## Equity Securities Overview

Equity securities represent ownership in a corporation. The two main types are common stock and preferred stock. Owning equity means participating in the company's growth and profits, but also bearing the risk of loss. Equity holders are considered residual claimants, meaning they are paid after bondholders and other creditors in the event of liquidation.

## Common Stock

Common stock represents residual ownership and is the most basic form of equity. Common stockholders have:

• Voting rights: To elect directors and approve major corporate policies (e.g., mergers, stock splits). They typically do *not* vote on dividend declarations.
• Pre-emptive rights: The right to maintain their proportionate ownership in the company if new shares are issued.
• Limited liability: Maximum loss is the amount invested.
• Capital appreciation potential: Value can increase over time.
• Risks: Market risk, business risk, and the lowest priority in liquidation (residual claim).

Shares can be authorized (maximum allowed), issued (sold to public), outstanding (issued minus treasury), and treasury stock (issued shares repurchased by the company; no voting rights, no dividends).

## Preferred Stock

Preferred stock is a hybrid security with characteristics of both debt and equity. Key features:

• Fixed dividend: Paid before common stockholders, typically a percentage of par value. Dividends are not guaranteed but must be paid before common dividends.
• No voting rights: Generally.
• Priority in liquidation: Paid before common stockholders, but after bondholders.
• Less capital appreciation potential: Price is more sensitive to interest rate changes.

Types include cumulative (missed dividends accrue), callable (company can repurchase), convertible (can be exchanged for common stock), and adjustable-rate (dividend varies with interest rates).

## Other Equity-Related Instruments

• American Depositary Receipts (ADRs): Facilitate U.S. trading of foreign company stocks. They are denominated in USD and trade on U.S. exchanges, but carry foreign currency risk.
• Rights: Short-term, allow existing shareholders to buy new shares at a discount to the market price, often used to exercise pre-emptive rights. They have intrinsic value.
• Warrants: Long-term options to buy a company's stock at a specified price, typically issued with bonds or preferred stock to make them more attractive. They are usually issued with an exercise price above the current market price (no intrinsic value at issuance).

## Dividends and Corporate Actions

Dividends (cash, stock, property) are paid to shareholders. Key dates:

• Declaration Date: Board declares dividend.
• Ex-Dividend Date: First day stock trades without dividend (typically one business day *before* the record date for regular way trades).
• Record Date: Shareholders on record receive dividend.
• Payment Date: Dividend is paid.

Stock splits (e.g., 2-for-1) increase the number of shares and decrease the price per share, but total market value remains the same. Reverse stock splits do the opposite.

## Debt Securities Overview

Debt securities, commonly known as bonds, represent a loan made by an investor to an issuer (such as a corporation, municipality, or government). In return for the loan, the issuer promises to pay regular interest payments (the coupon rate or nominal yield) and repay the principal (par value, typically $1,000) at a specified maturity date. Bondholders are creditors, not owners, and have a higher claim on assets than stockholders in case of bankruptcy.

## Types of Debt Securities

• Corporate Bonds: Issued by corporations. Can be secured (e.g., mortgage bonds, collateral trust bonds, equipment trust certificates, backed by specific assets) or unsecured (debentures, backed only by the issuer's full faith and credit). Zero-coupon bonds are a type of corporate bond sold at a discount and mature at par, with the difference considered interest.
• Government Securities (Treasuries): Issued by the U.S. Treasury and considered the safest. Includes Treasury Bills (T-bills) (short-term, sold at a discount, no semi-annual interest), Treasury Notes (T-notes) (2-10 years, semi-annual interest), Treasury Bonds (T-bonds) (10+ years, semi-annual interest), and Treasury Inflation-Protected Securities (TIPS) (principal adjusts with inflation).
• Agency Bonds: Issued by federal agencies or government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac, Ginnie Mae. Often mortgage-backed securities (MBS). While not direct obligations of the U.S. government, they carry an implicit government backing.
• Municipal Bonds (Munis): Issued by state and local governments. Interest is generally tax-exempt at the federal level, and often at the state/local level if the investor lives in the issuing state. General Obligation (GO) bonds are backed by the full faith and credit (taxing power) of the issuer. Revenue bonds are backed by the revenue generated from a specific project (e.g., tolls from a bridge).

## Bond Pricing and Yields

Bond prices are quoted as a percentage of par. Corporate and municipal bonds are quoted in 1/8ths (e.g., 98 1/8 = $981.25), while Treasuries are quoted in 1/32nds (e.g., 98-16 = 98 and 16/32nds = $985.00).

• Current Yield (CY): Annual interest / Current market price.
• Yield-to-Maturity (YTM): Total return if held to maturity, considering interest and any capital gain/loss.
• Yield-to-Call (YTC): Total return if the bond is called prior to maturity.

When a bond trades at a premium (above par), the yields rank: Nominal > CY > YTM > YTC. When trading at a discount (below par), the yields rank: YTC > YTM > CY > Nominal. At par, all yields are equal.

## Key Features and Risks

• Call Feature: Allows the issuer to redeem the bond before maturity, typically when interest rates fall. Benefits the issuer, poses call risk (reinvestment risk) to the investor.
• Put Feature: Allows the investor to sell the bond back to the issuer before maturity, typically when interest rates rise. Benefits the investor.
• Convertible Feature: Allows the bondholder to convert the bond into a fixed number of common shares of the issuing company.
• Sinking Fund: A fund established by the issuer to set aside money for principal repayment, enhancing bond safety.

Key risks include interest rate risk (the most significant; bond prices move inversely to interest rates), default risk (credit risk, the issuer may not repay), inflation risk (purchasing power of future payments diminishes), and liquidity risk (difficulty selling quickly without a significant price concession).

## Packaged Investment Products

Packaged investment products allow investors to pool money for professional management and diversification. They offer various structures, risk profiles, and liquidity levels.

## Investment Companies

These entities pool money from investors and invest it in securities. They are regulated under the Investment Company Act of 1940.

Open-End Management Companies (Mutual Funds)

Mutual funds are the most common type of investment company. They continuously offer new shares and redeem existing shares at the Net Asset Value (NAV) at the end of each trading day. They are actively managed, diversified, and offer various share classes (e.g., Class A with a front-end load, Class B with a contingent deferred sales charge, Class C with level loads).

Closed-End Management Companies

Closed-end funds issue a fixed number of shares during an initial public offering (IPO) and then trade on exchanges like stocks. Their market price is determined by supply and demand, which can be above or below their NAV. They do not continuously offer new shares or redeem shares.

Unit Investment Trusts (UITs)

UITs have a fixed portfolio of securities, are unmanaged, and typically self-liquidating. They issue redeemable shares representing an undivided interest in the portfolio.

## Exchange Traded Funds (ETFs)

ETFs are typically passively managed funds that track an index (e.g., S&P 500). They trade on exchanges like stocks throughout the day, allowing for intraday buying and selling. They generally have lower expense ratios than actively managed mutual funds and can be bought on margin or sold short.

## Real Estate Investment Trusts (REITs)

REITs are companies that own, operate, or finance income-producing real estate. They are publicly traded and offer investors a way to invest in real estate without direct ownership. To avoid corporate taxation, REITs must distribute at least 90% of their taxable income to shareholders. They offer liquidity and diversification.

## Direct Participation Programs (DPPs)

DPPs are investments that pass through income, gains, losses, and tax credits directly to the investors, avoiding corporate taxation. Common examples include Limited Partnerships (e.g., real estate, oil and gas). Investors are typically limited partners with limited liability, while a general partner manages the program. DPPs are generally illiquid.

## Collateralized Mortgage Obligations (CMOs)

CMOs are debt instruments backed by pools of mortgages. They are structured into different maturity classes called tranches, each with varying payment priorities and interest rates. CMOs are subject to prepayment risk (when interest rates fall, mortgages pay off early) and extension risk (when interest rates rise, mortgages pay off slowly). They are complex and not suitable for all investors.

## Introduction to Options

Options are derivative securities that derive their value from an underlying asset, typically a stock. They provide the holder with the *right*, but not the *obligation*, to buy or sell the underlying asset at a predetermined price (the strike price) on or before a specific date (the expiration date). The price paid for this right is called the premium.

## Call Options

A call option gives the buyer the right to buy the underlying asset at the strike price.

• Long Call (Buyer): Bullish strategy. Pays the premium. Max loss is the premium paid. Max gain is theoretically unlimited. Breakeven = Strike Price + Premium.
• Short Call (Seller): Bearish strategy. Receives the premium. Max gain is the premium received. Max loss is theoretically unlimited. Breakeven = Strike Price + Premium.

## Put Options

A put option gives the buyer the right to sell the underlying asset at the strike price.

• Long Put (Buyer): Bearish strategy. Pays the premium. Max loss is the premium paid. Max gain is the strike price minus the premium (since the stock price cannot go below zero). Breakeven = Strike Price - Premium.
• Short Put (Seller): Bullish strategy. Receives the premium. Max gain is the premium received. Max loss is the strike price minus the premium. Breakeven = Strike Price - Premium.

## Moneyness and Value

• In-the-money (ITM): An option has intrinsic value.
• Call: Market Price > Strike Price
• Put: Market Price < Strike Price
• Out-of-the-money (OTM): An option has no intrinsic value.
• Call: Market Price < Strike Price
• Put: Market Price > Strike Price
• At-the-money (ATM): Market Price = Strike Price.
• Time Value: The portion of the premium exceeding the intrinsic value. It erodes as expiration approaches.

## The Options Clearing Corporation (OCC)

The OCC is the issuer and guarantor of all listed options contracts. It standardizes contracts and ensures performance. All options trades must be reported to the OCC.

## Customer Accounts and Suitability

Opening New Accounts

When opening a new customer account, registered representatives (RRs) must adhere to specific procedures. The New Account Form collects essential customer information, including name, address, date of birth, Social Security Number (SSN), employment status, investment objectives, risk tolerance, and financial status. The Customer Identification Program (CIP), mandated by the USA PATRIOT Act, requires firms to verify the identity of any person opening an account to combat money laundering and terrorism financing. All new accounts must be approved by a principal (a qualified supervisor) promptly after receiving the necessary information, but before the first trade.

Types of Accounts

• Cash Account: Requires full payment for all securities purchased. No margin borrowing is permitted.
• Margin Account: Allows customers to borrow money from the broker-dealer to purchase securities, using the securities themselves as collateral. This leverages their investment but also increases risk.
• Joint Accounts:
• Joint Tenants with Rights of Survivorship (JTWROS): Ownership passes automatically to the surviving tenant(s) upon the death of one tenant, avoiding probate.
• Tenants in Common (TIC): Each tenant owns a specified percentage of the account. Upon death, the deceased's share passes to their estate, not the surviving tenant(s).
• Discretionary Accounts: An account where the RR has written authorization to make investment decisions (asset, amount, or action) without prior client approval for each trade. A Power of Attorney (POA) grants legal authority to another person to act on behalf of the account holder.

Suitability (FINRA Rule 2111)

FINRA Rule 2111 requires RRs to have a reasonable basis to believe that a recommended transaction or investment strategy is suitable for the customer. This is based on information obtained through the firm's Know Your Customer (KYC) efforts. Suitability has three main obligations:

• Reasonable-Basis Suitability: The RR must have a reasonable basis to believe the recommendation is suitable for *at least some investors*.
• Customer-Specific Suitability: The RR must have a reasonable basis to believe the recommendation is suitable for *this specific customer* based on their investment profile (objectives, risk tolerance, financial situation, tax status, investment experience, time horizon, liquidity needs).
• Quantitative Suitability: The RR must have a reasonable basis to believe a series of recommended transactions, even if suitable individually, are not excessive or unsuitable when viewed in aggregate, considering the customer's investment profile. This prevents practices like churning (excessive trading to generate commissions).

Customer Privacy

Regulation S-P (Privacy of Consumer Financial Information) requires financial institutions to provide customers with a privacy notice explaining what information is collected, where it is shared, and how it is protected. Customers must be given the opportunity to opt-out of information sharing with non-affiliated third parties.

## Market Structures

The secondary market is where securities trade after initial issuance. It facilitates liquidity.

• Exchanges (e.g., NYSE, Nasdaq) are centralized trading venues, often auction markets with specialists/Designated Market Makers (DMMs) or electronic systems.
• Over-the-Counter (OTC) market is a decentralized, negotiated market for unlisted securities (e.g., most bonds, penny stocks). It's a network of dealers.
• Third Market: Refers to OTC trading of exchange-listed securities, primarily by institutional investors. Broker-dealers execute these trades away from the primary exchange.
• Fourth Market: Involves direct institution-to-institution trading of securities, often through electronic communication networks (ECNs) or Dark Pools.
• Dark Pools are private exchanges or forums for trading securities that are not accessible by the investing public. They offer anonymity and minimal market impact for large block trades, reducing price volatility.

## Types of Orders

Orders instruct a broker-dealer on how to execute a trade.

• Market Order: Executed immediately at the best available price. It guarantees execution, but not a specific price.
• Limit Order: An order to buy or sell at a specific price or better. It guarantees price, but not execution.
• Buy Limit: Placed below the current market price.
• Sell Limit: Placed above the current market price.
• Stop Order: Becomes a market order once the "stop price" is triggered (hit or passed). Used to protect profits or limit losses.
• Buy Stop: Placed above the current market price (e.g., to protect a short sale).
• Sell Stop: Placed below the current market price (e.g., to protect a long position).
• Stop Limit Order: Combines features of stop and limit orders. Once the stop price is triggered, it becomes a limit order (not a market order). This guarantees price (if executed), but not execution.

## Order Modifiers and Execution

• Time Limitations:
• Day Order: Valid only until the end of the trading day. If not executed, it expires.
• Good 'Til Canceled (GTC): Remains active until executed or canceled, typically renewed periodically (e.g., every 60 or 90 days).
• Size Limitations:
• Fill-or-Kill (FOK): Execute the entire order immediately, or cancel it. No partial fills.

Immediate-or-Cancel (IOC): Execute as much as possible immediately; cancel the remaining balance. Partial fills are allowed.

• All-or-None (AON): Execute the entire order, but not necessarily immediately. It can be held until the full amount is available.
• Bid and Ask:
• Bid: The highest price a buyer is willing to pay for a security.
• Ask (Offer): The lowest price a seller is willing to accept for a security.
• The spread is the difference between the bid and ask, representing the market maker's profit.
• Market Makers/Specialists/DMMs: Broker-dealers who stand ready to buy and sell specific securities, providing liquidity and maintaining a fair and orderly market by quoting both bid and ask prices.

## Municipal Securities Overview

Municipal securities are debt obligations issued by state and local governments and their agencies. They are used to finance public projects like schools, roads, and hospitals. A key characteristic is that the interest income is generally exempt from federal income tax, and often from state and local taxes if the investor resides in the issuing state (known as triple tax-exempt).

## Types of Municipal Bonds

1. General Obligation (GO) Bonds: These are backed by the full faith and credit and taxing power of the issuing municipality. For cities and counties, this means ad valorem taxes (property taxes); for states, it includes sales and income taxes. GO bonds typically require voter approval and are subject to statutory debt limits. They are considered less risky than revenue bonds.

2. Revenue Bonds: These bonds are backed by the revenues generated by a specific project or facility, such as tolls from a turnpike, user fees from a water treatment plant, or lease payments from an airport. They are self-supporting and do not typically require voter approval. Revenue bonds are generally considered riskier than GO bonds because their repayment depends solely on the success and revenue stream of the specific project.

## Disclosure and Regulation

For new issues, the primary disclosure document is the Official Statement (OS), prepared by the issuer. It provides detailed information about the bond, the issuer, and the project.

The Municipal Securities Rulemaking Board (MSRB) is the primary regulatory body for the municipal securities market. The MSRB creates rules for municipal securities firms, including broker-dealers and municipal advisors, but it does not regulate the issuers themselves. MSRB rules are enforced by FINRA (for broker-dealers), the SEC (for broker-dealers and municipal advisors), and federal bank regulators.

## Tax Considerations

While interest income is often tax-exempt, capital gains from selling a municipal bond are always subject to federal, state, and local taxes. Certain municipal bonds, known as private activity bonds, may have interest income subject to the Alternative Minimum Tax (AMT) for some investors. Investors often calculate a tax-equivalent yield to compare tax-free municipal bonds with taxable investments: Tax-Equivalent Yield = Tax-Free Yield / (1 - Investor's Tax Bracket).

## Key MSRB Rules

Rule G-37 is a critical MSRB rule that prohibits municipal firms from engaging in municipal securities business with an issuer for two years after making a political contribution to an official of that issuer. This rule aims to prevent pay-to-play practices.

## Regulations and Prohibited Activities

Understanding the rules governing the securities industry is crucial for protecting investors and maintaining market integrity. Key regulatory bodies include the Securities and Exchange Commission (SEC), the primary federal regulator responsible for enforcing federal securities laws. FINRA (Financial Industry Regulatory Authority) is the largest self-regulatory organization (SRO) for broker-dealers, creating and enforcing rules for its members. The Municipal Securities Rulemaking Board (MSRB) regulates municipal securities firms and professionals.

## Prohibited Activities and Market Manipulation

Broker-dealers and their representatives must adhere to strict ethical standards. Prohibited activities include:

• Market Manipulation: Actions designed to deceive or defraud investors by artificially influencing prices. Examples include:
• Churning: Excessive trading in a customer's account solely to generate commissions.
• Front-Running: A broker executing orders for their own account ahead of a customer's pending order, knowing it will impact the price.
• Free-Riding: Buying and immediately selling securities without paying for them.
• Painting the Tape: Spreading rumors or engaging in trades to create false activity or price movements.
• Insider Trading: Using material, non-public information to trade securities for personal gain or to tip others. Both the "tipper" (one who provides information) and the "tippee" (one who receives and acts on it) can be held liable. Penalties include significant fines and imprisonment.
• Misrepresentation: Making false or misleading statements about a security or service, or omitting material facts.
• Guarantees: Promising a customer a specific return or protection against loss. This is strictly prohibited.
• Sharing in Accounts: Representatives may only share in profits/losses of a customer account if they have written permission from the customer and the firm, and the sharing is proportionate to their financial contribution (unless it's a joint account with a family member).
• Borrowing/Lending: Generally prohibited unless the customer is a financial institution, or there's a pre-existing personal or business relationship, and the firm approves.

## Anti-Money Laundering (AML)

The Bank Secrecy Act (BSA) and the USA Patriot Act are foundational to AML efforts. Firms must establish comprehensive AML programs.

• Customer Identification Program (CIP): Required under the Patriot Act to verify the identity of new customers.
• Suspicious Activity Reports (SARs): Must be filed with FinCEN for transactions of $5,000 or more that are deemed suspicious, within 30 days of detection.
• Currency Transaction Reports (CTRs): Filed with FinCEN for cash transactions exceeding $10,000 within a 24-hour period.
• Office of Foreign Assets Control (OFAC): Maintains a list of Specially Designated Nationals (SDNs) with whom U.S. persons are prohibited from doing business. Firms must block accounts and report to OFAC.

## Communication with the Public

FINRA rules govern all communications with the public:

• Retail Communications: Any written (or electronic) communication distributed to 25 or more retail investors within a 30-calendar-day period. Requires principal approval and often FINRA filing.
• Correspondence: Any written (or electronic) communication distributed to fewer than 25 retail investors within a 30-calendar-day period. Subject to supervision and review, but not necessarily principal pre-approval or FINRA filing.
• Institutional Communications: Any written (or electronic) communication distributed exclusively to institutional investors. Subject to supervision and review, but typically not principal pre-approval or FINRA filing.