Module 4

More commonly referred to as the Fed, was founded by Congress in 1913. Its purpose is to regulate the economy by establishing the monetary policies of the government, regulate banks, maintain stability of the financial system, and provide financial services to the U.S. government. One of its most visible tasks is the controlling of the federal funds rate and the discount rate. Through the control of these rates, the Fed attempts to keep inflation in check and promote the credit and banking system within the U.S.

• •Open market operations
• •Discount rate
• •Reserve requirement
• •Margin requirements

More money flows into the economy. This increases the money supply, or eases money, which causes interest rates to go down. As interest rates go down, the prices of Treasury securities go up.

• •If the Fed (FOMC) is buying, overnight lending between banks goes down.
• •If the Fed is selling, there may be more overnight borrowing by the banks.

The Fed controls the money supply by changing the DISCOUNT RATE, which is the rate that the Fed lends money to member banks for loans.

By changing the discount rate, the Fed controls the money supply.

Fewer banks borrow money, and the supply of money available for loans decreases. The result is that fewer customers borrow due to the higher costs of borrowing. When the Fed increases the discount rate, it discourages borrowing. In contrast, when the Fed decreases the discount rate, it encourages borrowing, because the cost of borrowing is reduced.

It influences other interest rates as well. The yields on outstanding short- and long-term corporate, municipal, and U.S. government debt securities are also affected. As interest rates increase, commercial paper, negotiable CDs, T-bills, and bonds all decrease in price, causing their yields to rise. As interest rates decrease, the same securities increase in price, causing their yields to decrease.

The Fed can control the money supply through the use of the RESERVE REQUIREMENT. The reserve requirement is the percentage of deposits that the banks must keep on reserve and not loan out to other customers.

• The banks must keep more of their deposits in reserve, and as a result, they have less money available to lend. If demand for loans exceeds available supply, the costs of borrowing may increase. Higher interest rates (borrowing costs increase) result in fewer people borrowing, which, in turn, result in less money being circulated in the market. Less money in the marketplace results in slower growth.
• •If the Fed increases the reserve requirement, it lowers the money supply.

• The banks have to keep less deposit money in reserve and therefore have more to lend. This will allow the banks to lend and keep up with the demand, thus lowering interest rates and encouraging more borrowing, which, in turn, results in more money in the market being used.
• •If the Fed decreases the reserve requirement, it increases the money supply.

• •Reg T defines the terms of margin lending by broker/dealers to customers. The rule establishes the initial requirements and defines eligible securities to be used as collateral for margin loans.
• •Reg U defines the amount of money that a bank can lend to a customer for purchases of securities.

• •Selling Treasury securities in the open market
• •Raising the discount rate
• •Raising the reserve requirement
• •Raising the margin requirement

• •Buying Treasury securities in the open market
• •Lowering the discount rate
• •Lowering the reserve requirement
• •Lowering the margin requirement

• •The Fed influences the banks by persuading them to follow its lead. The Fed can suggest that banks restrict or loosen credit on their own and the Fed can use its authority, if needed.
• •If the Fed wants the money supply to decrease, but doesn’t want to raise rates, it will notify the banks and “request” that they increase their reserves. Since self-imposed restrictions are easier to remove, the banks will do so. Moral suasion is the unofficial method of controlling the money supply, but it is not a correct answer for the test.

The FEDERAL FUNDS RATE is the interest rate that commercial banks charge when borrowing from each other to meet the overnight reserve requirement. This is sometimes called the OVERNIGHT LENDING RATE. Banks would rather borrow from each other to meet overnight reserves than go to the Fed for the money.

• •Prime rate
• •Call money rate
• •Commercial paper rate
• •Banker’s acceptances rate
• •Discount rate
• •Federal funds rate

Is the rate that broker/dealers charge clients for purchases of exchange-listed securities on margin. This is the rate charged on the client’s debit balance.

COPYRIGHT

M1, M2, and M3. Note that M1 is the most liquid of all of these and represents the cash that is spent on goods and services on a daily basis.

• •All currency in circulation
• •Demand deposits
• •Interest-bearing checking accounts

• •Money market funds
• •Small savings and small “time” deposits
• •Overnight repurchase agreements
• •Overnight Eurodollar deposits

• •Large time deposits in commercial and savings banks and savings and loans ($100,000 or more) (Large time deposits are also called jumbo CDs.)
• •Balances in institutional money funds
• •Eurodollars held by U.S. residents in foreign branches of U.S. banks

Liquidity includes M3 plus liquid assets held by individuals.

Is the increase in the average price level of all products in an economy.


Inflation increases when the demand increases faster than the supply.

Is the decrease in the average price level of all products in an economy.

• The amount of times a dollar is spent in a given period of time is called the VELOCITY OF MONEY.
• Economist Irving Fisher first explained the concept of the velocity of money (also known as the TURNOVER OF MONEY), in the 1920s. In essence, the greater turnover of a monetary unit for goods and services, the greater the velocity of that monetary unit. The Federal Reserve Board factors the velocity of the dollar into our nation’s monetary policy. Therefore, the faster that money is being used again, the less the Fed has to go in and change the money supply through the buying and selling of Treasury securities in its open market operation. If the velocity of money slows down, the Fed uses its open market operations to inject money into the economy. Any downtrend in velocity could signal a reduction in economic growth — even if the money supply stays the same.

a short-term decline in business activity, stock prices, and employment. A recession is also defined as two consecutive quarters of declining business activity, as measured by the Gross Domestic Product (GDP).

Is defined as a general economic decline with falling prices, high unemployment, and a low confidence in the economy. It is sometimes also defined as six consecutive quarters of declining business activity as measured by the GDP.

• Is also an indicator of the economy in that it reflects the money supply as well as the demand for money. The prime rate is the rate the banks charge their best customers during these demands. Banks set the prime rate according to demand for money and the rate at which they can get the funds from the Fed.
• The demand for money drives the rates higher. Interest rates directly influence bond prices. This is true because as interest rates climb, bond prices drop due to the low demand for the outstanding low-interest bonds.

The prime rate reflects the money supply and the demand for money.

• In reviewing the impact of changing interest rates on fixed rate investments, short-term bonds react more quickly to fluctuating interest rates than do long-term bonds. This quick change is due to the need for short-term bonds to adjust to the present rates.
• Long-term bonds adjust their prices more. Because the premium or discount of long-term bonds is divided by a larger number (the time to maturity) to achieve the same change rate, these bonds move more in price.
• At all times, the par value has a tendency to pull prices to it faster than letting prices be driven away from it.

Short-term bonds react quickly to fluctuating interest rates and adjust their present rates.

• Utility companies and auto manufacturers are greatly affected by changing interest rates because they borrow for a large amount of their expansion.
• When an investor has a municipal bond portfolio, the one risk that cannot be protected against is overall interest rate risk.

1. The U.S has a large trade deficit with other countries causing them to have a trade surplus with us.



This means that the U.S. is buying more goods from other countries than we are exporting to those countries.

• 2. The center of economic activity is shifting to fast-growing countries such as China, Japan, and Brazil.
• This is because products are being made in these countries by cheap labor, thus creating trade surpluses for those countries and trade deficits for the U.S.

• 3. The dollar is the underlying backing of all foreign currency.
• Today, the dollar, not gold, underlies world currencies

•When the U.S. dollar loses value, U.S. exports become more competitive in markets at home and abroad, while foreign goods become less competitive.

•When the U.S. dollar increases in value, or if the exchange rate increases, U.S. goods become less competitive at home and abroad, and foreign goods become more competitive.

The Euro is the main currency used in most of the countries in Europe.

• •Euro holders use the Euro in their trade with other businesses and individuals, and usually do not exchange it for the currency of their country. However, the currency of these countries can be exchanged for the Euro.
• •Only those countries that have adopted the Euro use it as payment for services and goods, and those that do not treat it as a foreign currency.

• •Monetarist theory
• •Keynesian theory
• •Supply-side theory

• Monetarists believe that the actions of the Federal Reserve Board represent the largest influence on the business cycles and, thus, on our economy.
• •Monetarists believe that the most influence can be exerted on the economy by changing interest rates and the money supply.

Keynesians believe that if the government raises taxes and puts more money in the economy through increased government spending, it will result in more money for people to spend. While some people believe that raising taxes takes money out of people’s hands and, therefore, gives them less money to spend, Keynesians feel that the more the government spends, the more prosperous the economy.

• an opposing theory to the Keynesian theory, holds that good fiscal policy, tax cuts, and less government spending will generate a healthy economy. The supply-side theory suggests that the government should take a passive role in the economy.
• •This theory holds that with tax cuts, people have more money in their pockets thus encouraging more spending and, therefore, increased economic growth. This was a major economic theory followed during President Reagan’s term in office during the 1980s. The nickname “Reaganomics” reflects the use of this economic theory.

Leading indicators are signs suggesting where the market may be in four to six months.

• •STANDARD & POOR’S 500 INDEX (S&P 500)
• •BUILDING PERMITS FROM THE HOUSING STARTS REPORTS
• •DURABLE GOODS (also known as CONSUMER GOODS)
• •MACHINE TOOL ORDERS
• •CONSUMER CONFIDENCE INDEX (CCI)

Tend to move as the economy moves. These indicators usually do not forecast how the economy will go, but rather show the trend that the economy is taking.

•INDUSTRIAL PRODUCTION INDEX — This index generally shows the capacity at which our nation is producing goods. If we are producing at 40% to 60%, we can assume that orders are down, inventories may be built up, and people are not spending. In contrast, if we are at 80% to 90% productivity, people are buying and the economy is strong.

• EMPLOYMENT
• GROSS DOMESTIC PRODUCT (GDP)
• GROSS NATIONAL PRODUCT (GNP)
• CONSUMER PRICE INDEX (CPI)

Is actually found in all of the indicators, but because it can be a leading, coincidental, or lagging indicator (depending upon which employment is being considered), it is not considered a correct answer for an indicator on the test.

The GNP is also not an indicator, but a quarterly report showing how the economy is growing or not growing. This is never a correct answer for an indicator on the test. The most accurate method of looking at the GNP is through constant dollars. This report is the same as the GDP except that it does include the cost of goods and services produced by U.S. companies in foreign countries.

• Remember them in alphabetical order: E, P, R, T.
• •EXPANSION or RECOVERY— when things are getting good and the economy is rising
• •PEAK — the high point
• •RECESSION or CONTRACTION — when business is doing poorly and the economy is going down
• •TROUGH — the low point

• An analyst will generally fall into one of these two categories:
• •Fundamental analysts
• •Technical analysts

• FUNDAMENTAL ANALYSTS look at the company’s financial performance to determine how the stock will perform. They determine the future movements of stock by watching a company’s:Fundamental analysts look at the company and how it measures up to its competitors.
• •Management
• •Outlook
• •Research abilities
• •Earnings
• •Dividends
• •Balance sheet
• •Annual report
• •Financial ratios (working capital, current ratio, debt/equity ratio, and so forth)

Fundamental analysts look at the company and how it measures up to its competitors.

A fundamental analyst thinks EGG at $30 is a good buy because the company has a low debt-equity ratio, the company’s management has increased sales, and the estimated earnings for the year are up. The analyst’s view is that the stock is a good value; however, the technical aspects of the stock should be reviewed before purchasing to make sure that the stock price is not declining.

• TECHNICAL ANALYSTS look at what is happening in the stock market in general and the individual price action of stocks in similar industries. Technical analysts chart the movement of stock in the industry and look at various theories, including:Technical analysts chart what is happening in the stock market and look at various theories.
• •Dow theory
• •Odd-lot theory
• •Advance-decline theory
• •Short interest theory

Technical analysts chart what is happening in the stock market and look at various theories.


Technical analysts base their outlook on how the market is moving, how the particular stock is doing in the market, what the P/E ratio is, and where the stock is in relation to the highs and lows for that stock. Technical analysts establish resistance and support levels by charting the stock of a company. The resistance level is when the number of stock sellers outnumbers the number of buyers and the stock price doesn’t seem to move upward past this price. Support level is when the number of buyers outnumbers sellers and the price of a stock begins to rise.

A technical analyst sees that IBM has gone through a resistance level. The stock has just gone up from a previous low. This would be a good time to buy because it has a trend of going up and will possibly go even higher until it reaches the next resistance level.

(C) I and IV. A fundamental analyst looks at the company; a technical analyst looks at the market. The fundamental analyst looks at earnings and the capitalization (debt/equity ratio) of the company.

• The DOW JONES AVERAGE comprises 65 stocks, consisting of:
• •The DOW JONES INDUSTRIAL AVERAGE (DJIA) (30 component stocks)
• •The DOW JONES TRANSPORTATION AVERAGE (20 transportation stocks)
• •The DOW JONES UTILITIES AVERAGE (15 utility stocks)The Dow Jones Industrial Average is calculated by totaling up the prices of the 30 component stocks and dividing by a divisor (determined by Dow Jones) that will change with stock splits and stock dividends.

• STANDARD AND POOR’S 500 INDEX comprises 500 stocks, consisting of:
• •400 industrial stocks
• •20 transportation stocks
• •40 utility stocks
• •40 financial stocks

• The NEW YORK STOCK EXCHANGE COMPOSITE INDEX comprises:
• •All industrial stocks on the NYSE
• •All transportation stocks on the NYSE
• •All utility stocks on the NYSE
• •All the financial stocks on the NYSE

• MOODY’S AVERAGE comprises 200 stocks:
• •125 industrial stocks
• •25 railroad stocks
• •25 utility stocks
• •15 bank stocks
• •10 insurance company stocks

• THE WILSHIRE 5000 TOTAL MARKET INDEX comprises 6,000 stocks found on the NYSE, AMEX, and Nasdaq; for historical reasons, this index is still referred to as the Wilshire 5000.
• −This is the broadest measure of the market.
• −The averages help show the course of the market and measure the change from the previous day and previous years.
• −As stated, it actually comprises over 6,000 stocks, but it is called the Wilshire 5000 for historical purposes.

Is based on the thought that the odd-lot investor (small individual investor) buys at the high points of a stock’s movement and sells at the low points.

Therefore, an ODD-LOT TRADER is considered a bad investor. The odd-lot theory is based on the numbers of small investors that purchase small amounts of stock Today odd-lot traders are those people who are purchasing less than 1,000 shares. Any trades less than 1,000 shares is considered an odd lot, and those that purchase these small amounts are an "odd-lot trader." In essence, the general public.

• The odd-lot theory states that when the odd-lot purchases exceed odd-lot sales, the market will drop, and vice versa. In essence, odd-lot traders do just the opposite of what will happen because they wait until they are
• sure the stock is rising before they buy. Of course, this is when the big traders (mutual funds, etc.) have made profits and are getting ready to sell. Now the prices of the stocks start to fall, so the odd-lotters have to sell or take big losses.

The ADVANCE-DECLINE THEORY is a ratio and chart based on the number of advancing stocks versus the number of declining stocks.

• The ratio is the number of advancing stocks in a given day compared to the number of declining stocks on the same day. This ratio is placed on a chart, and the points are connected to develop the advance/decline line. This line is charted with another index, such as the DJIA or NYSE Composite, and the trend lines and movements are compared.
• Many people say, "Let the trend be your friend," and are referring to the advance-decline line trend.
• The ADVANCE-DECLINE THEORY states that if the advance-decline index rises faster than the other index, a rise in the market will occur (and vice versa).

• Investors can sell stock without owning it, but they have to purchase shares of that stock at a later date to replace those borrowed from the broker/dealer.
• However, they are hoping to making money the only way possible — buy low and sell high. These investors just do it in reverse — sell high and buy low. Therefore, SELL SHORT = SELL WITHOUT OWNING, and eventually replace the borrowed stock.

Based on the fact there are investors selling a stock, or many stocks, short. The theory compares the number of shares that are sold short in a given month to the total volume for the month.

A BULL MARKET is a market on the rise or in an upswing.

• Investors can take three positions that are always considered BULLISH:A bull market is when the market is on the rise. Investors are considered bullish if they long a stock, long a call, or short a put.
• •Owning stock, or being LONG THE STOCK
• •Owning calls, or LONG CALLS
• •Writing or selling puts, or SHORT PUTS

A BEAR MARKET is a market that is falling or on a downswing.

Investors can take three positions that are always considered bearish:

• •Selling stock short, or owning a SHORT POSITION
• •Buying puts, or LONG PUTS
• •Writing or selling calls, or SHORT CALLS

Is a volatility measurement based on the past volatility, independent of market-related factors, of a company’s stock price. The price is compared with fundamental changes within the company and its industry sector. This method uses "1" as the starting point (as do most of the following measurement methods). An alpha of 1 indicates that no change is expected. An alpha of 1.50 would forecast a 50% increase in market value; an alpha of .75 would forecast a 25% decline in market value. A high alpha indicates lower risk.

(also called the BETA COEFFICIENT) is a volatility measurement based on the comparison of a stock’s market price movements against the movement of a stock market index. Again, "1" is the starting point. A beta of 1 indicates that the stock’s price (or a portfolio’s market value) will go up and down as the market index rises and falls by the same percentage. If the beta is other than 1, the stock will move up and down in proportion to the beta (sometimes referred to as SYSTEMATIC RISK.) A beta of more than one indicates that the stock’s price will be more volatile than the index or general market. A beta of less than one indicates the stock will move less than the index or the general market movement.


The beta coefficient may be used in assembling a portfolio of securities. By mixing high-beta stocks with low-beta stocks, the investor can seek higher returns in rising markets (high-beta portion) and reduce downside losses in declining markets (low-beta portion). The betas for most stocks are available from research organizations such as Value Line and others.

Refers to volatility in relation to market price. Low-priced securities are usually more volatile than high-priced securities. The so-called "square root rule" says that if the market advances, all stocks advance in price by adding a constant amount to the square root of their market price. Or, more simply, the lower a stock’s price, the greater its percentage of gain (or loss) when the market moves.

Is a reversal of an upward trend of stock, meaning the start of a bear market. It looks like the diagram on the right.

Are levels to which a stock will rise or fall, respectively. Below is a graphic, followed by the descriptions.

A resistance level is the highest level to which a stock will rise because of a price barrier. The resistance price is based on a predominance of sellers versus buyers in the market. This can also be stated that the resistance level is the level BELOW which a stock will stay.

•When the price of a stock reaches this level, a large selling trend occurs because the stock price is high. This decreases demand for the stock, which results in the stock price falling.

A SUPPORT LEVEL is the lowest level to which a stock will fall because of a price barrier. The support price is based on a predominance of buyers verses sellers in the market. It can also be stated that the support level is the level ABOVE which a stock will stay.

•When the price of a stock reaches the SUPPORT LEVEL, a large buying trend occurs because the stock price is low. This increases demand for the stock, which results in the stock price rising.

•The stock may not always hit the barrier, but will come very close to it. Then it will reverse the trend.

•Stocks will break these barriers, but they are considered to be on their way to the next barrier when they do.

Is when a stock goes above the present resistance level on its way to the next resistance level or when a stock drops below a support level in a large sell-off, and is on its way down to the next support level.

Is when there is a large sell-off of a stock. After a steady decline with little volume, a sudden drop with heavy volume occurs.

• Technical analysts refer to situations on charts where stocks that have been decreasing in value hit their lowest point and are now moving up in a “saucer” movement.
• •This is typically when “chartists,” also known as technical analysts, put in buy orders on the stock.
• •This is a bullish position.

• You may see a reference to an “inverted saucer” which is a bearish position.
• •This is typically when “chartists,” also known as technical analysts, put in sell orders on the stock.
• •This is a bearish position.

• A DEFENSIVE ISSUE is an equity issue that holds its price, even in periods of economic downturn. Examples are:
• •Utility stocks
• •Food stocks
• •Liquor and tobacco stocks

• A DEFENSE ISSUE is an equity issue that manufactures defense items for a country. Examples are:
• •Aerospace
• •Airplane manufacturers

• •Debt/equity ratio
• •Fixed charges coverage

DEBT/EQUITY

Is a method analysts use in determining if a company can pay the interest, or principal and interest, when due.

• The INTEREST COVERAGE RATIO:
• TOTAL REVENUES - EXPENSES/
• YEARLY INTEREST

• The DEBT SERVICE COVERAGE RATIO:
• TOTAL REVENUES - EXPENSES/
• YEARLY INTEREST AND PRINCIPAL PAYMENT
• Note: Debt service is composed of both principal and interest.

• •Past performance in payment of interest
• •Per capita income of the population
• •Projected population growth of an area
• •Industrial development of an area

• Long positions are taken when an investor believes the market in a particular security, or in securities in general, will rise because of demand.A long position is taken when the market in a security rises due to demand.
• •The investor is hoping to buy low and sell high — the only way to make money.
• •This investor is considered to be a BULLISH INVESTOR; meaning that the investor thinks the market will rise. Bullish investors take a position on their security (stock, bond, or option) and are hoping to buy low, sell high, and make money by the rise in the market price of their security.

Short positions are taken when an investor believes the market in a particular security, or in securities in general, will fall for one of many reasons.

•This investor is hoping to sell high, and then, when the time is right to buy low. Once again this is the only way to make money, except in reverse order from long positions. Normally an investor buys and later sells that security, but in the case of a short sale, the investor first sells the security, then after a time the investor buys the security to replace what was borrowed. When selling short, an investor is borrowing the stock or bond from the broker/dealer, but will have to purchase and replace it at some future time. This investor is considered to be a BEARISH INVESTOR, meaning that the investor thinks the market will decline.

•Bearish investors are those who have taken a position by selling first on their security (stock, bond, or call option) and are hoping to buy low later because of a fall in its market price.

ARBITRAGE is taking advantage of a price discrepancy on one stock in two markets or between two securities.

• The most common arbitrage is buying a security in one market and selling it short in another market — generally where the stock is selling for more in one market than in the other.

• The sell side, for a bona fide arbitrage, must be a short sale.
• If the sale is not a short sale, then both transactions are required to be paid for.
•  
• Arbitrage is taking advantage of a price discrepancy between two markets or securities.

When a person buys stock on one exchange and sells it later on the same day, but not in a short sale, the transaction is called "DAY TRADING."


Note that day trading is similar to market arbitrage, but there is no short sale in day trading, while arbitraging requires a short sale to take place.