The Series 6 outline lists equities, debt, options, Treasuries, agency securities and money market instruments under the product knowledge section, and it lists the tax and financial statement topics beside them. A representative who cannot explain these cannot make a suitable recommendation, so this chapter works through each product, then the tax rules that apply to gains and losses, then the financial statements.
14.1 Equity securities
Common stock
Common stock is ownership. Holders have residual claims on assets and earnings, voting rights (statutory or cumulative), preemptive rights if the charter grants them, the right to inspect the books, and a share of dividends if declared. They are paid last in a liquidation, after creditors and preferred holders. Dividends are not guaranteed; the board declares them.
| Term | Meaning |
|---|---|
| Authorized, issued, outstanding, treasury | Authorized is the maximum the charter allows; issued has been sold; outstanding = issued less treasury; treasury stock is repurchased stock that does not vote or receive dividends |
| Statutory voting | One vote per share per director seat, no cumulating |
| Cumulative voting | Shares x number of seats can be put all on one candidate, helping minority holders |
| Stock split | More shares, lower price; no change in total value or the company's equity |
| Reverse split | Fewer shares, higher price |
| Stock dividend | Additional shares paid to holders; same total value |
Example 1. Splits. A holder owns 300 shares at $90 ($27,000). In a 3-for-2 split the holder has 300 x 3/2 = 450 shares at $90 x 2/3 = $60 ($27,000). In a 1-for-5 reverse split the holder has 300 / 5 = 60 shares at $90 x 5 = $450 ($27,000).
Example 2. Dividend yield and the ex-date. A stock pays $0.60 each quarter and trades at $48. Annual dividend $2.40; yield = 2.40 / 48 = 5.0%. Under Rule 11140, the stock goes ex-dividend on the record date under the T+1 settlement cycle (for ordinary dividends below 25% of the stock's value); a buyer who purchases on or after the ex-date does not receive the dividend. Chapter 16 covers the dividend calendar.
Preferred stock
Preferred has a fixed dividend, ranks ahead of common in dividends and liquidation, usually has no vote, and trades mainly on yield and the issuer's credit.
| Type | Feature |
|---|---|
| Cumulative | Missed dividends accumulate as "arrears" and must be paid before any common dividend |
| Non-cumulative | Missed dividends are lost |
| Participating | Shares in extra earnings beyond the stated dividend |
| Convertible | Convertible into common at a set ratio |
| Callable | The issuer can redeem, usually at a premium |
| Putable | The holder can force redemption |
| Adjustable-rate | Dividend resets with a reference rate |
Preferred prices move opposite to interest rates, as bond prices do. The par value is typically $25 or $100.
Example 3. Preferred yield. A $100 par, 5% preferred pays $5 a year. At a market price of $80, current yield = 5 / 80 = 6.25%. If the price rises to $100, the yield is 5.00%.
Example 4. Convertible parity. A convertible bond with $1,000 par is convertible at $40 a share: conversion ratio = $1,000 / $40 = 25 shares. If the stock trades at $45, parity (conversion value) = 25 x $45 = $1,125. The bond will trade at or above parity. If the bond trades at $1,150 the premium over parity is $25.
ADRs, rights and warrants
- American depositary receipts (ADRs) are receipts issued by a US depositary bank for shares of a foreign company held by a custodian abroad. They trade in dollars, pay dividends in dollars, and carry currency risk and foreign-market risk. Sponsored ADRs involve the issuer; unsponsored do not. Foreign withholding tax may apply on dividends.
- Rights are short-term (usually 30 to 60 days) offers to existing holders to buy new shares at a subscription price below market, in proportion to existing holdings, protecting preemptive rights. They are issued on a rights offering.
- Warrants are long-term (years, sometimes perpetual) options to buy stock at a fixed price above the market price at issue. They are often attached to a bond or preferred issue as a "sweetener".
Example 5. Value of a right. The stock trades at $50 cum-rights. The subscription price is $40, and 4 rights plus $40 buy one share. Value of a right while the stock still carries the right = (50 - 40) / (4 + 1) = $2.00. After the stock goes ex-rights, it should trade near $48. Then the value of one right = (48 - 40) / 4 = $2.00. The holder who sells the rights gets the same economic value as exercising them.
14.2 Debt securities
A bond is a loan. The issuer promises to pay interest (the coupon) and return the principal (par, face) at maturity. Bonds are quoted as a percentage of par, so a quote of 98 is $980 per $1,000 bond.
| Term | Meaning |
|---|---|
| Coupon rate | Annual interest as a percentage of par |
| Current yield | Annual interest / current market price |
| Yield to maturity (YTM) | The annual return if held to maturity, including the gain or loss against par and reinvestment of coupons at the same rate |
| Yield to call (YTC) | The same, assuming the bond is called on the first call date |
| Nominal yield | Coupon yield |
| Discount / par / premium | Price below / equal / above par |
The relationships to memorize:
- Price and yield move in opposite directions.
- Premium bond: coupon rate > current yield > YTM (and YTC lower still if the call price is below the bond's price).
- Discount bond: coupon rate < current yield < YTM.
- Par bond: coupon = current yield = YTM.
- Longer maturity and lower coupon mean more price sensitivity (greater duration) for a given rate change.
- Callable bonds: the investor is hurt when rates fall because the bond is called at a time of lower rates (call risk and reinvestment risk), so callable bonds pay more.
- Basis point: 0.01%. A move of 50 basis points is 0.50%.
Example 6. Current yield and yield to maturity. A 6% coupon, 10-year bond with $1,000 par trades at 95 ($950).
- Annual interest = 6% x $1,000 = $60.
- Current yield = 60 / 950 = 6.32%.
- Approximate YTM = (60 + (1,000 - 950) / 10) / ((1,000 + 950) / 2) = (60 + 5) / 975 = 6.67%. The exact YTM, solved by present value, is 6.70%. The exam asks for the order (coupon 6.00% < current yield 6.32% < YTM 6.70%), not for the exact solve.
Example 7. Accrued interest. The bond above is a corporate bond with a 6% coupon paid January 1 and July 1, and the trade settles April 15. Corporate and municipal bonds count interest on a 30/360 basis (30-day months, 360-day year): January 1 to April 15 is 3 x 30 + 14 = 104 days. Accrued interest = $1,000 x 0.06 x 104 / 360 = $17.33 per bond. The buyer pays the price plus accrued interest, and receives the full coupon on July 1. Treasury notes and bonds use actual days/actual days. A bond that trades "flat" (bonds in default, income bonds) has no accrued interest added.
Types of corporate bonds.
| Type | Feature |
|---|---|
| Secured / mortgage / equipment trust | Backed by specific assets |
| Debenture | Unsecured; backed by the issuer's credit |
| Subordinated debenture | Ranks below other debt |
| Convertible | Convertible to stock |
| Zero-coupon | Sold at a deep discount; no interest paid; accretion is taxable each year as phantom income |
| Income / adjustment bond | Pays interest only if earned |
| Floating rate | Coupon resets |
| Callable / puttable / extendable | Call and put features |
| High yield ("junk") | Rated below BBB-/Baa3 |
| Investment grade | BBB-/Baa3 and above |
Seniority in liquidation: secured creditors, then unsecured creditors (debentures), then subordinated debt, then preferred stock, then common stock. Bondholders are creditors, with a claim in bankruptcy, while stockholders are owners.
Municipal bonds were covered in Chapter 1 (official statements, and the issuance process) and Chapter 10 (municipal fund securities). The key tax point: interest on most municipal bonds is exempt from federal income tax and, if the investor lives in the issuing state, from state tax. General obligation (GO) bonds are backed by taxing power; revenue bonds by the revenue of the project. Municipal bond interest is tax-exempt, but a gain on sale is taxable as a capital gain.
Bond ratings. Moody's Aaa/Aa/A/Baa are investment grade; Ba and below are speculative. S&P and Fitch use AAA/AA/A/BBB. A rating change moves price.
14.3 Options
An option is a contract giving the holder the right, but not the obligation, to buy (call) or sell (put) the underlying at the strike price until expiration. A standard equity option covers 100 shares. Standardized listed options are issued and guaranteed by the Options Clearing Corporation (OCC). The buyer pays a premium to the seller (writer).
| Position | Market view | Maximum gain | Maximum loss | Breakeven |
|---|---|---|---|---|
| Long call | Bullish | Unlimited | Premium paid | Strike + premium |
| Short (naked) call | Neutral to bearish | Premium received | Unlimited | Strike + premium |
| Long put | Bearish | Strike - premium (stock goes to zero) | Premium paid | Strike - premium |
| Short put | Neutral to bullish | Premium received | Strike - premium | Strike - premium |
In, at and out of the money. A call is in the money if the stock is above the strike; a put is in the money if the stock is below the strike. Intrinsic value = the amount in the money (zero if not). Time value (extrinsic value) = premium - intrinsic value; it goes to zero at expiration.
Example 8. Long call. A customer buys 2 contracts of an XYZ 50 call at 3.00.
- Cost = 2 x 100 x $3 = $600; this is the maximum loss.
- Breakeven = $50 + $3 = $53.
- If XYZ is $58 at expiration the intrinsic value is $8, so the profit is (8 - 3) x 200 = $1,000.
- If XYZ is $50 or lower at expiration the options expire worthless and the loss is $600.
Example 9. Long put. Buy a 50 put at 3.00. Breakeven = 50 - 3 = $47. The maximum gain (stock to zero) = (50 - 3) x 100 = $4,700 per contract; the maximum loss is $300.
Hedging and income strategies.
| Strategy | Construction | Purpose | Result |
|---|---|---|---|
| Covered call | Own the stock, sell a call | Income; limits upside | Breakeven = stock cost - premium; gain capped at strike + premium - cost |
| Protective put | Own the stock, buy a put | Insurance for a long position | Loss limited to cost + premium - strike; breakeven = stock cost + premium |
| Married put | Buy stock and put together | Same | Same |
| Collar | Own the stock, buy a put, sell a call | Protect downside, give up upside; may be low-cost | |
| Long straddle | Buy call and put, same strike and expiry | Profits from a big move either way | Two breakevens: strike plus total premium and strike minus total premium |
| Spread | Buy and sell options of the same type | Defined risk and reward |
Example 10. Covered call. An investor buys 100 XYZ at $48 and sells a 50 call for $2.
- Breakeven = 48 - 2 = $46.
- Maximum gain = (50 + 2 - 48) x 100 = $400 (if the stock is called away at 50).
- Maximum loss = (48 - 2) x 100 = $4,600 if the stock goes to zero.
Example 11. Straddle. Buy a 50 call at 3 and a 50 put at 2. Total premium $5. Breakevens: 50 + 5 = $55 and 50 - 5 = $45. The maximum loss is $500, at a stock price of exactly $50 at expiration.
Example 12. Bull call spread. Buy a 50 call at 5, sell a 60 call at 2. Net debit $3. Maximum loss = $300; maximum gain = (10 - 3) x 100 = $700; breakeven = 50 + 3 = $53. A debit spread has a maximum loss equal to the net debit.
Other rules. Options accounts require approval and the Options Disclosure Document, and approval by a Registered Options Principal or another principal the rule permits (Rule 2360(b)(16)); a suitability standard applies to each level. Exercise of a stock option settles in the standard stock cycle, which is one business day after exercise (OCC T+1 conversion, effective 2024-05-28). Index options settle in cash. LEAPS are long-dated options. Margin on options is in Chapter 16.