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The FEDERAL RESERVE BOARD (FRB)
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.
The Fed can influence the economy through four types of actions.
- •Open market operations
- •Discount rate
- •Reserve requirement
- •Margin requirements
FEDERAL OPEN MARKET COMMITTEE (FOMC)
The Fed uses open market operations the most to influence the economy.
If the FOMC buys securities in the open market
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 FOMC sells securities in the open market
Less money flows into the economy. This decreases the money supply, or tightens money, which causes interest rates to go up. As interest rates go up, the prices of Treasury securities go down due to the increasing supply.
Since all settlement (payment) for Treasury securities is in federal funds:
- •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.
When the Fed increases the discount rate to member banks...
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.
When the Fed changes the discount rate...
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.
When the Fed increases the reserve requirement...
- 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.
When the Fed decreases the reserve requirement...
- 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.
Whenever the Fed changes the reserve requirement, the action has a MULTIPLIER EFFECT on the money supply. If the Fed reduces the reserve requirement, the amount of money that can be loaned allows other banks to increase the amount of money that they lend. As an example, if a bank receives a deposit of $1,000,000 and the reserve requirement is 20%, the bank may lend $800,000, which could be deposited into another bank. This, in turn, allows that bank to lend more, and so on. If the reserve requirement is reduced, the banks can lend more money. This is the multiplier effect.
The Fed regulates the amount that must be deposited by investors when purchasing securities, through Regulations T and U.
- •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.
When the margin requirement is higher, credit is tighter; when the requirement is lower, credit is easier.
This only affects the stock and bond market and, thus, the fewest people. For this reason, the changing margin rates for stock purchases is the least used method for influencing the money supply.
The Fed changes the reserve requirements when it believes it will benefit the economy. Changing the bank reserve requirement has what effect on the economy?
(A) It has a halting effect.
(B) It has a multiplier effect.
(C) It has an increasing effect.
(D) It has no effect.
(B) It has a multiplier effect. Whether the Fed increases or decreases the amount the banks must hold, it is considered a multiplier effect because it will affect dollars that are lent and deposited.
The Fed will use any or all of the above methods to influence the money supply, but for the test, you should know the order in which they will work.
The Fed decreases the flow of money by taking money in from the market. This is considered a DEFLATIONARY MOVE and is done by:
- •Selling Treasury securities in the open market
- •Raising the discount rate
- •Raising the reserve requirement
- •Raising the margin requirement
The Fed increases the flow of money by putting more money into the market. This increase is considered an INFLATIONARY MOVE, and is done by:
- •Buying Treasury securities in the open market
- •Lowering the discount rate
- •Lowering the reserve requirement
- •Lowering the margin requirement
MORAL SUASION is similar to "arm twisting."
- •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 Reserve Board most often uses which of the following methods to affect the money supply and the economy?
(A) Change the discount rate.
(B) Change the reserve requirement.
(C) Change margin rates.
(D) Change the federal funds rate.
(A) Change the discount rate. The Fed will frequently change the discount rate as it feels necessary to speed up or slow down the economy. From 2000 through 2007, the Fed increased, decreased, increased, and decreased the discount rate, effecting the economy every time.
FEDERAL FUNDS RATE
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.
The federal funds rate is the most volatile of all the interest rates
The federal funds rate is generally lower than the discount rate set by the Fed.
The rates for money, from highest to lowest, are generally:
- •Prime rate
- •Call money rate
- •Commercial paper rate
- •Banker’s acceptances rate
- •Discount rate
- •Federal funds rate
The CALL MONEY 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.
Which of the following rates is the most volatile?
(C) Federal funds
(C) Federal funds. The Federal Funds Rate is the most volatile rate because it changes by the moment every day as the banks meet their reserve requirements. The discount rate changes when the Fed decides to change it; therefore, it is not as volatile. The Prime Rate is affected by the discount rate and the interest rates charged for commercial loans are based on it. The savings account rate, called the passbook rate, is the least volatile of the listed interest rates.
The money supply is divided into three groups:
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.
M1 is composed of:
- •All currency in circulation
- •Demand deposits
- •Interest-bearing checking accounts
M2 is all of M1 plus:
- •Money market funds
- •Small savings and small “time” deposits
- •Overnight repurchase agreements
- •Overnight Eurodollar deposits
M3 is all of M2 plus:
- •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.
When the demand for products exceeds the supply of goods, the price of the goods increases, because consumers are competing for the goods. As prices increase, the amount that a dollar buys decreases, and thus, inflation occurs. Inflation can be said to reduce the real purchasing power of the dollar.
When the Fed lowers interest rates and increases the supply of money and credit, people have money and can purchase goods. This causes a demand for the goods and inflation occurs.
During inflation, interest rates are decreasing or are already low.
To counter inflation, the Fed will increase interest rates until the prices of goods level off or even drop to some degree.
Is the decrease in the average price level of all products in an economy.
Deflation occurs when the aggregate demand decreases faster than the aggregate supply.
As prices decrease, the amount that a dollar buys increases, and thus, deflation occurs. Deflation can be said to increase the real purchasing power of the dollar.
During deflationary periods, interest rates are increasing or are very high. To counter deflation, the Fed lowers interest rates, hoping to entice the consumer to borrow for purchases and investments.
Deflationary periods also affect securities and other investments, as the demand for them decreases. As the Fed counters deflation with decreases in interest rates, the bonds that are already issued will rise in price, giving lower yields.
VELOCITY OF MONEY
- 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.
All of the following are indications that credit conditions are worsening, except:
(A) An increase in property values
(B) An increase in inventories
(C) An increase in tax delinquencies
(D) An increase in bankruptcies
(A) Correct answer (false statement): An increase in property values. An increase in property values is not an indication that credit conditions are worsening. When property values increase, people are able to borrow more. An increase in inventory usually indicates that fewer companies and individuals are able to buy goods. An increase in tax delinquencies and bankruptcies can indicate more financial difficulties for companies and individuals; therefore, they may be less capable of paying off credit.
- 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.
FLUCTUATING INTEREST RATES
- 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.
Bonds at a discount will appreciate faster than bonds at a premium, due to the pull of par; bonds at a premium will decrease faster than bonds at a discount for the same reason.
Interest rates have been rising. Which of the following bonds will decrease the most?
(A) 7.0% bond with five years to maturity
(B) 8.0% bond with seven years to maturity
(C) 7.50% bond with ten years to maturity
(D) 7.75% bond with fifteen years to maturity
(D) 7.75% bond with fifteen years to maturity. The prices of bonds with the greatest amount of time remaining until maturity always move the most. The longest bonds always move the most. When in doubt, always pick the longest to maturity.
Causes of the Devaluing Dollar
The dollar becomes devalued against other currencies for three main reasons:
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
Causes of Revaluing the Dollar
The devaluation of the U.S. dollar has many effects:
•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.
When the U.S. dollar loses value, exports become more competitive. When it increases in value, imports become more competitive.
To sum it up and keep it simple:
•If the dollar is DEVALUED, bonds drop in price, yields go up, and U.S. goods become more competitive.
•If the dollar is REVALUED (appreciates), bonds go up in price, yields go down, and U.S. goods become less 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.
The exchange rate of the dollar has been increasing. Which of the following is true regarding foreign imports and U.S. exports?
IU.S. exports are more competitive in foreign markets.
IIU.S. exports are less competitive in foreign markets.
IIIForeign imports are more competitive in the United States.
IVForeign imports are less competitive in the United States.
(A) I and III
(B) I and IV
(C) II and III
(D) II and IV
(C) II and III. When the exchange rate goes up, the dollar is stronger; therefore, U.S. manufacturers must charge more for goods in foreign countries, and thus, U.S. goods become less competitive. By the same token, foreign manufactures can charge less because they are getting more of their currency for the dollar, and therefore, they become more competitive.
For this exam, the three main economic theories regarding how our economy is influenced include:
- •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.
Those who promote KEYNESIAN THEORY believe that an economy can only grow if the government increases its spending. For this reason, the Keynesian theory states that there must be increased taxation by the government and increased government spending to motivate the economy.
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.
The economic theory that says the government should influence the business cycle through decreased government spending and tax cuts is called:
(C) Macro economics
(A) Supply-side. Those who promote supply-side theory believe that tax cuts and less government spending increase the amount of money consumers can spend, and thus encourage economic growth. The Keynesian theory promotes increasing taxation and government spending. The monetarist theory implies that controlling the money supply affects the economy.
Leading indicators are signs suggesting where the market may be in four to six months.
There are about 10 leading indicators. For the exam, know the following:
- •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)
STANDARD & POOR’S 500 INDEX (S&P 500)
If this stock index is rising, so should the economy; and if it is declining, the economy may be headed for a downturn.
BUILDING PERMITS FROM THE HOUSING STARTS REPORTS
New housing construction projects are indicators that people are increasing their spending. This stimulates the economy.
DURABLE GOODS (also known as CONSUMER GOODS)
If consumers increase purchases for small appliances and other durable goods (such as cars), it is a sign that consumer sentiment is strong, people are willing to spend money, and thus, the economy will grow. In contrast, when consumers are not spending money on durable or consumer goods, it is a sign that they are concerned about the economy because they are saving money. This indicates that the economy is slowing down.
This indicator is factory orders for new tools. An increase in tool purchases signifies an increase in demand for labor and large construction projects — another strong economic sign. A decrease in tool orders signifies a decrease in the economy for the same reasons.
CONSUMER CONFIDENCE INDEX (CCI)
The latest indicator to be used, the CCI is probably the most relevant one in today’s market. Consumer confidence tends to support upward trends in stock prices.
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.
There are four such coincident indicators. For the exam, know one of them:
•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.
LAGGING INDICATORS usually follow the economy. Once the U.S. economy has established a trend, and people are spending or not spending as the case may be, these indicators show how the trend progressed. They are the last to change as the economy changes. For the exam, know this one:
CORPORATE PROFITS — Companies and their profits always follow the economy, since it is not until after an up or down swing that it can compare its results to the economy and its competitors. The company is able to evaluate its success only after sales have been aggregated and it can evaluate its returns.
People interested in economic forecasting commonly use other regularly reported figures:
- 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.
GROSS DOMESTIC PRODUCT (GDP)
The GDP is 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 GDP gives the market value of all goods produced in a country in a given year, equal to the total of consumer spending and government spending, plus the value of exports, minus the value of imports. This figure only includes goods and services produced within the boundaries of the U.S.
GROSS NATIONAL PRODUCT (GNP)
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.
CONSUMER PRICE INDEX (CPI)
The CPI is not considered an indicator, but it is a monthly inflationary report that gives consumers an idea of how the dollar is doing and how their buying power is holding. This is never a correct answer for an indicator on the test. Do not confuse this with the CCI above, which is a leading indicator.
Which of the following are leading indicators according to the Department of Commerce?
Industrial Production Index
(A) I only
(B) I, II, and V only
(C) II, V, and VI only
(D) II, III, IV, V, and VI
(C) II, V, and VI only. The S&P 500, Housing Starts, and CCI are leading indicators. The Industrial Production Index is a coincident indicator. The CPI and GNP report statistical information about the economy.
- 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
When answering the question, write down the business cycle in alphabetical order: E P R T. Also draw the figure at right. Then, find the only answer that is in this order, regardless of which part is given first. Even if the order starts with P or R or T, it must be in the order that the business cycle flows. There will only be one answer with the letters in this order. The answer could even be R T E P.
- 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.
- •Research abilities
- •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.
A fundamental analyst would use which of the following in making decisions in their investing policies?FIRE Drill
IEarnings of a company
IISupport and resistance levels
IIITrend of the market
IVThe debt/equity ratio of a company
(A) III and IV only
(B) I and II only
(C) I and IV
(D) II and III
(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.
(this multiple choice question has been scrambled)
DOW JONES AVERAGE
- 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
- STANDARD AND POOR’S 500 INDEX comprises 500 stocks, consisting of:
- •400 industrial stocks
- •20 transportation stocks
- •40 utility stocks
- •40 financial stocks
NEW YORK STOCK EXCHANGE COMPOSITE INDEX
- 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
- 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.
The Wilshire 5000 Total Market Index is comprised of stocks found in which of the trading markets?
(A) I, III, and V only
(B) II and IV only
(C) II, III, and IV only
(D) I, II, III, IV, and V
(C) II, III, and IV only. The stocks that make up the Wilshire 5000 are on the NYSE, Nasdaq, and the AMEX only; no stocks are included that are on other regional exchanges, nor any OTC stocks that are not on Nasdaq.
DOW THEORY is a classification of the stock market. It is based on the theory that market trends often precede the trends in prosperity and depression in general business. The Dow Theory bases its assumptions about the performance of stocks on various components of the stock market, including averages of other stocks.
The ODD-LOT THEORY
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).
The investors borrow stock from the broker/dealer and then have them sell the stock that they have borrowed, even though they do not own it. (If you have always been told you must own something to sell it, that is not true anymore.)
- 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.
SELL WITHOUT OWNING, and eventually replace the borrowed stock.
SHORT INTEREST THEORY
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.
If the number of stocks being sold short is high, the outlook is for a strong market because the short sales will have to be covered, which means a large amount of buying in the near future. This creates a large demand for the stock and a rise in the market.
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.
Which of the following are considered to be bearish positions?
Long a call
Long a put
(A) I and III
(B) II and III
(C) I and IV
(D) II and IV
(D) II and IV. Short stock and long a put are bearish positions because these investors want the market to go down.
HEAD AND SHOULDERS TOP FORMATION
Is a reversal of an upward trend of stock, meaning the start of a bear market. It looks like the diagram on the right.
HEAD AND SHOULDERS BOTTOM FORMATION
is a reversal of a downward trend in the stock, meaning the start of a bull market. It looks like the diagram on the right.
A head and shoulders formation cannot be determined until the second shoulder appears. If one shoulder and the head are visible, this could just be a flattening of the price for a brief time.
RESISTANCE AND SUPPORT LEVELS
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.
General Points about Resistance and Support
•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.
Which of the following is the best description of a resistance level?
(A) The point above which a falling stock will stay.
(B) The point below which a rising stock will stay.
(C) The point at which investors will resist purchasing rising stock.
(D) The point at which investors will resist selling falling stock.
(B) The point below which a rising stock will stay. The resistance level is the point at which a rising stock goes up to, hits, and then starts to go down. Most stock rises and falls; the high points become resistance levels and the low points become support levels, until the stock breaks through them.
SAUCER STOCK MOVEMENT
- 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:
- •Airplane manufacturers
Fundamental analysts look for indicators of the issuer’s ability to pay interest on corporate bonds when it is due and the principal at maturity.
Fundamental analysts consider two important ratios:
- •Debt/equity ratio
- •Fixed charges coverage
The DEBT/EQUITY RATIO is the ratio of funded debt of a corporation to the amount of equity making up the capitalization of the company. Since it is a ratio, it is a calculation based on:
FIXED CHARGES COVERAGE
Is a method analysts use in determining if a company can pay the interest, or principal and interest, when due.
Two formulas used to calculate fixed charge coverage are:
- 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.
In analyzing general obligation bonds, municipal bond analysts look at:
- •Past performance in payment of interest
- •Per capita income of the population
- •Projected population growth of an area
- •Industrial development of an area
A corporation has revenues for the year of $39 million. If the expenses for the corporation are $17 million, the principal payment is $8 million, and the interest expense is $2 million, what is the debt service coverage?
(A) 2.2X. The DEBT SERVICE COVERAGE is the amount available for debt service. It is the number of times that the debt service is covered after deduction of expenses. Do not forget that debt service includes the interest, so the interest cost here must be included. In this case: 39 - 17 = 22 ÷ 10 = 2.2 times.
- 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.
A SHORT AGAINST THE BOX is actually two different positions on the same stock. This is an investor who owns the stock and then sells it short. This used to be done at the end of the year to lock in a profit on their stock, but defer the taxes on the profit to the next year. This technique is no longer allowed as a method to lock in profits and reduce taxes. It should not be on the test, but know it just in case.
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.
Another type of arbitrage is buying a convertible bond when the bond and stock prices are not equal.
One method of describing this arbitrage is "the bond is selling below parity with the stock" it is convertible into.
The other method of describing this arbitrage is "the stock is selling above parity with the bond."
Which of the following is an arbitrage using a convertible bond?
(A) When a stock is selling at a discount to parity with the bond
(B) When the bond is selling at a discount to parity with the stock
(C) When the bond is selling below yield parity
(D) When the bond is selling at parity with the stock
(B) When the bond is selling at a discount to parity with the stock. If the bond is lower than parity with the stock, or phrased as, "the stock is selling above parity with the bond," the investor can buy the bond, convert, and sell the stock and make a profit.