purchase new shares before the public to maintain their proportional ownership.

Common Stock Valuation and Shareholder Rights

The financial health of a corporation is assessed using tools like the balance sheet, which provides a snapshot of assets, liabilities, and net worth at a specific point in time. Key valuation metrics for common stock include the dividend yield and the price-to-earnings ($P/E$) ratio. The formulas for these metrics are as follows:

$\text{Dividend Yield} = \frac{\text{Annual Dividends}}{\text{Market Price}}$

$\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{Earnings per Share (EPS)}}$

Common shareholders possess several basic rights, including the right to inspect corporate books and records, the right to transfer ownership, preemptive rights, and the right to receive dividends if they are declared by the board of directors. In the event of corporate dissolution, they have a residual claim on assets. Furthermore, common shareholders have voting rights on specific corporate actions, such as forward or reverse stock splits, the issuance of convertible securities, and the granting of stock options to executives.

Shareholders may exercise their voting power through two primary methods: statutory voting and cumulative voting. In statutory voting, votes must be distributed evenly across all candidates, whereas cumulative voting allows a shareholder to concentrate their votes on one or more specific candidates to increase their influence. Many shareholders utilize proxy voting, a method that authorizes another party to vote on their behalf, eliminating the need to attend the annual meeting in person.

Preferred Stock Fundamentals and Varieties

Preferred stock is a class of equity that holds senior status over common stock, particularly regarding dividend payments and claims during liquidation. Dividends on preferred stock are generally fixed and calculated as a percentage of a typical par value of $\$100$. For example, a $10\%$ preferred stock would result in an annual dividend of $\$10$. Unlike common shareholders, preferred shareholders typically lack voting rights and preemptive rights.

Several varieties of preferred stock exist to meet different investor needs. Cumulative preferred stock allows for the accumulation of missed dividend payments, requiring that all unpaid dividends (dividends in arrears) be settled before any common stock dividends are paid. Callable preferred stock gives the issuer the right to redeem the shares at par after a certain date. Convertible preferred stock can be exchanged for common stock, providing the potential for capital appreciation; due to this added value, these shares usually offer lower dividend rates. Participating preferred stock is unique because it allows shareholders to receive extra dividends beyond the fixed rate if the company demonstrates strong earnings and the board declares them. The market price of preferred stock shares an inverse relationship with interest rates: when interest rates rise, the price of existing preferred stock generally falls. The yield for preferred stock is calculated as follows:

$\text{Current Yield} = \frac{\text{Annual Dividends}}{\text{Market Price}}$

Warrants and American Depositary Receipts (ADRs)

Warrants are long-term options that allow an investor to buy stock at a fixed price, which is initially set above the current market price. They are often attached to new stock or bond issues as an incentive and typically have an extended lifespan of $5$ to $10$ years, or may even be perpetual. The key distinction between rights and warrants is their duration and pricing: rights are short-term with an exercise price below the market price, while warrants are long-term with an exercise price above the market price.

American Depositary Receipts (ADRs) facilitate the trading of foreign stocks in U.S. markets. These instruments represent foreign shares held in trust by a bank. While ADRs are priced in U.S. dollars, they do not grant the holder voting or preemptive rights, as these are retained by the bank holding the underlying shares. Investors in ADRs are subject to exchange rate risk (currency risk), meaning the investment value can fluctuate based on the foreign currency’s performance relative to the U.S. dollar.

Debt Fundamentals and Bond Characteristics

A bond is a fixed-income security representing a loan from an investor to an issuer, such as a government or corporation. The issuer agrees to pay periodic interest and return the par value (face value), which is typically $\$1,000$, at maturity. Interest is paid based on the coupon rate, a fixed annual percentage of the par value. Bonds can be categorized by their issuance structure: term bonds share the same maturity date and interest rate; serial bonds are issued together but mature at different dates; and series bonds are issued at different times but share a single maturity date. Zero-coupon bonds are unique because they pay no periodic interest; they are issued at a deep discount and redeem at par upon maturity.

Bond prices are quoted as a percentage of par value, where one point equals $1\%$ of par ($\$10$). A bond quoted at $100$ is trading at par ($\$1,000$), while a quote of $110$ represents a premium price of $\$1,100$, and a quote of $90$ represents a discount price of $\$900$. The difference between the price a dealer will pay (bid) and the price they will sell at (ask) is known as the spread. Yield changes are measured in basis points ($bps$), where one basis point equals $0.01\%$

Bond Yields and the Inverse Relationship

There is a fundamental inverse relationship between bond prices and interest rates: when interest rates rise, bond prices fall, and vice versa. There are three primary types of yields. Nominal yield (coupon rate) is fixed at issuance. Current yield is the annual interest divided by the market price. Yield to Maturity ($YTM$) is the anticipated total return if the bond is held until it matures, accounting for the purchase price, interest, and time value of money.

The relationship between these yields changes depending on whether the bond is trading at a discount or a premium. For a discount bond, the hierarchy is $YTM > \text{Current Yield} > \text{Nominal Yield}$. For a premium bond, the hierarchy is $YTM < \text{Current Yield} < \text{Nominal Yield}$. If a bond is quoted on a yield basis that equals its coupon rate, it is selling at par. Bonds trade at a discount when their coupon rate is lower than the rates currently offered on new, comparable bonds.

Bond Features and Investment Risks

Issuers may include call features in bonds, allowing them to redeem the security before maturity, often when interest rates drop. This often involves a call premium, which is an extra amount paid to the bondholder above par. The relevant return metric for these securities is the Yield to Call ($YTC$). Conversely, puttable bonds allow the investor to sell the bond back to the issuer at a specific price, typically when interest rates rise.

Bonds are subject to several risks. Credit risk (also known as default risk) is the possibility that the issuer fails to make timely payments; this is assessed by agencies like Moody’s and Standard \& Poor’s ($S\&P$). Interest rate risk is the risk that rising rates will lower market prices; bonds with long maturities, low coupon rates, or deep discounts are most vulnerable, while variable rate bonds are least affected. Other risks include liquidity risk (inability to sell quickly), purchasing power risk (inflation eroding value), and reinvestment risk (falling rates forcing lower returns on reinvested interest). Prepayment risk is a specific type of reinvestment risk associated with mortgage-backed securities ($MBS$), occurring when borrowers refinance early during periods of falling rates.

Corporate Debt Instruments and Liquidation Priority

Corporate debt was historically issued as bearer bonds (physical coupons) but is now primarily fully registered or issued in book-entry form (electronic records). The bond indenture is the legal contract detailing terms such as collateral and protective provisions. Secured bonds are backed by specific assets: mortgage bonds use real estate, equipment trust certificates use physical machinery (like airplanes), and collateral trust certificates use marketable securities. Unsecured debt includes commercial paper, which is short-term (typically $14$ to $90$ days) and matures at face value; debentures, which rely solely on creditworthiness; and subordinated debentures, which have a lower priority in liquidation. Income bonds only pay interest if the company has sufficient earnings.

Convertible bonds provide the option to exchange the bond for a set number of common shares. The conversion ratio is calculated as:

$\text{Conversion Ratio} = \frac{\text{Par Value}}{\text{Conversion Price}}$

The parity price is the point where the bond's market value equals the value of the stock it can be converted into. In the event of corporate liquidation, the order of priority for payments is: $1$. Secured creditors
$2$. Unpaid administrative claims and wages
$3$. Unsecured creditors
$4$. Subordinated creditors
$5$. Preferred stockholders
$6$. Common stockholders

U.S. Government and Agency Securities

U.S. government debt is issued by the Treasury and is considered the most liquid and risk-free market, exempt from SEC regulation. These are issued in book-entry form. Treasury bonds ($T-bonds$) have maturities up to $30$ years and pay interest semiannually. Treasury bills ($T-bills$) are short-term ($1$ to $12$ months), issued at a discount with no periodic interest. STRIPS (Separate Trading of Registered Interest and Principal of Securities) are zero-coupon bonds created by stripping interest from Treasury bonds. TIPS (Treasury Inflation-Protected Securities) adjust their principal based on the Consumer Price Index ($CPI$) to combat inflation.

Government agencies and sponsored agencies issue mortgage-backed securities ($MBS$). Ginnie Mae securities are fully guaranteed by the government, whereas those from Fannie Mae and Freddie Mac have only an implied guarantee. The Federal Reserve influences the bond market through open market operations: buying bonds to loosen credit and selling bonds to tighten credit. Interest on U.S. government debt is subject to federal tax but exempt from state and local taxes.

Municipal Debt and Money Market Instruments

Municipal securities are regulated by the Municipal Securities Rulemaking Board ($MSRB$). A bond counsel provides a legal opinion on the bond's validity and tax status. General Obligation ($GO$) bonds are backed by the issuer's taxing power (ad valorem taxes) and are often subject to statutory debt limits. Revenue bonds are backed by income from specific projects, such as toll roads, and require a feasibility study. Other municipal types include special tax bonds (backed by cigarette or gasoline taxes) and moral obligation bonds (backed by a non-binding legislative promise).

Short-term municipal debt includes Bond Anticipation Notes ($BANs$) for capital projects and Tax Anticipation Notes ($TANs$) for property tax collections. Municipal bonds trade over-the-counter ($OTC$) with $T+1$ settlement. Their interest is federally tax-exempt and may be state-exempt for residents of the issuing state. Money market instruments are high-liquidity, low-risk debt with maturities of one year or less. These include commercial paper ($\le 270$ days), repurchase agreements ($repos$) used by the Fed to control money supply, and brokered CDs, which are large CDs divided into smaller units by brokers for retail sale.

Management Companies and Packaged Products

The Investment Company Act of $1940$ classifies investment companies into management companies (open-end/mutual funds and closed-end), Unit Investment Trusts ($UITs$), and face-amount certificate companies. Open-end funds continuously issue and redeem shares, while closed-