Canadian Securities Exam Fast-Track Study Guide

By W. Sean Cleary

Whether your career aspirations lie in banking, financial planning, the mutual fund industry or a brokerage, you can't avoid taking the Canadian Securities Exam. But there's a lot of material to know for the day of the examination, and it can be a daunting task to assimilate such a wide body of knowledge.

The Wiley Canadian Securities Exam Fast-Track Study Guide is a quick-review tool that covers all the basics you need to know to pass the exam. It presents "quick hits" of the key points you need to know, in language that's easy to understand and follow. This concise study aid:

• summarizes the essential, "need-to-know" information
• highlights important topics
• features multiple choice review questions at the end of each chapter
• makes material easy to read, understand and remember
• includes two practice exams and double the number of review questions in the last edition

This edition has been completely updated and revised to reflect recent changes to the course and the exams. It features updates throughout, new questions and new practice exams, and it has been restructured for ease of use and comprehension.

Don't let the stress and amount of material you need to know for the exam overwhelm you. Prepare yourself with the Wiley Canadian Securities Exam Fast-Track Study Guide. It's the perfect quick-review tool to wrap up your studying and help you focus on doing your best on the exam.

• Language: English
• Publisher: Wiley
• Release date: Oct 15, 2009
• ISBN: 9780470675731

Book preview

chapter 1

THE CAPITAL MARKET

CSC EXAM SUGGESTED GUIDELINES:

15 questions combined for Chapters 1 to 3

INTRODUCTION

004

The vital function served by financial markets is the transfer of wealth from those who have extra wealth to those who need capital. In other words, financial markets drive economic growth by transforming savings into investments.

• The three components of this process of wealth transfer are

1. financial instruments;

2. financial markets; and

3. financial intermediaries.

SUPPLIERS AND USERS OF INVESTMENT CAPITAL

Investment Capital

005

Capital incorporates the savings of individuals, corporations, governments, and other entities. It is scarce and valuable; however, it is only economically significant when it is properly utilized.

006

Capital can be utilized through

1. direct investment in real assets that generate wealth directly (e.g., land, buildings, equipment, human capital) or

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2. indirect investment in financial assets (e.g., stocks, bonds, treasury bills), which allows issuers of these securities to invest funds directly in wealth generating assets.

008

Capital is mobile, scarce, and sensitive — efficient allocation promotes economic growth, while inefficient allocation can constrain economic growth. As a result of these characteristics, capital is selective and tends to flow toward attractive economic environments.

• Capital tends to flow in and out of countries in response to several variables such as

• the political environment;

• economic trends;

• fiscal policy;

• monetary policy;

• investment opportunities and risk-return opportunities; and

• labour force characteristics.

• The availability of capital is critical to any nation. It is necessary to promote economic output, improve productivity, encourage innovations, and in general improve the competitive position of a nation.

Sources of Capital

009

Investors, both retail and institutional, provide investment capital. Retail refers to investors who invest for their own account, while institutional investors are organizations such as pension funds or mutual funds that buy and sell securities on behalf of the underlying entity — which in turn is set up to serve its plan members, unit holders, etc. Individuals represent a significant source of investment capital in Canada.

• Corporations tend to retain a large portion of their earnings to finance operations and growth and are not an important source of capital.

• Canadian governments have generally been net borrowers in recent years to fund their deficits.

• Foreign investment has grown in importance in Canada and has been necessary to fund deficits and growth. The benefit of this fact is that it helps to expand our international trading relationships, while the cost is that this may take long-term cash flows out of the country. It is an issue that will be debated for some time to come.

• Non-residents can invest in Canada through Canadian firms (which may be located at home or abroad), or through bonds or stocks that are listed on foreign exchanges or over-the-counter markets (such as the NASDAQ stock market in the United States).

• There are two main categories of international bond issues:

1. Foreign bonds: offered and denominated in the currency of a country other than the borrower and

2. Eurobonds: which may be denominated in one of several currencies and are sold in countries other than the currency in which they are denominated.

Investment Objectives

010

Primary investment objectives include

1. safety,

2. income, or

3. growth of capital.

These objectives are primarily mutually exclusive in the sense that one security can’t maximize two or more of these primary objectives. In other words, trade-offs exist. For example, if you wish to maximize safety, you must be willing to sacrifice income and growth potential.

• Secondary investment objectives include marketability or liquidity and tax minimization. They are secondary in the sense that they should never override a primary investment objective.

• The following table shows in general how well suited bonds, preferred stocks, and common stocks are to satisfying each of these objectives:

011

Users of Capital

• Individuals use capital primarily for consumption purposes, with the funds usually being obtained through personal loans, mortgage loans, or charge accounts.

• Businesses use capital to finance day-to-day operations, to maintain and upgrade plant and equipment, and to finance growth. A large proportion of funds are financed internally (through reinvested earnings), with the remainder coming from bank loans and through the issue of securities such as money market, bond, and equity instruments.

• Canadian governments have a long history of deficits, a situation that requires them to borrow to finance their expenditures.

• The federal government finances its debt using

1. treasury bills (T-bills);

2. marketable short- and long-term bonds (debentures); and

3. Canada Savings Bonds and Canada Premium Bonds (which can be sold only to Canadian residents).

T-bills and marketable bonds may be purchased by foreign investors.

• Prior to 1995, the yields on the Government of Canada’s debt were generally higher than on U.S. government debt. Since then, our yields have been lower than those in the United States. This change reflects the improved financial position of the federal government in recent years, as the government reduced, then eliminated, its federal budget deficit.

• Provincial governments may issue non-marketable bonds to the federal government or borrow funds from the Canada Pension Plan (CPP) assets (or QPP for Quebec firms). They may also issue marketable bonds, T-bills, or provincial versions of savings bonds.

• Municipal governments borrow to provide local services such as streets, sewers, waterworks, and police and fire protection. They often do so in the form of serial or installment debentures (which will be discussed in Chapter 6).

THE ROLE OF FINANCIAL INSTRUMENTS

• The broad categories of financial instruments available are discussed below, and they are elaborated upon in subsequent chapters. The role of these instruments is to enable the transfer of capital from suppliers to users. The financial markets provide the environment that allows this transfer to take place, as discussed in the section below.

Financial Instruments

These are legal, formal documents that set out the rights and obligations of the parties involved. The major categories are described below:

DEBT

• Represents a legal obligation to repay borrowed funds at a specified maturity date and provide interim interest payments as specified in the agreement.

• Examples include bank loans, commercial paper, treasury bills, mortgages, bonds, debentures, as well as many other instruments.

EQUITY

• Represents part-ownership of a company.

• Common shares usually provide holders with voting privileges and holders may receive dividends (however, they are not obligatory).

• Preferred shareholders typically receive a fixed dividend amount that must be paid before any dividends are paid to common shareholders.

INVESTMENT FUNDS

• An investment fund is a company that manages investments for its clients. The most common form is the open-end fund, which is known as a mutual fund.

DERIVATIVE PRODUCTS

• Derivatives are so-called because they derive their value from the price of another underlying asset such as a stock, stock or bond index, commodity price, etc.

• They are suitable for hedging or speculative purposes by more sophisticated investors.

OTHER INVESTMENT PRODUCTS

• Income trusts and exchange-traded funds are recent innovations that have become very popular investments. Both trade on stock exchanges, and both will be discussed in later chapters.

FINANCIAL MARKETS

• The benefits of investment products depend on the existence of efficient markets for buying and selling these instruments. An efficient market should allow for fast and low-cost transactions, and maintain a high degree of liquidity. Obviously, proper regulation of these markets is essential.

• Primary markets involve the sale of securities to the market by the issuer for the first time, and money flows to the issuer. They may be in the form of seasoned offerings or initial public offerings (IPOs). Secondary markets involve the sale of previously issued securities. No funds go the issuer. Secondary markets facilitate the primary markets by making securities transferable.

• Financial intermediaries improve the efficiency of markets by facilitating the trading or movement of the financial instruments that transfer capital between suppliers and users (including corporate, government, private, and global entities).

• Examples of financial intermediaries include the Bank of Canada, chartered banks, trust and mortgage companies, credit unions, insurance companies, pension funds, investment dealers/bankers, venture capital firms, mutual funds, leasing companies, sales finance companies, and factors.

Auction Markets (Stock Exchanges):

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Auction markets are those where all transactions converge to one location.

• Canadian stock exchanges have undergone significant changes in recent years. At the start of 1999, there were five stock exchanges in Canada: the Toronto Stock Exchange (TSX — formerly called the TSE), the Montreal Exchange (ME), the Vancouver Stock Exchange (VSE), the Winnipeg Stock Exchange (WSE), and the Alberta Stock Exchange (ASE). A complete overhaul of that structure occurred during 1999 and 2000, and as a result of this restructuring, there are two remaining stock exchanges in Canada — the TSX and the newly created TSX Venture Exchange (which replaced the Canadian Venture Exchange in 2001). Both of these exchanges are owned by the TSX Group Inc., which became the first North American exchange to become publicly listed in November 2002. Trading operations for both the TSX and the TSX Venture Exchange are conducted by TSX Markets, also a member of the TSX Group.

• In May 2008, the TSX Group and the ME merged to form the TMX Group.

• Today, the TSX is the official exchange for trading of Canadian senior stocks — big companies with solid histories of profits. In 2007, the TSX accounted for approximately 64% of the volume of shares traded in Canada and 97.4% of the dollar value of share trades.²

• There are over 80 exchanges in 60 countries, and the TSX was the seventh largest exchange in the world in 2002, based on market capitalization, with the New York Stock Exchange being number one, followed in order by Tokyo, NASDAQ, London, and Euronext.²

• Since March 2000 the Bourse de Montreal assumed its role as the Canadian national derivatives market, and it now carries on all trading in financial futures and options that previously occurred on the TSX, the ME, and the now-defunct Toronto Futures Exchange.

• The only other Canadian exchange is ICE Futures Canada (formerly the Winnipeg Commodity Exchange), which handles futures trading in commodities and is discussed in Chapter 10 along with the Bourse.

• Traditionally, exchanges have been not-for-profit organizations. Under this arrangement, stock exchange memberships (in the form of stock exchange seats) are sold to individuals, which permits them to trade on the exchange. These seats are valuable assets that may be sold, subject to certain exchange conditions. For-profit exchanges are now owned by the shareholders, and firms (called Participating Organizations or Approved Participants) do not have to be owners to have access to exchange trading.

• Member firms must be publicly owned, they must maintain capital adequacy requirements, and key personnel must complete required courses of study.

• Exchanges are governed by bodies that consist of at least one permanent exchange official (e.g., the president), plus members of the Board of Directors who are selected from member firms, as well as two to six highly qualified Public Governors appointed or elected from outside the brokerage community.

• Exchanges are financed by transaction fees, initial listing fees, sustaining listing fees, fees paid by companies with respect to capital structure changes, and through the sale of historic and market information.

• Over the past decade, several trends have emerged in response to increased global trading and the resulting competition, as well as to the availability of enhanced technology. These include the dominance of electronic trading systems over physical locations, increasing mergers and alliances (the number of exchanges has decreased from over 200 to fewer than 100), and the move to the for-profit corporate structure.

• Future trends expected to continue are the move to for-profit structures, additional mergers, increased focus on niche markets, and easier trading between exchanges.

• Exchanges have the power to suspend the trading or listing privileges of an individual security temporarily or permanently.

Temporary withdrawals of privileges include

1. delayed opening (which may arise if there exists a large number of buy and/or sell orders);

2. halt in trading (to allow significant news to be reported, such as merger activity); and

3. suspension of trading, which may occur for more than one session until an identified problem is rectified by the company to the exchange’s satisfaction (if the company fails to meet requirements for continued trading or does not comply with listing requirements).

A listed security can be cancelled or delisted for a variety of reasons such as

1. it no longer exists (e.g., a preferred share issue that has been redeemed);

2. the company has no assets or is bankrupt;

3. public distribution of the security is no longer sufficient; or

4. the company no longer complies with the terms of its listing agreement.

Dealer Markets: The unlisted market

013

Dealer markets or over-the-counter (OTC) markets comprise a network of dealers that trade directly with each other over the phone or through a computer network. They are negotiated networks, which maintain bid and ask quotations received from the dealers acting as market makers in given securities. Market makers execute trades from their inventories.

014

Almost all bonds and debentures are sold through dealer markets (about 14 times the volume that is conducted for unlisted equities); however, the volume of unlisted equity trading is much smaller than the volume of exchange-traded equity transactions.

• It is important to note that this market does not set listing requirements.

• Unlisted trades need not be reported except in Ontario, where the Ontario Securities Commission (OSC) requires such trades to be reported on the Canadian Unlisted Board Inc. automated system.

• The first Canadian quotation and reporting system, the Canadian Trading and Quotation System Inc. (CNQ), was launched in July 2003. These stock markets operate similar to exchanges, by providing users with the means to post quotations and report trades, and CNQ became officially recognized as an exchange in 2004. The CNQ provides an alternative market for small cap emerging companies, since the requirements to trade on this market are less stringent than those required to trade on the TSX Venture Exchange. It is regulated by the Investment Industry Regulatory Organization (IIROC).

Alternative Trading Systems:

• Alternative Trading Systems (ATS) are computerized systems that execute orders outside traditional exchange facilities by matching orders from their own inventory, or by matching buy and sell orders from outside parties. Sometimes, they permit buyers and sellers to contact each other directly to negotiate trades. These systems are privately owned, often by individual brokerage firms or groups of firms. Most of their customers are institutional investors, who are able to reduce their transactions costs through the use of such a system. In addition, since these systems can operate when exchanges are closed, they are ideal for the trading of securities on a global basis.

• Concern has mounted over the growth of ATS trading because the details of such trades are not available to the general public, there is the ever-present threat of technological problems, and potential issues can arise from trading across country borders. In response to such concerns, both Canada and the United States have recently introduced legislation to regulate ATS trading activities. There are currently dozens of ATS in the United States, but there were only four in Canada as of 2008. Trading activity of Canadian ATS is governed by IIROC.

• Three recently launched electronic trading systems handle much of the bond and money market OTC trades in Canada. They are:

1. CanDeal: A joint venture among Canada’s largest six investment dealers, and a member of IIROC. Handles federal government bonds and plans to expand to provincials, corporate debt and commercial paper. Handles over 80% of market transactions.

2. CBID: IIROC member and ATS. Maintains retail and institutional marketplaces, dealing with more than 2,500 debt instruments.

3. CanPX: Joint venture of Investment Industry Association of Canada (IIAC) and IIROC member firms. Deals in government bonds and T-bills, and some corporate bonds.

Chapter 1 Review Questions

015016

Bonus Questions

017018

chapter 2

THE CANADIAN SECURITIES INDUSTRY

CSC EXAM SUGGESTED GUIDELINES:

15 questions combined for Chapters 1 to 3

THE ROLE OF FINANCIAL INTERMEDIARIES

• "Intermediaries" facilitate the transfer of capital from suppliers to users. There are several categories of intermediaries, and they tend to focus on different aspects of this process. For example, banks and trust companies accept deposits from their customers (capital suppliers) and lend to capital users. Investment funds, pension funds, and insurance companies use the funds collected from their customers to invest in the financial securities (e.g., bonds, equities) of various users of capital. Investment dealers serve a number of functions in the capital transformation process, sometimes acting as agents for their clients, and sometimes acting as principals (on their own behalf). These points are elaborated on in the next section.

• The Canadian financial system is very solid, and has experienced substantial growth in recent years. The total assets of financial institutions grew by approximately 47% over the 2003 to 2007 period, from $3.02 trillion to $4.44 trillion. Investment fund assets increased 50.1% over this period, from $454 billion to $681 billion. Bank assets also grew dramatically, from $1.96 trillion to $2.98 trillion. This growth has been attributed to increased international activity, changes in the Bank Act permitting them to compete in new financial sectors, and the creation of new banks (especially foreign-owned Schedule II and III banks).

THE CANADIAN SECURITIES INDUSTRY

The Securities Industry Today:

• Some basic characteristics of the Canadian securities industry include the following:

1. The dollar value of new issues brought to market exceeded $249 billion in 2007.

2. The combined trading activity in money and bond markets reached approximately $15.7 trillion in 2007. Equity trading reached $1.7 trillion that year.

• There were 203 securities firms in Canada as of 2007, with the larger houses that are national in scope accounting for about 70% of total industry revenue. Many of the smaller firms are referred to as investment boutiques, which reflects the fact that they tend to concentrate on one particular segment of the market.

• In addition to traditional full-service brokers, there are presently a large number of discount brokerage firms in Canada that execute trades over the phone or via the Internet. They provide fewer services, but offer investors much lower fees, and are ideal for more knowledgeable investors.

• One might expect a typical large securities firm to be organized into several departments dealing with sales, underwriting/financing, trading, research and portfolio services, and administration. A number of the smaller dealers specialize in areas such as unlisted stock trading, tax-shelter sales, etc. In addition, the major banks have opened discount brokerage services.

• The industry is highly leveraged, and short-term funding is obtained through a variety of arrangements, including

1. day-to-day loans by chartered banks that are secured by the dealer’s inventory of T-bills and short-term Canada bonds;

2. call loans by banks that are secured by a wide range of securities and must be liquidated within 24 hours after notice has been given;

3. purchase and resale agreements with the Bank of Canada; and

4. free credit balances from customer accounts, which represent another source of borrowed funds on which interest must be paid.

• Competition in the securities industry has become fierce as a result of the growth of electronic communications and computerized trading, as well as the increased globalization of world financial markets. This increased globalization of markets is evidenced by several developments, including the following:

1. The increase in the number of interlisted securities, which refers to those that are listed on exchanges in more than one country (e.g., Royal Bank is listed on the TSX and the NYSE).

2. The linking of most major stock exchanges around the world electronically through exchange trading links.

3. The extension of trading hours that many exchanges around the world offer, in order to allow responses to global events.

4. The growth of unregulated markets, such as the Eurobond market.

5. The large increase in investment mobility, with investors shifting their funds across borders, much more often, and with less difficulties than in the past.

Primary Markets

019

An important role for investment dealers (IDs) is to bring together those with surplus capital with entities that require investment capital. This function is performed in the primary or new issue market, where the IDs may act as principals or agents.

020

Underwriting or financing refers to the purchase of new securities from the issuer on a given date at a specified price, which is then to be sold to others. IDs serve as principals under this arrangement, and their compensation is the spread between the purchase price and the resale price. Under this arrangement, dealers assume the risk of the security not selling at adequate prices; however, they take a number of precautions to minimize this risk. Typically, they work closely with the issuers regarding the pricing, timing, and design of the issue so that it will be well received by the market. In addition, underwriting syndicates are often formed to spread the financing risk and enhance marketability of the issue. The issue may also include special clauses that may terminate the agreement under exceptional circumstances.

021

IDs may also perform this function by assuming the role of agents who market the newly issued securities on a "best efforts" basis. They receive compensation in the form of a commission, and it is the issuer that assumes the risk of the issue not selling. This arrangement is more typical for issues of smaller or more speculative companies, or for private placements for large companies with good credit ratings (where the risk of the issue not selling is negligible).

Secondary Markets

022

IDs also serve an important role in secondary markets, which facilitate the transfer of existing securities among investors. Secondary markets enhance the effectiveness of the primary market. This function may also be achieved by having IDs act as principals or agents.

023

IDs serve as principals by trading securities with clients from their own inventory, and also when they trade for their own account. They earn income in the form of a spread and assume the majority of the risk.

024

IDs act as brokers (or agents) when they execute transactions for customers and charge them commissions. Minimum commission rates are no longer prescribed by the exchanges, and commissions may be negotiated between clients and their brokers. This has led to the development of several discount brokerage houses in Canada, which eliminate many traditional services offered by full brokerage firms and pass the savings on to investors in the form of reduced commission fees. They are tailored toward knowledgeable do-it-yourself investors.

• A typical agency transaction involves clients instructing their IDs to get the best possible price (i.e., a market order to be discussed in Chapter 9). Once the transaction is completed on the floor (or electronically), the details of the trade are reported over the exchange’s ticker, and the buying and selling firms are provided with specific details of the trade (e.g., price, time, identity of the other party). The firms phone their clients to confirm the transaction, and then mail written confirmation to them that day or the next business day.

• Once the transaction has occurred, the parties must settle the transaction. If the buying firm has sufficient funds available in its cash or margin account, these funds will be used to execute the transaction. Otherwise, the buyer must provide sufficient funds by the