CHAPTER TWO : FINANCIAL INSTRUMENTS ON THE FINANCIAL MARKETS

1. Stocks Introduction Stocks are among the most talked about and most popular investment opportunities available. Shares of stock represent partial ownership in a company. Ownership in the company is determined by the number of shares we own divided by the total number of shares outstanding. For many companies, shares of stock are limited to the founders of the company and/or their employees. These companies are called "private" companies because their stock is owned privately; that is to say, it is not possible for the public to buy shares in the company. All corporations start out private; after all, the founders of the company usually want to maintain control over the company and its profits. However, after a company has grown for a while, the private owners will sometimes decide to sell shares of stock in the company to the public. This is what is called "going public" or performing an "initial public offering". Companies choose to sell shares of their stock to the public in order to raise money for the company. They might need this money in order to expand their operations, pay off existing debt, develop a new product, or for any number of other reasons. Categories of stocks Stocks can be classified into many different categories. The two most fundamental categories of stock are common stock and preferred stock, which differ in the rights that they confer upon their owners. Common Stock Most shares of stock are called "common shares". If we own a share of common stock, then we are a partial owner of the company. We are also entitled to certain voting rights regarding company matters. Typically, common stock shareholders receive one vote per share to elect the company's board of directors (although the number of votes is not always directly proportional to the number of shares owned). The board of directors is the group of individuals that represents the owners of the corporation and oversees major decisions for the company. Common INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 51

stock shareholders also receive voting rights regarding other company matters such as stock splits and company objectives. In addition to voting rights, common shareholders sometimes enjoy what are called "preemptive rights." Preemptive rights allow common shareholders to maintain their proportional ownership in the company in the event that the company issues another offering of stock. This means that common shareholders with preemptive rights have the right but not the obligation to purchase as many new shares of the stock as it would take to maintain their proportional ownership in the company. But although common stock entitles its holders to a number of different rights and privileges, it does have one major drawback: common stock shareholders are the last in line to receive the company's assets. This means that common stock shareholders receive dividend payments only after all preferred shareholders have received their dividend payments . It also means that if the company goes bankrupt, the common stock shareholders receive whatever assets are left over only after all creditors, bondholders, and preferred shareholders have been paid in full. Preferred Stock The other fundamental category of stock is preferred stock. Like common stock, preferred stock represents partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common stockholders. Also unlike common stock, preferred stock pays a fixed dividend that does not fluctuate, although the company does not have to pay this dividend if it lacks the financial ability to do so. The main benefit to owning preferred stock is that you have a greater claim on the company's assets than common stockholders. Preferred shareholders always receive their dividends first and, in the event the company goes bankrupt, preferred shareholders are paid off before common stockholders. In general, there are four different types of preferred stock: cumulative : these shares give their owners the right to "accumulate" dividend payments that were skipped due to financial problems; if the company later resumes paying dividends, cumulative shareholders receive their missed payments first. non-cumulative: these shares do not give their owners back payments for skipped dividends. participating: these shares may receive higher than normal dividend payments if the company turns a larger than expected profit. INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 52

convertible: These shares may be converted into a specified number of shares of common stock.

Stocks can also be classified according to a number of other criteria, including company size and company sector. Stocks can be classified according to the market capitalization of the company. The market capitalization of a company represents the total dollar value of the company's outstanding shares. This is equal to the current market price of its stock multiplied by the number of shares of stock that it has outstanding. That number gives us the market value of the company, which is one measure of the company's size. Roughly speaking, there are three basic categories of market capitalization: large cap, mid cap, and small cap. The definitions for each of these might vary somewhat depending on whom we're talking to, but usually they are as follows: large cap: market cap valued at more than $10 billion (or euro) mid cap: market cap valued between $1 billion and $10 billion (or euro) small cap: market cap valued at less than $1 billion (or euro) In general, the larger the cap size, the more established the company, and the more stable the price of its stock. Small cap and mid cap companies usually have a higher potential for future growth than large cap companies, but their stock tends to fluctuate more in price. Penny Stocks A penny stock is a stock priced under one dollar (or one euro) per share. Most penny stocks have only a few million dollars (euro) in net tangible assets and have a short operating history. The term "penny stock" is sometimes used in a derogatory fashion, since many penny stocks are virtually worthless and should be considered extremely high-risk investments. Sector Stocks Stocks are often grouped into different sectors depending upon the company's business. For example, Standard & Poor's breaks the market into 11 different sectors. Two of these sectors, utilities and consumer staples, are said to be defensive sectors, while the rest tend to be more cyclical in nature . The other nine sectors are: transportation, technology, INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 53

health care, financial, energy, consumer cyclicals, basic materials, capital goods, and communications services. Cyclical Stocks Stocks can be classified according to how they react to business cycles. Cyclical stocks are stocks of companies whose profits move up and down according to the business cycle. Cyclical companies tend to make products or provide services that are in lower demand during downturns in the economy and higher demand during upswings. The automobile, steel, and housing industries are all examples of cyclical businesses. Defensive Stocks Defensive stocks are the opposite of cyclical stocks: they tend to do well during poor economic conditions. They are issued by companies whose products and services enjoy a steady demand. Food and utilities stocks are defensive stocks since people typically do not cut back on their food or electricity consumption during a downturn in the economy. But although defensive stocks tend to hold up well during economic downturns, their performance during upswings in the economy tends to be lackluster compared to that of cyclical stocks.

Stock Classes Although common stock usually entitles you to one vote for every share that you own, this is not always the case. Some companies have different "classes" of common stock that vary based on how many votes are attached to them. So, for example, one share of Class A stock in a certain company might give you 10 votes per share, while one share of Class B stock in the same company might only give you one vote per share. And sometimes it is the case that a certain class of common stock will have no voting rights attached to it at all. The company will typically issue the class of shares with the fewest number of votes attached to it to the public, while reserving the class with the largest number of votes for the owners.

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Splits and Buybacks A corporation whose stock is performing well may opt to split its shares, distributing additional shares to existing shareholders. The price per share immediately adjusts to reflect the change, since buyers and sellers of the stock all know about the split. A company will usually decide to split its stock if the price of the stock gets very high. High stock prices are problematic for companies because they make it seem as though the stock is too expensive. By splitting a stock, companies hope to make their equity more attractive, especially to those investors that could not afford the high price. A buyback is a corporation's repurchase of stocks or bonds that it has previously issued. In the case of stocks, this reduces the number of shares outstanding, giving each remaining shareholder a larger percentage ownership of the company. This is usually considered a sign that the company's management is optimistic about the future and believes that the current share price is undervalued. Initial Public Offerings Initial Public Offerings (IPOs) are the first time a company sells its stock to the public. Sometimes IPOs are associated with huge first-day gains; other times, when the market is cold, they flop. It's often difficult for an individual investor to realize the huge gains, since in most cases only institutional investors have access to the stock at the offering price. By the time the general public can trade the stock, most of its first-day gains have already been made. However, a savvy and informed investor should still watch the IPO market, because this is the first opportunity to buy these stocks. REASONS FOR AN IPO When a privately held corporation needs to raise additional capital, it can either take on debt or sell partial ownership. If the corporation chooses to sell ownership to the public, it engages in an IPO. Corporations choose to "go public" instead of issuing debt securities for several reasons. The most common reason is that capital raised through an IPO does not have to be repaid, whereas debt securities such as bonds must be repaid with interest. Despite this apparent benefit, there are also many drawbacks to an IPO. A large drawback to going public is that the current owners of the privately held corporation lose a part of their ownership. Corporations INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 55

weigh the costs and benefits of an IPO carefully before performing an IPO. If a corporation decides that it is going to perform an IPO, it will first hire an investment bank to facilitate the sale of its shares to the public. This process is commonly called "underwriting". Measuring a Stock's Risk Basically, stocks are subject to two types of risk - market risk and nonmarket risk. Nonmarket risk, also called specific risk, is the risk that events specific to a company or its industry will adversely affect the stock's price. Market risk, on the other hand, is the risk that a particular stock's price will be affected by overall stock market movements. Nonmarket risk can be reduced through diversification. By owning several different stocks in different industries whose stock prices have shown little correlation to each other, you reduce the risk that nonmarket factors will adversely affect your total portfolio. No matter how many stocks we own, we can't totally eliminate market risk. However, you can measure a stock's historical response to market movements and select those with a level of volatility you are comfortable with. Beta and standard deviation are two tools commonly used to measure stock risk. BETA Beta, which can be found in a number of published services, is a statistical measure of the impact stock market movements have historically had on a stock's price. By comparing the returns of the Standard & Poor's 500 (S&P 500) to a particular stock's returns, a pattern develops that indicates the stock's exposure to stock market risk. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market and has a beta of 1. A stock with a beta of 1 means that, on average, it moves parallel with the S&P 500 - the stock should rise 10% when the S&P 500 rises 10% and decline 10% when the S&P 500 declines 10%. A beta greater than 1 indicates the stock should rise or fall to a greater extent than stock market movements, while a beta less than 1 means the stock should rise or fall to a lesser extent than the INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 56

S&P 500. Since beta measures movements on average, you cannot expect an exact correlation with each market movement. Calculating our portfolio's beta will give you a measure of its overall market risk. To do so, we have to find the betas for all our stocks. Each beta is then multiplied by the percentage of our total portfolio that stock represents (i.e., a stock with a beta of 1.2 that comprises 10% of our portfolio would have a weighted beta of 1.2 times 10% or .12). Add all the weighted betas together to arrive at our portfolio's overall beta. STANDARD DEVIATION Standard deviation, which can also be found in a number of published services, measures a stock's volatility, regardless of the cause. It basically tells us how much a stock's short-term returns have moved around its long-term average return. The most common way to calculate standard deviation is to figure the deviation from an average monthly return over a three-, five-, or 10-year period and then annualize that number. Higher standard deviations represent more volatility. 2. Bonds Introduction Bonds have long been considered the poorer performing alternative to stocks. However, in most portfolios, there is an important role to be played by bonds and it is crucial to understand the nature of this alternative to the stock market. A bond is basically a loan. The owner of a bond has given the issuerwhether it be a corporation, a government or another agency-a sum of money that can be used at any point. In exchange, the issuer will pay interest to the bondholder over a period of time and will eventually return the initial amount loaned, called the principal. Unlike a stock, the bondholder does not own a part of the company. Because a bond is basically a loan, they are often called "debt securities" because they represent a debt obligation from the issuer to the bondholder. Bonds are also known as fixed income securities. At the time of purchase, the characteristics of the bond will be stated in the certificate. Here are the items that will be specified on most (but not all) bonds: INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 57

Time to Maturity - This is the date the issuer will make a lump sum payment to return the principal to the bondholder, which eliminates the debt. Principal, par value, face value - These are three names for the same item, the amount that will be returned to the bondholder at maturity. Coupon - This is the interest payment that will be made to the bondholder. Generally, a percentage of the face value will be fixed which will represent the annual interest rate on the loan. Also, a timetable will be set up for the payment of the coupons, usually semiannually. Not all bonds pay out interest through coupon payments.

Par value is the amount that will be received at the time of maturity. It is also known as the principal, face value, or par value. It is important to remember that bonds are not always sold at par value. In the secondary market, a bond's price fluctuates with interest rates. If interest rates are higher than the coupon rate on a bond, the bond will have to be sold below par value (at a "discount"). If interest rates have fallen, the price will be higher. Maturity is the length of time before the principal is returned on a bond. It is also called term-to-maturity. At the time of maturity, the issuer is no longer obligated to make interest payments. Maturities range significantly, from 1 month for some municipal notes to 40+ years for some corporate bonds. The coupon rate is the interest rate that is paid out to the bond holder. The name derives from the old system of payment, in which bond holders would need to send in coupons in order to receive payment. The coupon is set when the bond is issued and is usually expressed as an annual percentage of the par value of the bond. Payments usually occur every six months, but this can vary. There are really two markets for bonds: the primary market and the secondary market. The primary market is when the bond is first issued. In the primary market the bond is purchased directly from the issuer. The secondary market occurs later, when bonds are sold from one bondholder to another. The prices on bonds in the secondary market are set by supply and demand and are impacted by what is expected of interest rates and inflation, how many coupon payments are left to maturity, and how long it will be until the bond matures. INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 58

Categories of bonds There are many types of bonds. The different types of bonds are usually defined by the issuer, though some are defined by the characteristics of the bonds. The major types of bonds are: Corporate Bonds Municipal Bonds Treasury Bonds Agency Bonds/Mortgage-Backed Securities Zero-Coupon Bonds Corporate Bonds Bonds issued by a corporation are called corporate bonds. When a company needs to raise funds for some type of investment or expenditure, they often turn to the public markets for funding. One way to do this is to issue additional stock in the company, but this has implications on the value of the shares and dilutes ownership. The other major option is to sell bonds to the public and take on debt. Selling bonds is often more attractive to companies than getting a loan from a bank. Corporate bonds are very common and you can find prices and other information in the financial or business sections of major newspapers. Most corporate bonds have a different par value and carry various maturity dates. Generally, these bonds pay higher rates than government or municipal bonds due to the increased risk. Corporate bonds have a wide range of ratings and yields because the financial health of the issuers can vary widely. If a company goes bankrupt, both bondholders and stockholders can make a claim on the company's assets. However, one of the benefits of being a bondholder is that your claim takes precedence over that of stockholders in a liquidation situation. Additionally, some corporate bonds are "secured." This means that the debt obligation is backed by some asset that can be liquidated in order to pay off the interest and principal. Corporations will often issue mortgage bonds, which are backed by real estate or physical equipment. These bonds are safer than unsecured bonds, which are backed only by the "full faith and credit" of the company - which basically means you are taking their word for it. Most corporate bonds are straightforward with a fixed coupon rate that INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 59

doesn't change until maturity. There are some variations, however. Some bonds will have a floating rate, which means the interest paid in the coupon will be pegged to some independent index like the money market interest rate or the rate on a short term Treasury Bill. While these bonds insure you against a change in interest rates, they tend to offer lower yields. Another type of bond that might be issued is a zero coupon bond, which has no interest payments at all prior to maturity . Here is a brief look at what to consider when evaluating corporate bonds: Coupon Yield and its permutations Maturity Duration Rating Callability Convertibility The yield of a bond is, roughly speaking, the return on the bond. The yield is expressed as an annual percentage of the face amount. There are several different measures of yield: nominal yield, current yield, and yield to maturity. Nominal yield is equal to the coupon rate; that is, the return on the bond without accounting for any outside factors. If we purchase the bond at par value and hold to maturity, this will be the annual return we receive on the bond. Current yield is a measure of the return on the bond in relation to the current price. It can differ from the coupon rate. Yield to maturity is the overall return on the bond if it is held to maturity. It reflects all the interest payments that are available through maturity and the principal that will be repaid, and assumes that all coupon payments will be reinvested at the current yield on the bond. This is the most valuable measure of yield because it reflects the total income that we can receive. Duration is a weighted measure of the length of time the bond will pay out. Unlike maturity, duration takes into account interest payments that occur throughout the course of holding the bond. Basically, duration is a weighted average of the maturity of all the income streams from a bond or portfolio of bonds. So, for a two-year bond with 4 coupon payments every six months of $50 and a $1000 face value, duration (in years) is . 5[(50/1200)] + 1[(50/1200)]+ 1.5[(50/1200)]+ 2[(50/1200)] + 2[(1000/1200)] = 1.875 years. Notice that the duration on any bond that pays coupons will be below the maturity because there is some amount of INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 60

the payments that are going to come before the maturity date. As discussed earlier, the yield of a bond will be influenced by the risk of default by the issuer. Naturally, there is far more risk associated with a small telecom company's bond than with the federal government's. Investors need to be compensated for the additional risk. Conveniently, there are bond rating services that do most of the legwork for you in determining the default risk for a given issue. The biggest names in bond ratings are Moody's Investors Services, Fitch IBCA, and Standard &Poor's. These companies analyze each issuer's financial position and assign a letter grade that ranks their likelihood of successfully repaying the debts incurred. The basic ranking system is as follows (each ranking system is a little different, but this should be a useful general guide):

AAA - Highest quality, with the least likelihood of default. AA - High likelihood of repayment; together with AAA bonds these are considered "high grade bonds." A - Quite safe, thought to be a good medium-grade bond. There is some risk if conditions become quite difficult. BAA or BBB - Somewhere in the middle, they aren't extremely safe, but they are not a great risk either. Anything with BAA or higher is called an "investment grade bond." BA or BB - The future of this issuer is somewhat in doubt. Bonds at or below this ranking are called "speculative." B - These bonds are fairly speculative. Significant risk of default if conditions become difficult. CAA or CCC - These bonds are highly speculative. Bonds with this ranking or lower are considered junk bonds. CA or CC - Significant risk of default, highly speculative. C - In some rankings this is just another grade of junk bonds, others use it to mean that these bonds are no longer paying interest or are in default already. D - Bonds that have been defaulted on N - Not rated, usually because the company did not want the issue to be rated or because the company is too new to have a credit history to base a rating on.

When a bond is issued, it will be either callable or non-callable. A callable bond is one in which the company can require the bondholder to sell the bond back to the company. Buying back outstanding bonds is called "redeeming" or "calling". A company will often call a bond if it is paying a higher coupon than the current market interest rates. Basically, INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 61

the company can reissue the same bonds at a lower interest rate, saving them some amount on all the coupon payments; this process is called "refunding." Generally, callable bonds will carry something called call protection. This means that there is some period of time during which the bond cannot be called. Municipal Bonds Municipal bonds are bonds issued by any municipal organization including cities, counties, states, and school districts. The purpose of these bonds is for general expenditures or to fund specific projects such as highways, new schools, or an athletic stadium. These bonds offer the municipality the opportunity to raise funds without directly raising taxes. Of course, the funds needed to repay the bonds will often come from a tax increase. Generally, municipal bonds are considered safer than corporate bonds because a local government is far less likely to go bankrupt than a corporation-however, it has happened in the past, so be aware of the possibility. Because of this safety and the tax benefits, municipal bonds generally have a lower yield than corporate bonds. Treasury Bonds Treasury bonds are issued by the government of the United States in order to pay for government projects. The money paid out for a Treasury bond is essentially a loan to the government. As with any loan, repayment of principal is accompanied by a fixed interest rate. These bonds are guaranteed by the 'full faith and credit' of the government, meaning that they are extremely low risk. The government sells Treasury bonds by auction in the primary market, but they can also be purchased through a broker in the secondary market. Treasury bonds are marketable securities, meaning that they can be traded after the initial purchase. Additionally, they are highly liquid because there is an active secondary market for them. Prices on the secondary market and at auction are determined by interest rates. One possible downside to Treasury bonds is that if interest rates increase during the term of the bond, the money invested will be earning less interest than it could earn elsewhere. Accordingly, the resale value of the bond will decrease as well. Rising inflation can also eat into the interest earned on INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 62

Treasury bonds. Because there is almost no risk of default by the government, the return on Treasury bonds is relatively low, and a high inflation rate can erase most of the gains by reducing the value of the principal and interest payments. Agency Bonds/Mortgage-Backed Securities Other government agencies and organizations issue securities to fund their own projects. While these bonds often deliver higher returns than Treasury securities because some of them are not explicitly guaranteed by the government, they must often be purchased from brokers, incurring a commission. They are considered very safe investments because they would most likely be honored by the government if default occurred. The most common agency bonds are mortgage-backed securities. Mortgage-backed securities are debt obligations with a pool of mortgages as collateral. They fall into the general category of asset-backed securities, which package a group of securities and offer investors access to the cash flows generated by the underlying securities. Mortgage backed securities are a relatively low-risk investment vehicle. For example, securities issued by the Government National Mortgage Association (Ginnie Mae) are particularly safe because they are backed by the full faith and credit of the U.S. government. One downside to these investments is the risk of prepayment by borrowers, or paying back part or all of the loan before it becomes due, which can lower returns by reducing the interest paid on a given mortgage. ZERO COUPON BONDS Some bonds, called zero coupon bonds, don't pay out any interest prior to maturity. These bonds are sold at a deep discount because all of the value from the bond occurs at maturity when the principal is returned to the bondholder along with interest. These bonds are also known as "zeros." Zeros are more volatile than bonds that have regular interest payments. The main benefit of zero coupon bonds is if we are saving for a specific event that will occur at a specific time. Benefits and risks associated with bonds While bonds traditionally earn lower returns than stocks, that does not INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 63

mean there isn't a place in our portfolio for bonds. The most common reason for investors to purchase bonds are below: Diversification - Bonds tend to be less volatile than stocks and can therefore stabilize the value of your portfolio during times when the stock market struggles. Stability - If investors know they will need access to large sums of money in the near future-for then it does not make sense to place that money in a highly volatile investment like stocks. Because the majority of the return on bonds comes from the interest payments (the coupon payments), fluctuations in the price of a bond will have little impact on the value of the investment. Consistent Income - Unlike stock dividends, coupon payments are consistently distributed at regular intervals. Bonds are not riskless investments. While they are usually considered much safer than stocks, bonds can still lose value while we hold them. Here is a brief look at some of the risks associated with bonds: Interest rate risk - Bond prices are inversely related to interest rates, so if interest rates increase, the price of the bond will decrease. Credit Risk - Just as individuals occasionally default on their loans or mortgages, some organizations that issue bonds occasionally default on their obligations. Bonds issued by corporations are more likely to be defaulted on-companies often go bankrupt. Municipalities occasionally default as well, although it is much less common. Call Risk - Some bonds can be called by the company that issued them. That means the bonds have to be redeemed by the bondholder, usually so that the issuer can issue new bonds at a lower interest rate. Inflation Risk - With few exceptions, the interest rate on your bond is set when it is issued, as is the principal that will be returned at maturity. If there is significant inflation over the time you held the bond, the real value (what you can purchase with the income) of your investment will suffer. 3. Mutual funds Introduction A mutual fund is a special type of company that pools together money from many investors and invests it on behalf of the group, in accordance with a stated set of objectives. Mutual funds raise the money by selling INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 64

shares of the fund to the public, much like any other company can sell stock in itself to the public. Funds then take the money they receive from the sale of their shares (along with any money made from previous investments) and use it to purchase various investment vehicles, such as stocks, bonds and money market instruments. In return for the money they give to the fund when purchasing shares, shareholders receive an equity position in the fund and, in effect, in each of its underlying securities. For most mutual funds, shareholders are free to sell their shares at any time, although the price of a share in a mutual fund will fluctuate daily, depending upon the performance of the securities held by the fund. Mutual funds can offer you the following benefits: Diversification can reduce our overall investment risk by spreading our risk across many different assets . With a mutual fund we can diversify your holdings both across companies (e.g. by buying a mutual fund that owns stock in 100 different companies) and across asset classes (e.g. by buying a mutual fund that owns stocks, bonds, and other securities). When some assets are falling in price, others are likely to be rising, so diversification results in less risk than if we purchased just one or two investments. Choice: Mutual funds come in a wide variety of types. Some mutual funds invest exclusively in a particular sector (e.g. energy funds), while others might target growth opportunities in general. The key is for you to find the mutual funds that most closely match our own particular investment objectives. Liquidity is the ease with which we can convert your assets--with relatively low depreciation in value--into cash. In the case of mutual funds, it's as easy to sell a share of a mutual fund as it is to sell a share of stock. Low Investment Minimums: We do not need to be exceptionally wealthy in order to invest in a mutual fund. Convenience: we don't need to worry about tracking the dozens of different securities in which the fund invests; rather, all we need to do is to keep track of the fund's performance. Low Transaction Costs: Mutual funds are able to keep transaction costs -- that is, the costs associated with buying and selling securities -- at a minimum because they benefit from reduced brokerage commissions for buying and selling large quantities of investments at a single time.

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Professional Management: Mutual funds are managed by a team of professionals, which usually includes one mutual fund manager and several analysts.

Basic Mutual Fund Concepts There's a lot of terminology associated with mutual funds. These concepts are an important part of mutual fund investing. Open-end Funds All mutual funds fall into one of two broad categories: open-end funds and closed-end funds. Most mutual funds are open-end. The reason why these funds are called "open-end" is because there is no limit to the number of new shares that they can issue. New and existing shareholders may add as much money to the fund as they want and the fund will simply issue new shares to them. Open-end funds also redeem, or buy back, shares from shareholders. In order to determine the value of a share in an open-end fund at any time, a number called the Net Asset Value is used. We purchase shares in open-end mutual funds from the mutual fund itself or one of its agents; they are not traded on exchanges. Closed-end Funds Closed-end funds behave more like stock than open-end funds; that is to say, closed-end funds issue a fixed number of shares to the public in an initial public offering, after which time shares in the fund are bought and sold on a stock exchange. Unlike open-end funds, closed-end funds are not obligated to issue new shares or redeem outstanding shares. The price of a share in a closed-end fund is determined entirely by market demand, so shares can either trade below their net asset value ("at a discount") or above it ("at a premium"). Net Asset Value (NAV) Open-end mutual funds price their shares in terms of a Net Asset Value (NAV). NAV is calculated by adding up the market value of all the fund's underlying securities, subtracting all of the fund's liabilities, and then dividing by the number of outstanding shares in the fund. The resulting NAV per share is the price at which shares in the fund are INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 66

bought and sold (plus or minus any sales fees). Mutual funds only calculate their NAVs once per trading day, at the close of the trading session.

Public Offering Price (POP) The public offering price (POP) is the price at which shares are sold to the public. For funds that don't charge a sales commission (or "load"), the POP is simply equal to the Net Asset Value (NAV). For a load fund, the POP is equal to the NAV plus the sales charge. As with the NAV, the POP will typically change on a day to day basis. Stock Mutual Funds Simply put, stock funds (also sometimes called "equity funds") are mutual funds that invest only in stocks. For that reason, they are considered to be more risky than most other types of funds, such as bond funds or money market funds. Along with the greater risk, however, comes the potential for greater returns. Over long periods of time, equities have historically outperformed both bonds and cash investments, and when stocks do well, stock mutual funds naturally follow suit. But not all stock funds are alike -- these funds can vary greatly according to their stated objectives, their style of management, and the types of companies in which they invest. GROWTH FUNDS Growth funds are stock funds that invest in stocks with the potential for long-term capital appreciation. They focus on companies that are experiencing significant earnings or revenue growth, rather than companies that pay out dividends. The hope is that these rapidly growing companies will continue to increase in value, thereby allowing the fund to reap the benefits of large capital gains. In general, growth funds are more volatile than other types of funds -- in bull markets they tend to rise more than other funds but in bear markets they can fall much lower . VALUE FUNDS Value funds invest in companies that are thought to be good bargains -INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 67

that is to say, they invest in companies that have low P/E ratios . These are the stocks that have fallen out of favor with mainstream investors for one reason or another, either due to changing investor preferences, a poor quarterly earnings report or hard times in a particular industry. Value stocks are often the stock of mature companies that have stopped growing and that use their earnings to pay dividends . Thus value funds produce current income (from the dividends) as well as long-term growth (from capital appreciation once the stocks become popular again). They tend to have more conservative and less volatile returns than growth funds. AGGRESSIVE GROWTH FUNDS Aggressive growth funds are similar to regular growth funds, only they are more extreme. Like growth funds, aggressive growth funds target stocks of companies that are experiencing very rapid earnings or revenue growth. But aggressive growth funds tend to trade more frequently and take many more risks than regular growth funds. An aggressive growth fund might, for example, buy initial public offerings (IPOs) of stock from small companies and then resell that stock very quickly in order to generate big profits . Some aggressive growth funds may even invest in derivatives, such as options, in order to increase their gains . You should note that these funds can be quite volatile and risky investments. BLEND FUNDS These funds invest in both value and growth stocks so that we can enjoy current income and long-term capital appreciation within the same fund. Since blend funds tend to vary considerably it is difficult to make generalizations about how risky they are in comparison to other types of mutual funds -- most likely, they are somewhat more risky than value funds and somewhat less risky than growth funds. SECTOR FUNDS Sector funds are stock funds that invest in a single sector of the market, such as the energy sector or the biotechnology sector. Sector funds are usually used by investors to achieve growth -- in other words, you would choose sector funds that match the industries that you think are going to do well in the future. Some common sector funds include financial services funds, gold and precious metals funds, health care funds, and real estate funds, but mutual funds exist for just about every sector. To be INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 68

considered a sector fund, a fund must invest at least 25% of its portfolio in one sector, although many sector funds invest all of their holdings in a single industry. In general, sector funds are more volatile and risky than mutual funds that invest their assets across a wide variety of industries. LARGE CAP, MID CAP, SMALL CAP, AND MICRO CAP FUNDS Stock funds may also be classified according to the market capitalization of the companies in which they invest. The market capitalization, or "market cap", of a company is simply the value of the company on the stock market -- in other words, it is the number of outstanding shares of the company times the price of those shares. There are three main types of cap funds: large-cap, mid-cap, and small-cap. In general, the smaller the average market cap of the fund's holdings, the more volatile the return; micro-cap funds can be especially risky. FOCUSED FUNDS Focused funds are funds which hold large positions in a small number of stocks. While many mutual funds hold 100 positions or more, focused funds usually have 10 to 40 positions at any given time. They emphasize quality over quantity, and would rather hold just the stocks they have the most confidence in, rather than diversifying across a large number of holdings. Bond Mutual Funds As the name suggests, bond mutual funds invest in bonds and other debt securities. Investors typically choose to buy bond funds for two reasons: income and diversification. Bond funds tend to pay higher dividends than money market and savings accounts, and they usually pay out dividends more frequently than individual bonds. Bond funds are also considered to be "low risk" investments that can provide stability to a portfolio that is weighted heavily with stock. GOVERNMENTS BOND FUNDS Governments bond funds invest in debt securities that are issued by the INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 69

governments and its agencies. These funds are regarded as the safest of the bond funds because the underlying securities are backed by the full faith and credit of the government.

MUNICIPAL BOND FUNDS Municipal bond funds invest in debt securities issued by state and local governments to pay for local public projects, such as bridges, schools, and highways. CORPORATE BOND FUNDS Corporate bond funds are comprised of bonds issued by corporations. Unlike the securities held by governments and municipal bond funds, the bonds in a corporate bond fund are not backed by any government institution. Thus it is more likely that the underlying bonds could default if the companies that issue them run into financial trouble. Along with the greater risk, however, comes a greater reward -- the income paid out by corporate bond funds is typically much greater than that paid by municipal or government bond funds. OTHER TYPES OF BOND FUNDS Besides the aforementioned bond funds, there are many other types of bond funds. Zero-coupon bond funds invest in zero coupon bonds ; international bond funds invest in bonds issued by foreign governments and corporations; convertible securities funds invest in bonds that may be converted into stock . Other Types of Mutual Funds The mutual funds in this section cannot be classified as either stock funds or bond funds. Some, like lifecycle funds and balanced funds, invest in both stocks and bonds, while others, like money market funds, invest in neither. MONEY MARKET FUNDS Money market funds are among the safest and most stable of all the INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 70

different types of mutual funds. These funds invest in short term (one day to one year) debt obligations such as Treasury bills, certificates of deposit, and commercial paper . The main goal is the preservation of principal, accompanied by modest dividends.

INCOME FUNDS Income funds focus on providing investors with a steady stream of fixed income. In order to achieve this, they might invest in bonds, government securities, or preferred stocks that pay high dividends . They are considered to be conservative investments, since they stay away from volatile growth stocks. BALANCED FUNDS The purpose of balanced funds (also sometimes referred to as "hybrid funds") is to provide investors with a single mutual fund that combines both growth and income objectives. In order to achieve this goal, balanced funds invest in both stocks (for growth) and bonds (for income). Balanced funds typically invest no more than 50% of their money in stocks, with the rest allocated to debt instruments. ASSET ALLOCATION FUNDS Asset allocation funds are a type of balanced fund that invest in a number of different asset classes, such as stocks, bonds and cash. They are similar to balanced funds, except they invest in many other types of asset classes in addition to stocks and bonds (e.g. money market accounts). INTERNATIONAL, MARKETS GLOBAL, REGIONAL, AND EMERGING FUNDS

Global funds invest throughout the world, including in the U.S. Global mutual funds can provide more opportunities for diversification than domestic funds alone. We should take into account, however, that there can be additional risks associated with global funds involving currency fluctuations and political and economic instability abroad. International funds (sometimes referred to as foreign funds) are similar to global funds but with one major exception: they do not invest in any INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 71

domestic assets. International funds therefore do not offer as great an opportunity for diversification as global funds, but they are useful for investors who want to concentrate their holdings in foreign assets only, or who already have significant domestic investments in their portfolio. As with global funds, international funds can involve risks associated with currency fluctuations and political and economic instability abroad. Regional funds can be thought of as a particular type of international fund that focuses on only one particular region -- for example, Western Europe or Latin America. Even more specific are emerging markets funds that invest only in the capital markets of foreign countries that are undergoing dramatic economic transitions, such as those economies that are transforming from an agricultural economy to an industrialized one (as in the case of many third world countries) or those that are transforming from a state-run economy to a free-market one (as in the case of many former Eastern bloc countries). Emerging markets funds offer potentially higher-than-normal returns due to these economic transitions, but they can also involve a significant amount of risk if the economic transition fails or if there is instability in the country or its currency. MORTGAGE-BACKED SECURITIES FUNDS Mortgage-backed securities funds invest in home mortgage securities that are offered through several government agencies. Mortgage-backed securities funds receive interest payments on the mortgages, which they pass on to shareholders, as well as principal payments, which they use to reinvest in more securities . These funds are considered to be very safe since mortgage-backed securities from the aforementioned agencies are either backed by the federal government or they have very high credit ratings. However, these funds may suffer from prepayment risks (in which case the mortgagor may pay off the principal earlier than anticipated) and interest rate fluctuations (which could cause the value of the fund to go up and down). HEDGE FUNDS Hedge funds are funds that use a variety of aggressive investing strategies (such as short selling, investing in derivatives, and leverage) to seek higher returns. Hedge funds are exempt from many of the rules and regulations governing other mutual funds, which allows them to accomplish aggressive investing goals. They are restricted by law to no more than 100 investors per fund, and as a result most hedge funds set exceptionally high minimum investment amounts. INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 72

FUND SUPERMARKETS Fund supermarkets are analogous to grocery supermarkets: they allow consumers to buy a variety of goods from different producers at one central location. In the case of fund supermarkets, the consumers are investors, the producers are mutual fund families, and the central location is a brokerage firm. The primary benefit of such an arrangement is simplicity: we get to buy funds from different families and receive all their statements in a single report. Fund supermarkets are also supposed to save on costs, since the funds are usually traded with no commissions and no transaction fees. FUNDS OF FUNDS "Funds of funds" (FOFs) are meta-mutual funds; that is, they are mutual funds that invest in other mutual funds. Just as a normal mutual fund invests in a number of different securities, so an FOF buys shares of many different mutual funds. These funds were designed to achieve even greater diversification than normal mutual funds; however, they suffer from several drawbacks. Expense fees on FOFs are typically higher than those on regular funds because they include part of the expense fees charged by the underlying funds. INSTITUTIONAL FUNDS Institutional funds are mutual funds that target pension funds, endowments, the wealthy, and other multi-million dollar investors. Their main objective is to reduce risk, so they invest in hundreds of different securities, which makes these funds among the most diversified funds available. They also do not tend to trade securities very often, so they are able to keep operating costs to a minimum. SOCIALLY RESPONSIBLE FUNDS Perhaps the most subjective of all the types of mutual funds, socially responsible funds aim to invest only in companies that adhere to certain ethical and moral principles. Exactly what this means obviously varies from fund to fund, but some examples include: funds that only invest in environmentally conscious companies ("green funds"), funds that invest in hospitals and health care centers, and funds that avoid investing in alcohol or tobacco companies. Socially responsible funds try to maximize returns while staying within these self-imposed boundaries. INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 73

CONTRARIAN FUNDS Contrarian funds seek to make a profit by investing in the opposite direction of the prevailing market sentiment. Contrarian funds will invest in bonds when the stock market is high (in anticipation that it will fall) and stocks when the stock market is low (in anticipation it will rise). GIC FUNDS GIC funds are mutual funds that invest solely in guaranteed investment contracts (GICs). GICs are fixed income debt instruments sold by insurance companies to pensions and other types of retirement plans. They pay a fixed interest rate over a short period of time, usually about 5 years, and they are guaranteed by the insurance agency that issues them, not by the government. As with other mutual funds that invest in debt instruments, GIC funds are generally considered to be conservative investments. OPTION AND FUTURES FUNDS Option and futures funds are among the most risky mutual funds available. This is because the fund does not own the securities underlying the options or the futures; it only owns the right or the obligation to buy or sell those securities at a certain date in the future . The goal of option and futures funds is primarily capital appreciation, although sometimes they are used to hedge against prevailing market conditions. Most option and futures funds have minimum net worth requirements and are not appropriate investments for inexperienced investors (just as options and futures aren't appropriate for beginners). 4. Commodities A commodity is any physical substance, such as food, grains, and metals, which is interchangeable with another product of the same type, and which investors buy or sell, usually through futures contracts. The term is sometimes used more generally to include any product which trades on a commodity exchange; this would also include foreign currencies and financial instruments and indexes. The price of the commodity is subject to supply and demand factors. Risk is actually the reason exchange trading of the basic agricultural products began. For example, a farmer risks the cost of producing a product ready for market at sometime in the INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 74

future because he doesn't know what the selling price will be. A speculator can pay the farmer or anyone else producing commodities because the speculator wants to make a profit. This is called trading in futures. The following is a list of commodities available for futures trading: Agricultural: grains, oils, livestock, wood, textiles, food products Metallurgical: metals, petroleum, chemicals Interest Bearing Assets: T-bills, bonds, notes Stock Indices Currencies Most of these contracts are used by corporations to hedge positions taken elsewhere. Some futures contracts, notably those for stock indices, are settled in cash because they are not deliverable goods. The contracts also vary in terms of the transaction date and the quality level of goods to be bought and sold. New futures contracts are created continuously, but many are not liquid enough to trade regularly and are used only as hedges. Investors can receive advice in the futures market from Commodity Trading Advisors. These advisors make specific recommendations about buying and selling futures contracts after considering the circumstances of the investor. Managed futures accounts result from giving power of attorney to trade futures to an account manager. Even though the investor is no longer making trades, he is responsible for margin calls, and gains and losses appear as credits or debits respectively in the managed account. Commodities pools are analogous to mutual funds in that many investors pool their assets to gain the power to make trades that they could not make individually. Additional benefits include bypassing margin requirements and limiting risk to the amount invested in the pool. Investing with the help of an advisor, manager or pool may have its advantages, but it certainly does not eliminate risk or guarantee any degree of success, and we do not recommend commodities or future trading, with or without expert assistance, for any investors who aren't very experienced. 5. Futures INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 75

A futures contract is a standardized, transferable, exchange-traded contract that requires delivery of a commodity, bond, currency, or stock index, at a specified price, on a specified future date. Generally, the delivery does not occur; instead, before the contract expires, the holder usually "squares their position" by paying or receiving the difference between the current market price of the underlying asset and the price stipulated in the contract. Unlike options, futures contracts convey an obligation to buy. The risk to the holder is unlimited. Because the payoff pattern is symmetrical, the risk to the seller is unlimited as well. Money lost and gained by each party on a futures contract are equal and opposite. In other words, futures trading is a zero-sum proposition. Futures contracts are forward contracts, meaning they represent a pledge to make a certain transaction at a future date. The exchange of assets occurs on the date specified in the contract. Futures are distinguished from generic forward contracts in that they contain standardized terms, trade on a formal exchange, are regulated by overseeing agencies, and are guaranteed by clearinghouses. Also, in order to insure that payment will occur, futures have a margin requirement that must be settled daily. Finally, by making an offsetting trade, taking delivery of goods, or arranging for an exchange of goods, futures contracts can be closed. Futures are risky investment vehicle that are appropriate for only the smallest percentage of highly advanced investors. FUTURES TRADING Futures contracts are purchased when the investor expects the price of the underlying security to rise. This is known as going long. Because he has purchased the obligation to buy goods at the current price, the holder will profit if the price goes up, allowing him to sell his futures contract for a profit. The opposite of going long is going short. In this case, the holder acquires the obligation to sell the underlying commodity at the current price. He will profit if the price declines before the future date. Hedgers trade futures for the purpose of keeping price risk in check. Because the price for a future transaction can be set in the present, the INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 76

fluctuations in the interim can be avoided. Hedging with futures can even be used to protect against unfavorable interest rate adjustments. While hedgers attempt to avoid risk, speculators seek it out in the hope of turning a profit when prices fluctuate. Speculators trade purely for the purpose of making a profit and never intend to take delivery on goods. Accounts used to trade futures must be settled with respect to the margin on a daily basis. Gains and losses are tallied on the day that they occur. Margin accounts that fall below a certain level must be credited with additional funds. PRICING FUTURES Futures prices are presented in the same format as cash market prices. When these prices change, they must change by at least a certain minimum amount, called the tick. The tick is set by the exchange. Prices are also subject to a maximum daily change. These limits are also determined by the exchange. Once a limit is reached, no trading is allowed on the other side of that limit for the duration of the session. Both lower and upper limits are in effect. Limits were instituted to guard against particularly drastic fluctuations in the market. In addition to these limits, there is also a maximum number of contracts for a given commodity per person. This limit serves to prevent one investor from gaining such great influence over the price that he can begin to control it. 6. Options Options are a type of derivative, which simply means that their value depends on the value of an underlying investment. In most cases, the underlying investment is a stock, but it can also be an index, a currency, a commodity, or any number of other securities. A stock option is a contract that guarantees the investor who has purchased it the right, but not the obligation, to buy or sell 100 shares of the underlying stock at a fixed price prior to a certain date. Each option has a buyer, called the holder, and a seller, known as the writer. If the option contract is exercised, the writer is responsible for fulfilling the terms of the contract by delivering the shares to the appropriate party. In INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 77

the case of a security that cannot be delivered such as an index, the contract is settled in cash. There are two basic forms of options. A call option provides the holder with the right to buy 100 shares of the underlying stock at the strike price, and a put option provides the holder with the right to sell 100 shares of the underlying stock at the strike price. If the price of a stock is going to rise, a call option allows the holder to buy stock at the price before the increase occurs. Similarly, if the price of a stock is falling, a put option allows the holder to sell at the earlier, higher price. For the holder, the potential loss is limited to the price paid to acquire the option. When an option is not exercised, it expires. No shares change hands and the money spent to purchase the option is lost. The upside, however, is unlimited. Options, like stocks, are therefore said to have an asymmetrical payoff pattern. For the writer, the potential loss is unlimited unless the contract is covered, meaning that the writer already owns the security underlying the option. Option Components An option for a given stock has three main components: an expiration date, a strike price and a premium. The expiration date tells the month in which the option will expire. The strike price is the price at which the holder is allowed to buy or sell the underlying stock at a later date. The premium is amount that the holder must pay for the right to exercise the option. Because the holder acquires the right to trade 100 shares, the total cost of the option, if exercised, is 100 times the premium. In order to relate them to the price of the underlying stock at any given time, options are classified as in-the-money, out-of-the-money or at-themoney. A call option is in-the-money when the stock price is above the strike price and out-of-the-money when the stock price is below the strike price. For put options, the reverse is true. When the stock price and strike price are equal, both types of options are considered at-the-money. Valuing and Pricing Options The price of an option is primarily affected by: The difference between the stock price and the strike price The time remaining for the option to be exercised The volatility of the underlying stock INTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 78

Affecting the premium to a lesser degree are factors such as interest rates, market conditions, and the dividend rate of the underlying stock. Exercising Options Exercising an option consists of buying (in the case of a call option) or selling (in the case of a put option) 100 shares of the underlying stock at the strike price. Options are classified as American or European depending on the way in which the holder may exercise them. The holder may exercise an American style option at any point between the time of purchase and the expiration date. A European style option, on the other hand, cannot be exercised until expiration. Most stock options are American style, but some index options are European style. 7. Other Types of Cash Investments As their name implies, cash investments are easily redeemable with small, if any, penalties for withdrawal. Examples of cash investments include money market funds, bank accounts and certificates of deposit (CDs). Investors benefit from the low-risk yield and high liquidity of cash investments. The downsides to cash investments are the low interest rate and the fact that a favorable interest rate can only be locked in temporarily due to the short periods of time that the interest rate is locked in. CERTIFICATES OF DEPOSIT Traditional CDs are savings certificates that pay a fixed interest rate until they reach maturity. Most are issued by banks and have a somewhat higher interest rate than savings accounts. CDs are very flexible in that they can be issued in any denomination and have a range of maturities. The most common maturities are three months and six months. When the CD reaches maturity, the holder receives the principal invested plus all interest earned while the CD matured. One downside to CDs is that there is a penalty associated with removing funds before the maturity date. THE MONEY MARKET The money market is used to buy and sell fixed income securities. Unlike the bond market, money market investments are short-term. These shortINTERNATIONAL INVESTMENTS AND TRANSNATIONAL COMPANIES 79

term loans usually have a maturity of less than six months. Money market securities are generally very safe investments which return a reasonable interest rate that is most appropriate for temporary cash storage or shortterm time horizons. Bid and ask spreads are relatively small due to the large size of the market. TYPES OF MONEY MARKET INSTRUMENTS Treasury Bills are an extremely low-risk investment vehicle. T-Bills are auctioned off and guaranteed by the government. They mature in either 3 months, 6 months or 12 months, meaning that they have short enough terms to avoid the risks associated with rising interest rates. The bills are sold at a discount from face value and can be redeemed for their full value at maturity. Commercial paper is available in a wide range of denominations. These promissory notes are short-term debt instruments issued by companies. They can be of either the discounted or interest-bearing variety. They usually have a limited or nonexistent secondary market. Commercial paper is usually issued by companies with high credit ratings, meaning that the investment is almost always relatively low risk. There are a variety of other notes available that vary in terms of return, risk and liquidity, but all are relatively safe investments that return a modest interest rate.

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