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Infosys Technologies Limited, SBU2

TABLES OF CONTENT

ACKNOWLEDGEMENT ---------------------------------------------------------------------------------------------------------- 3 PREFACE ------------------------------------------------------------------------------------------------------------------------------ 4 STOCKS - BASICS------------------------------------------------------------------------------------------------------------------- 5 PREFERRED SHARES --------------------------------------------------------------------------------------------------------------------- 6 AMERICAN DEPOSITARY RECEIPTS (ADRS) ----------------------------------------------------------------------------------------- 7 DIVIDENDS -------------------------------------------------------------------------------------------------------------------------------- 8 HOW CAN YOU TRY TO PREDICT WHAT THE DIVIDEND WILL BE BEFORE IT IS DECLARED? ------------------------------------ 9 TYPES OF INDEXES: --------------------------------------------------------------------------------------------------------------------- 10 Type A index --------------------------------------------------------------------------------------------------------------------- 10 Type B index --------------------------------------------------------------------------------------------------------------------- 10 Type C index --------------------------------------------------------------------------------------------------------------------- 11 THE DOW JONES INDUSTRIAL AVERAGE -------------------------------------------------------------------------------------------- 11 OTHER INDEXES ------------------------------------------------------------------------------------------------------------------------- 11 US Indexes: ---------------------------------------------------------------------------------------------------------------------- 11 Non-US Indexes: ---------------------------------------------------------------------------------------------------------------- 12 IPOS (INITIAL PUBLIC OFFERINGS) -------------------------------------------------------------------------------------------------- 12 Introduction to IPOs ------------------------------------------------------------------------------------------------------------ 12 The Mechanics of Stock Offerings--------------------------------------------------------------------------------------------- 13 The Underwriting Process ----------------------------------------------------------------------------------------------------- 14 MARKET CAPITALIZATION ------------------------------------------------------------------------------------------------------------- 16 REPURCHASING BY COMPANIES (ALSO CALLED BUY BACK) --------------------------------------------------------------------- 16 STOCK SPLITS ---------------------------------------------------------------------------------------------------------------------------- 16 WARRANTS ------------------------------------------------------------------------------------------------------------------------------- 17 BONDS - BASICS ------------------------------------------------------------------------------------------------------------------- 18 MOODY BOND RATINGS --------------------------------------------------------------------------------------------------------------- 19 BOND TERMINOLOGY------------------------------------------------------------------------------------------------------------------- 20 Advance Refunding : ------------------------------------------------------------------------------------------------------------ 20 Callable Bond : ------------------------------------------------------------------------------------------------------------------ 20 Discount Bond : ----------------------------------------------------------------------------------------------------------------- 20 Double Barrelled: --------------------------------------------------------------------------------------------------------------- 20 Face Value: ---------------------------------------------------------------------------------------------------------------------- 20 Par Value: ------------------------------------------------------------------------------------------------------------------------ 20 Premium Bond: ------------------------------------------------------------------------------------------------------------------ 20 Principal: ------------------------------------------------------------------------------------------------------------------------- 20 Revenue Bonds: ------------------------------------------------------------------------------------------------------------------ 20 Sinking Fund: -------------------------------------------------------------------------------------------------------------------- 20 Yield: ------------------------------------------------------------------------------------------------------------------------------ 21 Yield to Maturity: ---------------------------------------------------------------------------------------------------------------- 21 RELATIONSHIP OF PRICE AND INTEREST RATE ------------------------------------------------------------------------------------- 21 TREASURY DEBT INSTRUMENTS ------------------------------------------------------------------------------------------------------ 21 ZERO-COUPON BONDS ------------------------------------------------------------------------------------------------------------------ 21 DERIVATIVES - BASICS --------------------------------------------------------------------------------------------------------- 23 FUTURES ---------------------------------------------------------------------------------------------------------------------------------- 24 Commodity futures -------------------------------------------------------------------------------------------------------------- 24 Stock index futures -------------------------------------------------------------------------------------------------------------- 24 Interest rate futures (including deposit futures, bill futures and government bond futures) --------------------------- 24

Infosys Technologies Limited, SBU2

STOCK OPTION BASICS ----------------------------------------------------------------------------------------------------------------- 25 CALL OPTION ---------------------------------------------------------------------------------------------------------------------------- 26 PUT OPTION ------------------------------------------------------------------------------------------------------------------------------ 27 LEAPS ------------------------------------------------------------------------------------------------------------------------------------ 28 EXCHANGES ------------------------------------------------------------------------------------------------------------------------ 29 MARKET MAKERS AND SPECIALISTS ------------------------------------------------------------------------------------------------- 29 THE NASDAQ -------------------------------------------------------------------------------------------------------------------------- 29 THE NEW YORK STOCK EXCHANGE-------------------------------------------------------------------------------------------------- 29 OVER THE COUNTER (OTC)----------------------------------------------------------------------------------------------------------- 29 TRADING ----------------------------------------------------------------------------------------------------------------------------- 30 AFTER HOURS --------------------------------------------------------------------------------------------------------------------------- 30 BID, ASK, AND SPREAD ---------------------------------------------------------------------------------------------------------------- 31 BROKER ----------------------------------------------------------------------------------------------------------------------------------- 31 INTRODUCING BROKER ----------------------------------------------------------------------------------------------------------------- 32 DISCOUNT BROKERS -------------------------------------------------------------------------------------------------------------------- 33 DIRECT INVESTING AND DRIPS ------------------------------------------------------------------------------------------------------ 34 FREE RIDE RULES ----------------------------------------------------------------------------------------------------------------------- 34 MARGIN TRADING ---------------------------------------------------------------------------------------------------------------------- 35 DELIVERY-VERSUS-PAYMENT --------------------------------------------------------------------------------------------------------- 37 INSIDERS TRADING ---------------------------------------------------------------------------------------------------------------------- 37 JARGON AND TERMINOLOGY1 --------------------------------------------------------------------------------------------------------- 37 CLEARING PROCESS--------------------------------------------------------------------------------------------------------------------- 39 NETTING ---------------------------------------------------------------------------------------------------------------------------------- 40 PORTFOLIO MANAGEMENT ------------------------------------------------------------------------------------------------------------ 40 DAY, GTC, LIMIT, AND STOP-LOSS ORDERS --------------------------------------------------------------------------------------- 40 PINK SHEET STOCKS -------------------------------------------------------------------------------------------------------------------- 42 PROCESS DATE -------------------------------------------------------------------------------------------------------------------------- 42 ROUND LOTS OF SHARES--------------------------------------------------------------------------------------------------------------- 42 SIZE OF THE MARKET ------------------------------------------------------------------------------------------------------------------- 45 TICK, UPTICK, AND DOWNTICK ------------------------------------------------------------------------------------------------------- 45 TRANSFERRING AN ACCOUNT --------------------------------------------------------------------------------------------------------- 45 APPNEDIX-1 ------------------------------------------------------------------------------------------------------------------------- 46 APPENDIX - 2------------------------------------------------------------------------------------------------------------------------ 49 APPNEDIX-3 ------------------------------------------------------------------------------------------------------------------------- 51 REFERENCES ----------------------------------------------------------------------------------------------------------------------- 52

Infosys Technologies Limited, SBU2

Acknowledgement

As in all undertakings of this kind, I have gained valuable advice from many people. I am especially thankful to Joydeep and Sachin whose valuable comments and suggestions went a long way in bringing this manual to a successful conclusion. I am also thankful the various module leaders of Goldman Sachs project for their valuable time in explaining me the details functional aspects of the project.

Anil Kumar Jena. 29th June 1998.

Infosys Technologies Limited, SBU2

Preface
This manual is about the securities and trading in various securities. It is aimed at providing a comprehensive introduction to various securities traded in the market place (U.S) and the trading mechanism. The approach is from a laymans perspective and aimed at the people joining SBU2 afresh. Though the idea was to prepare a manual which can be helpful for the people in Goldman Sachs project, this manual would be helpful to people who are in other projects but are related to securities. This book has been divided into five parts covering stocks, bonds, derivatives, Stock exchanges and trading. Each part starts with the basics of that particular topic and goes to more detailed covering later. Appendix 1 provides the areas of the operation of Goldman Sachs and the people not working in the project can skip this section. Even though the manual is designed for the freshers, it can be a good reading for the people who are going onsite. Apart from the manual the people who are going onsite can supplement their knowledge by reading Security analysis and portfolio Management by Donald E. Fischer and Ronald J. Jordan (Chapter 1 and 2. This book is available in IIM, Bangalore library of which Infosys is a corporate member.) Some of the sections in this manual will make advanced reading (Italicised in the manual) and the freshers can skip these sections. These sections are designed for the people going onsite. This manual might need two readings and will take 6-7 hours in all. I sincerely hope the readers find this manual interesting and helpful. The manual, though touches upon the all the basics, to the keen reader, will provide with many loose ends. Please feel free to ask any doubt you may have regarding the topics covered or any other areas of finance. I will be most happy to answer your queries. HAPPY LEARNING!!!

Anil Kumar Jena ANILKUMARJ@inf.com

Infosys Technologies Limited, SBU2

Stocks - Basics
Perhaps we should start by looking at the basics: What is stock? Why does a company issue stock? Why do investors pay good money for little pieces of paper called stock certificates? What do investors look for? What about Value Line ratings and what about dividends? Stock is nothing but a piece of ownership of a company. The owner of a stock is owner of the company to the extent of his/her holding as a percentage of the total stock floating in the market. Since the stockholder is the owner of the company, he obviously has right on the profit of the company. At the end of the year when the profit gets distributed, he/she also gets some booty depending upon his/her share. This we call as dividend. Now this is more of bookish definition. Let us understand stock in more detail. To start with, if a company wants to raise capital (money) one of its options is to issue stock. It has other methods, such as issuing bonds and getting a loan from the bank. But stock raises capital without creating debt, without creating a legal obligation to repay those funds. What do the buyers of the stock -- the new owners of the company -- expect for their investment? The popular answer, the answer many people would give is: they expect to make lots of money; they expect other people to pay them more than they paid themselves. Well, that doesn't just happen randomly or by chance (well, maybe sometimes it does, who knows?) The less popular, less simple answer is: shareholders -- the company's owners -- expect their investment to earn more, for the company, than other forms of investment. If that happens, if the return on investment is high, the price tends to increase. Why? Who really knows? But it is true that within an industry the Price/Earnings (i.e., P/E) ratio tends to stay within a narrow range over any reasonable period of time -- measured in months or a year or so. So if the earnings go up, the price goes up. And investors look for companies whose earnings are likely to go up. How much? There's a number -- the accountants call it Shareholder Equity -- which in some magical sense represents the amount of money the investors have invested in the company. I say magical because while it translates to (Assets - Liabilities) there is often a lot of accounting trickery that goes into determining Assets and Liabilities. But looking at Shareholder Equity, (and dividing that by the number of shares held to get the book value per share) if a company is able to earn, say, $1.50 on a stock whose book value is $10, that's a 15% return. That's actually a good return these days, much better than you can get in a bank or C/D or Treasury bond, and so people might be more encouraged to buy, while sellers are anxious to hold on. So the price might be bid up to the point where sellers might be persuaded to sell.

Infosys Technologies Limited, SBU2

A measure that is also sometimes used to assess the price is the Price/Book (i.e., P/B) ratio. This is just the stock price at a particular time divided by the book value. What about dividends? Dividends are certainly more tangible income than potential earnings increases and stock price increases, so what does it mean when a dividend is non-existent or very low? And what do people mean when they talk about a stock's yield? To begin with the easy question first, the yield is the annual dividend divided by the stock price. For example, if company XYZ is paying $.25 per quarter ($1.00 per year and XYZ is trading at $10 per share, the yield is 10%. A company paying no or low dividends (zero or low yield) is really saying to its investors -- its owners, "We believe we can earn more, and return more value to shareholders by retaining the earnings, by putting that money to work, than by paying it out and not having it to invest in new plant or goods or salaries." And having said that, they are expected to earn a good return on not only their previous equity, but on the increased equity represented by retained earnings. So a company whose book value last year was $10 and who retains its entire $1.50 earnings increases its book value to 11.50 less certain expenses. That increased book value - let's say it is now $11 -- means the company must earn at least $1.65 this year Just to keep up with its 15% return on equity. If the company earns $1.80, the owners have indeed made a good investment, and other investors, seeking to get in on a good thing, bid up the price. That's the theory anyway. In spite of that, many investors still buy or sell based on what some commentator says or on announcement of a new product or on the hiring (or resignation) of a key officer, or on general sexiness of the company's products. And that will always happen. Preferred Shares Preferred stocks combine characteristics of common stocks and bonds. Garden-variety preferred shares are a lot like general obligation bonds/debentures; they are called shares, but carry with them a set dividend, much like the interest on a bond. Preferred shares also do not normally vote, which distinguishes them from the common shares. While today there are a lot of different kinds of hybrid preferred issues, such as a call on the gold production of Freeport McMoran Copper and Gold to the point where they will deliver it, we will consider characteristics of the most ordinary variety of preferred shares. In general, a preferred has a fixed dividend (as a bond pays interest), a redemption price (as a bond), and perhaps a redemption date (like a bond). Unlike a stock, it normally does not participate in the appreciation (or drop) of the common stock (it trades like a bond). Preferreds can be thought of as the lowest-possible grade bonds. The big point is that the dividend must be paid from after-tax money, making them a very expensive form of capitalization. One difference from bonds is that in liquidation (e.g. following bankruptcy), bondholder claims have priority over preferred shares, which in turn have priority over common shares (in that sense, the preferred shares are "preferred"). These shares are also preferred (hence the name) with respect to payment of dividends, while common shares may have a rising, falling or omitted dividends. Normally a common dividend may not be paid unless the preferred shares are fully paid. In many
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Infosys Technologies Limited, SBU2

cases (sometimes called "cumulative preferred"), not only must the current preferred dividend be paid, but also any missed preferred dividends (from earlier time periods) must be made up before any common dividend may be paid. Basically, preferreds stand between the bonds and the common shares in the pecking order. So if a company goes bankrupt, and the bondholders get paid off, the preferreds have next call on the assets - and unless they get something, the common shareholders don't either. Some preferred shares also carry with them a conversion privilege (and hence may be called "convertible preferred"), normally at a fixed number of shares of common per share of preferred. If the value of the common shares into which a preferred share maybe converted is low, the preferred will perform price-wise as if it were a bond; that is often the case soon after issue. If, however, the common shares rise in value enough, the value of the preferred will be determined more by the conversion feature than by its value as a pseudo-bond. Thus, convertible preferred might perform like a bond early in its life (and its value as a pseudo-bond will be a floor under its price) and, if all goes well, as a (multiple of) common stock later in its life when the conversion value governs. And as time has gone on, even more elaborate variations have been introduced. The primary reason is that a firm can tailor its cost of funds between that of the common stock and bonds by tailoring a preferred issue. But it isn't a bond on the books - and it costs more than common stock.

American Depositary Receipts (ADRs) An American Depositary Receipt (ADR) is a share of stock of an investment in shares of a non-US corporation. The shares of the non-US corporation trade on a non-US exchange, while the ADRs, perhaps somewhat obviously, trade on a US exchange. This mechanism makes it straightforward for a US investor to invest in a foreign issue. ADRs were first introduced in 1927. Two banks are generally involved in maintaining an ADR on a US exchange: an investment bank and a depositary bank. The investment bank purchases the foreign shares and offers them for sale in the US. The depositary bank handles the issuance and cancellation of ADRs certificates backed by ordinary shares based on investor orders, as well as other services provided to an issuer of ADRs, but is not involved in selling the ADRs. To establish an ADR, an investment bank arranges to buy the shares on a foreign market and issue the ADRs on the US markets. For example, BigCitibank might purchase 25 million shares of a non-US stock. Call it Infosys Technologies Limited (INFOSYS). Perhaps INFOSYS trades on the Paris exchange, where BigCitibank bought them. BigCitibank would then register with the SEC and offer for sale shares of INFOSYS ADRs.

Infosys Technologies Limited, SBU2

INFOSYS ADRs are valued in dollars, and BigCitibank could apply to the NYSE to list them. In effect, they are repackaged INFOSYS shares, backed by INFOSYS shares owned by BigCitibank, and they would then trade like any other stock on the NYSE. BigCitibank would take a management fee for their efforts, and the number of INFOSYS shares represented by INFOSYS ADRs would effectively decrease, so the price would go down a slight amount; or INFOSYS itself might pay BigCitibank their fee in return for helping to establish a US market for INFOSYS. Naturally, currency fluctuations will affect the US Dollar price of the ADR. BigCitibank would set up an arrangement with another large financial institution for that institution to act as the depositary bank for the ADRs. The depositary would handle the day-to-day interaction with holders of the ADRs. Dividends paid by INFOSYS are received by BigCitibank and distributed proportionally to INFOSYS ADR holders. If INFOSYS withholds (foreign) tax on the dividends before this distribution, then BigCitibank will withhold a proportional amount before distributing the dividend to ADR holders, and will report on a Form 1099-Div both the gross dividend and the amount of foreign tax withheld. Dividends Dividend, as discussed earlier, is nothing but the portion of the profit, which is distributed among the shareholders. Dividend is always a percentage of the face value of the share. If the face value of the stock is $10, and the company declares 10% dividend, then you get $1 for each share you hold. Now remember that, not all of profit is distributed. Part of it is retained so that it can be used for further growth of the company or some contingency. This part is aptly called Reserve. A company may periodically declare cash and/or stock dividends. This article deals with cash dividends on common stock. Two paragraphs also discuss dividends on Mutual Fund shares. A separate article elsewhere in this manual discusses stock splits and stock dividends. The Board of Directors of a company decides if it will declare a dividend, how often it will declare it, and the dates associated with the dividend. Quarterly payment of dividends is very common, annually or semiannually is less common, and many companies don't pay dividends at all. Other companies from time to time will declare an extra or special dividend. Mutual funds sometimes declare a year-end dividend and maybe one or more other dividends. If the Board declares a dividend, it will announce that the dividend (of a set amount) will be paid to Shareholders of record as of the RECORD DATE and will be paid or distributed on the

Stock dividend is nothing but the dividend in forms of stock and is the distribution of stocks to the existing stockholders as a percentage of the present holding. If the stock dividend is 1:2, you will get 1 stock extra for every 2 stocks you hold.

Record Date: The date on which the tally is taken for who the shareholders are. The shareholders as of that date are eligible for dividend. So if you buy some stock and sold it just before the record date, you can as well forget the dividend. So bad !!!

Infosys Technologies Limited, SBU2

DISTRIBUTION DATE (sometimes called the Payable Date). Before we begin the discussion of dates and date cutoffs, it's important to note that three-day settlements (T+3) became effective 7 June 1995. In other words, the SEC's T+3 rule states that all stock trades must be settled within 3 business days. In order to be a shareholder of record on the RECORD DATE you must own the shares on that date (when the books close for that day). Since virtually all stock trades by brokers on exchanges are settled in 3 (business) days, you must buy the shares at least 3 days before the RECORD DATE in order to be the shareholder of record on the RECORD DATE. So the (RECORD DATE - 3 days) is the day that the shareholder of record needs to own the stock to collect the dividend. He can sell it the very next day and still get the dividend. If you bought it at least 3 business days before the RECORD date and still owned it at the end of the RECORD DATE, you get the dividend. (Even if you ask your broker to sell it the day after the (RECORD DATE - 3 days), it will not have settled until after the RECORD DATE so you will own it on the RECORD DATE.) So someone who buys the stock on the (RECORD DATE - 2 days) does not get the dividend. A stock paying a 50c quarterly dividend might well be expected to trade for 50c less on that date, all things being equal. In other words, it trades for its previous price, Except for the Dividend. So the (RECORD DATE - 2 days) is often called the EX-DIV date. In the financial listings, an x indicates that. How can you try to predict what the dividend will be before it is declared? Many companies declare regular dividends every quarter, so if you look at the last dividend paid, you can guess the next dividend will be the same. Exception: when the Board of IBM, for example, announces it can no longer guarantee to maintain the dividend, you might well expect the dividend to drop, drastically, next quarter. The financial listings in the newspapers show the expected annual dividend, and other listings show the dividends declared by Boards of directors the previous day, along with their dates. Other companies declare less regular dividends. Companies, whose shares trade as are very dependent on currency market fluctuations, so will pay differing amounts from time to time. Some companies may be temporarily prohibited from paying dividends on their common stock, usually because they have missed payments on their bonds and/or preferred stock. On the DISTRIBUTION DATE shareholders of record on the RECORD date will get the dividend. If you own the shares yourself, the company will mail you a check. If you participate in a DRIP (Dividend reinvestment Plan, see article on DRIPs elsewhere in this manual) and elect to reinvest the dividend, you will have the dividend credited to your DRIP account and purchase shares, and if your stock is held by your broker for you, the broker will receive the dividend from the company and credit it to your account.

Infosys Technologies Limited, SBU2

Dividends on preferred stock work very much like common stock, except they are much more predictable. Since most of the time they are mentioned at the time of issue. Finally, just a bit of accounting information. Earnings are always calculated first, and then the directors of a company decide what to do with those earnings. They can distribute the earnings to the stockholders in the form of dividends, retain the earnings, or take the money and head for Brazil (NB: the last option tends to make the stockholders angry and get the local district attorney on the case :-). Utilities and seasonal companies often pay out dividends that exceed earnings - this tends to prop up the stock price nicely - but of course no company can do that year after year. Types of Indexes: Indexes are the barometers of the market and are indicators of how the market is moving. They are constructed by taking some of the stocks, which are indicative of the market. The sample is such that they represent various sectors of economy. The better the sampling, the better is the indication. They are constructed by taking n number of stocks. The examples below give idea about various indexes. This list is by no way exhaustive. Investors use different indexes depending upon their requirements. For example the mutual funds use indexes, which are fairly broad based (That is in index, which is constructed by taking more number of shares into consideration. The reason Better sample which will represent the market better). There are three major classes of indexes in use today in the US. They are: A - equally weighted price index An example is the Dow Jones Industrial Average B - market-capitalization-weighted index An example is the S&P Industrial Average C - equally-weighted returns index The only one of its kind is the Value-Line index. Of these, A and B are widely used. Type A index As the name suggests, the index is calculated by taking the average of the prices of a set of companies: Index = Sum(Prices of N companies) / N Type B index In this index, each of the N company's price is weighted by the market capitalization of the company. Sum (Company market capitalization * Price) over N companies -----------------------------------------------------------Market capitalization for these N companies

Index =

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Type C index Here the index is the average of the returns of a certain set of companies. Value Line publishes two versions of it: the arithmetic index : (VLAI/N) = 1 * Sum(N returns) the geometric index : VLGI = {Product(1 + return) over N}^{1/n}, which is just the geometric mean of the N returns. The Dow Jones Industrial Average The Dow Jones averages are computed by summing the prices of the stocks in the average and then dividing by a constant called the "divisor". The divisor for the Dow Jones Industrial Average (DJIA) is adjusted periodically to reflect splits in the stocks making up the average. The divisor was originally 30 but has been reduced over the years to a value far less than one. The current value of the divisor is about 0.35; the precise value is published in the Wall Street Journal and Barron's. According to Dow Jones, the industrial average started out with 12 stocks in 1896. Those original stocks, for all of you trivia buffs out there, were American Cotton Oil, American Sugar, American Tobacco, Chicago Gas, Distilling and Cattle Feeding, General Electric (the only survivor), Laclede Gas, National Lead, North American, Tennesee Coal and Iron, U.S. Leather preferred, and U.S. Rubber. The number of stocks was increased to 20 in 1916. The 30-stock average made its debut in 1928, and the number has remained constant ever since. The most recent change was made effective 17 March 1997, when Hewlett-Packard, Johnson & Johnson, Travelers Group, and Wal-Mart joined the average, replacing Bethlehem Steel, Texaco, Westinghouse Electric and Woolworth.

Other Indexes US Indexes: AMEX Composite A capitalization-weighted index of all stocks trading on the ASE. NASDAQ 100 The 100 largest non-financial stocks on the NASDAQ exchange. NASDAQ Composite Midcap index made up of all the OTC stocks that trade on the NASDAQ Market System. 15% of the US market. NYSE Composite A capitalization-weighted index of all stocks trading on the NYSE.

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Standard & Poor's 500 Made up of 400 industrial stocks, 20 transportation stocks, 40 utility, and 40 financial. Market value (#of common shares * price per share) weighted. Dividend returns not included in index. Represents about 70% of US stock market. Cap range 73 to 75,000 million. Value Line Composite It is a price-weighted index as opposed to a capitalization index. Many think this gives better tracking of investment results, since it is not over-weighted in IBM, for example, and most individuals are likewise not weighted by market cap in their portfolios (unless they buy index funds). Non-US Indexes: CAC-40 (France) The CAC-Quarante, this is 40 stocks on the Paris Stock Exchange formed into an index. The futures contract on this index is probably the most heavily traded futures contract in the world. DAX (Germany) The German share index DAX tracks the 30 most heavily traded stocks (based on the past three years of data) on the Frankfurt exchange. FTSE-100 (Great Britain) Commonly known as 'footsie'. Consists of a weighted arithmetical index of 100 leading UK equities by market capitalization. Calculated on a minute-by-minute basis. The footsie basically represents the bulk of the UK market activity. Nikkei (Japan) "Nikkei" is an abbreviation of "nihon keizai" -- "nihon" is Japanese for "Japan", while "keizai" is "business, finance, economy" etc. Nikkei is also the name of Japan's version of the WSJ. The nikkei is sometimes called the "Japanese Dow," in that it is the most popular and commonly quoted Japanese market index. BSE (Sensex) A capitalization weighted index, which is constructed by taking 30 blue chip shares into consideration. The selection of the shares is done one basis of various parameters. Some of them are market capitalization, Number of floating shares, Volume of transaction etc. NSE (Nifty) A capitalization weighted index, which has been constructed by taking 50 shares into consideration. IPOs (Initial Public Offerings)

Introduction to IPOs

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When a company whose stock is not publicly traded wants to offer that stock to the general public, it usually asks an "underwriter" to help it do this work. The underwriter is almost always an investment banking company, and the underwriter may put together a syndicate of several investment banking companies and brokers. The underwriter agrees to pay the issuer a certain price for a minimum number of shares, and then must resell those shares to buyers, often clients of the underwriting firm or its commercial brokerage cousin. Each member of the syndicate will agree to resell a certain number of shares. The underwriters charge a fee for their services. For example, if BigGlom Corporation (BGC) wants to offer its privately- held stock to the public, it may contact BigBankBrokers (BBB) to handle the underwriting. BGC and BBB may agree that 1 million shares of BGC common will be offered to the public at $10 per share. BBB's fee for this service will be $0.60 per share, so that BGC receives $9,400,000. BBB may ask several other firms to join in a syndicate and to help it market these shares to the public. A tentative date will be set, and the issuer will issue a preliminary prospectus detailing all sorts of financial and business information, usually with the underwriter's active assistance. Usually, terms and conditions of the offer are subject to change up until the issuer and underwriter agree to the final offer. The issuer then releases the stock to the underwriter and the underwriter releases the stock to the public. It is now up to the underwriter to make sure those shares get sold, or else the underwriter is stuck with the shares. The issuer and the underwriting syndicate jointly determine the price of a new issue. The approximate price listed in the red herring (the preliminary prospectus - often with words in red letters which say this is preliminary and the price is not yet set) may or may not be close to the final issue price. Consider NetManage, NETM, which started trading on NASDAQ on Tuesday, 21 Sep 1993. The preliminary prospectus said they expected to release the stock at $9-10 per share. It was released at $16/share and traded two days later at $26+. In this case, there could have been sufficient demand that both the issuer (who would like to set the price as high as possible) and the underwriters (who receive a commission of perhaps 6%, but who also must resell the entire issue) agreed to issue at 16. If it then jumped to 26 on or slightly after opening, both parties underestimated demand. This happens fairly often. The Mechanics of Stock Offerings The Securities Act of 1933, also known as the Full Disclosure Act, the New Issues Act, the Truth in Securities Act, and the Prospectus Act governs the issue of new issue corporate securities. The Securities Act of 1933 attempts to protect investors by requiring full disclosure of all material information in connection with the offering of new securities. Part of meeting the full disclosure clause of the Act of 1933, requires that corporate issuers must file a registration statement and preliminary prospectus (also know as a red herring) with the SEC. The Registration statement must contain the following information:

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1. A description of the issuer's business. 2. The names and addresses of the key company officers, with salary and a 5 year business history on each. 3. The amount of ownership of the key officers. 4. The company's capitalization and description of how the proceeds from the offering will be used. Any legal proceedings that the company is involved in. Once the registration statement and preliminary prospectus are filed with the SEC, a 20 day cooling-off period begins. During the cooling-off period the new issue may be discussed with potential buyers, but the broker is prohibited from sending any materials (including Value Line and S&P sheets) other than the preliminary prospectus. Testing receptivity to the new issue is known as gathering "indications of interest." An indication of interest does not obligate or bind the customer to purchase the issue when it becomes available, since all sales are prohibited until the security has cleared registration. A final prospectus is issued when the registration statement becomes effective (when the registration statement has cleared). The final prospectus contains all of the information in the preliminary prospectus (plus any amendments), as well as the final price of the issue, and the underwriting spread. The clearing of a security for distribution does not indicate that the SEC approves of the issue. The SEC ensures only that all necessary information has been filed, but does not attest to the accuracy of the information, nor does it pass judgment on the investment merit of the issue. Any representation that the SEC has approved of the issue is a violation of federal law. The Underwriting Process The underwriting process begins with the decision of what type of offering the company needs. The company usually consults with an investment banker to determine how best to structure the offering and how it should be distributed. Securities are usually offered in either the new issue, or the additional issue market. Initial Public Offerings (IPOs) are issues from companies first going public, while additional issues are from companies that are already publicly traded. In addition to the IPO and additional issue offerings, offerings may be further classified as: Primary Offerings: Proceeds go to the issuing corporation. Secondary Offerings: Proceeds go to a major stockholder who is selling all or part of his/her equity in the corporation. Split Offerings: A combination of primary and secondary offerings. Shelf Offering: Under SEC Rule 415 - allows the issuer to sell securities over a two year period as the funds are needed.

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The next step in the underwriting process is to form the syndicate (and selling group if needed). Because most new issues are too large for one underwriter to effectively manage, the investment banker, also known as the underwriting manager, invites other investment bankers to participate in a joint distribution of the offering. The group of investment bankers is known as the syndicate. Members of the syndicate usually make a firm commitment to distribute a certain percentage of the entire offering and are held financially responsible for any unsold portions. Selling groups of chosen brokerages, are often formed to assist the syndicate members meet their obligations to distribute the new securities. Members of the selling group usually act on a " best efforts" basis and are not financially responsible for any unsold portions. Under the most common type of underwriting, firm commitment, the managing underwriter makes a commitment to the issuing corporation to purchase all shares being offered. If part of the new issue goes unsold, any losses are distributed among the members of the syndicate. Whenever new shares are issued, there is a spread between what the underwriters buy the stock from the issuing corporation for and the price at which the shares are offered to the public (Public Offering Price, POP). The price paid to the issuer is known as the underwriting proceeds. The spread between the POP and the underwriting proceeds is split into the following components: Manager's Fee: Goes to the managing underwriter for negotiating and managing the offering. Underwriting Fee: Goes to the managing underwriter and syndicate members for assuming the risk of buying the securities from the issuing corporation. Selling Concession - Goes to the managing underwriter, the syndicate members, and to selling group members for placing the securities with investors.

The underwriting fee is usually distributed to the three groups in the following percentages: Manager's Fee 10% - 20% of the spread Underwriting Fee 20% - 30% of the spread Selling Concession 50% - 60% of the spread

In most underwritings, the underwriting manager agrees to maintain a secondary market for the newly issued securities. In the case of "hot issues" there is already a demand in the secondary market and no stabilization of the stock price is needed. However many times the managing underwriter will need to stabilize the price to keep it from falling too far below the POP. SEC Rule 10b-7 outlines what steps are considered stabilization and what constitutes market manipulation. The managing underwriter may enter bids (offers to buy) at prices that bear little or no relationship to actual supply and demand, just so as the bid does not exceed the POP. In addition, the underwriter may not enter a stabilizing bid higher than the highest bid of an independent market maker, nor may the underwriter buy stock ahead of an independent market maker. Managing underwriters may also discourage selling through the use of a syndicate penalty bid. Although the customer is not penalized, both the broker and the brokerage firm are required to

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rebate the selling concession back to the syndicate. Many brokerages will further penalize the broker by also requiring that the commission from the sell be rebated back to the brokerage firm. Market Capitalization The market capitalization (or "cap") of a stock is simply the market value of all outstanding shares and is computed by multiplying the market price by the number of outstanding shares. For example, a publicly held company with 10 million shares outstanding that trade at US$20 each would have a market capitalization of 200 million US$. The value for a stock's "cap" is used to segment the universe of stocks into various chunks, including large-cap, mid-cap, and small-cap, etc. There are no hard-and-fast rules that define precisely what it means for a company to be in one of these categories, but there is some general agreement. Generally Large-cap: Over $5 billion Mid-cap: $500 million to $5 billion Small-cap: $150 million to $500 million Micro-cap: Below $150 million

Repurchasing by Companies (Also called Buy back) Companies may repurchase their own stock on the open market, usually common shares, for many reasons. In theory, the buyback should not be a short-term fix to the stock price but a rational use of cash, implying that a company's best investment alternative is to buy back its stock. Normally these purchases are done with free cash flow, but not always. What happens is that if earnings stay constant, the reduced number of shares will result in higher earnings per share, which, all else being equal will result, should result, in a higher stock price. But note that there is a difference between announcing a buyback and actually buying back stock. Just the announcement usually helps the stock price, but what really counts is that they actually buy back stock. Not all "announced share buybacks" are actually implemented. Some are announced just for the short-term bounce that usually comes with the announcement. Stock Splits Ordinary splits occur when a publicly held company distributes more stock to holders of existing stock. A stock split, say 2-for-1, is when a company simply issues one additional share for every one outstanding. After the split, there will be two shares for every one pre-split share. (So it is called a "2-for-1 split.") If the stock was at $50 per share, after the split, each share is worth $25, because the company's net assets didn't increase, only the number of outstanding shares.

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Sometimes an ordinary split is referred in terms of percentage. A 2:1 split is a 100% stock split can also be called 100% stock dividend or 100% stock split. (A 50% split would be a 3:2 split or 50% stock dividend). Each stockholder will get 1 more share of stock for every 2 shares owned. Reverse splits occur when a company wants to raise the price of their stock, so it no longer looks like a "penny stock" but looks more like a self-respecting stock. Or they might want to conduct a massive reverse split to eliminate small holders. If a $1 stock is split 1:10 the new shares will be worth $10. Holders will have to trade in their 10 Old Shares to receive 1 New Share. Warrants A warrant is a financial instrument, which was issued with certain conditions. The issuer of that warrant sets those conditions. Sometimes the warrant and common or preferred convertible stock are issued by a startup company bundled together as "units" and at some later date the units will split into warrants and stock. This is a common financing method for some startup companies. As an example of a "condition," there may be an exchange privilege which lets you exchange 1 warrant plus $25 in cash (or even no cash at all) for 100 shares of common stock in the corporation, any time after some fixed date and before some other designated date. (And often the issuer can extend the "expiration date.") So there are some similarities between warrants and call options for common stock. Both allow holders to exercise the warrant/option before an expiration date, for a certain number of shares. But independent parties, such as a member of the Chicago Board Options Exchange, issue the option while the warrant is issued and guaranteed by the corporate issuer itself. The lifetime of a warrant is often measured in years, while the lifetime of a call option in months. Sometimes the issuer will try to establish a market for the warrant, and even try to register it with a listed exchange. The price can then be obtained from any broker. Other times the warrant will be privately held, or not registered with an exchange, and the price is less obvious, as is true with nonlisted stocks.

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Bonds - Basics
A bond is just an organization's IOU; i.e., a promise to repay a sum of money at a certain interest rate and over a certain period of time. In other words, a bond is a debt instrument. Other common terms for these debt instruments are notes and debentures. Most bonds pay a fixed rate of interest (variable rate bonds are slowly coming into more use though) for a fixed period of time. Why do organizations issue bonds? Let's say a corporation needs to build a new office building, or needs to purchase manufacturing equipment, or needs to purchase aircraft. Or maybe a city government needs to construct a new school, repair streets, or renovate the sewers. Whatever the need, a large sum of money will be needed to get the job done. One way is to arrange for banks or others to lend the money. But a generally less expensive way is to issue (sell) bonds. The organization will agree to pay some interest rate on the bonds and further agree to redeem the bonds (i.e., buy them back) at some time in the future (the redemption date). This process is nothing but the taking back of the certificate and returning of the principal. Companies of all sizes issue corporate bonds. Bondholders are not owners of the corporation. But if the company gets in financial trouble and needs to dissolve, bondholders must be paid off in full before stockholders get anything. If the corporation defaults on any bond payment, any bondholder can go into bankruptcy court and request the corporation be placed in bankruptcy. Municipal bonds are issued by cities, states, and other local agencies and may or may not be as safe as corporate bonds. The taxing authority of the state of town backs some municipal bonds, while others rely on earning income to pay the bond interest and principal. Municipal bonds are not taxable by the federal government (some might be subject to A Minimum Tax, AMT) and so don't have to pay as much interest as equivalent corporate bonds. U.S. Bonds are issued by the Treasury Department and other government agencies and are considered to be safer than corporate bonds, so they pay less interest than similar term corporate bonds. Treasury bonds are not taxable by the state and some states do not tax bonds of other government agencies. Shorter-term bonds are called notes and much shorter term bonds (a year or less) are called bills, and these have different minimum purchase amounts.

Debt instruments are nothing but loans taken by either company or the govt. or the municipality. There are various types of debt instruments like debenture, bond, notes, bills and many more. The name varies depending upon the issuer or nature of the instrument. But one common characteristic of most of them is that, they all carry some coupon Interest rate. I say most and not all because Zero coupon bonds do not carry any coupon rate. We will discuss about these instruments else where in this document.

Variable rate of interest: The interest of these securities are linked to some reference rate, many cases to LIBOR (London Inter Bank Offer Rate). They may be some basis points above LIBOR, say 200 basis points. This means LIBOR + 2%. If LIBOR is 5%, then the interest comes to 7%. Depending upon the LIBOR movement, the interest rate on the bond also varies.

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In the U.S., corporate bonds are often issued in units of $1,000. When municipalities issue bonds, they are usually in units of $5,000. Interest payments are usually made every 6 months. The price of a bond is a function of prevailing interest rates. As rates go up, the price of the bond goes down, because that particular bond becomes less attractive (i.e., pays less interest) when compared to current offerings. As rates go down, the price of the bond goes up, because that particular bond becomes more attractive (i.e., pays more interest) when compared to current offerings. The price also fluctuates in response to the risk perceived for the debt of the particular organization. For example, if a company is in bankruptcy, the price of that company's bonds will be low because there may be considerable doubt that the company will ever be able to redeem the bonds. On the redemption date, bonds are usually redeemed at "par", meaning the company pays back exactly what the bondholders paid it way back when. Most bonds also allow the bond issuer to redeem the bonds at any time before the redemption date, usually at par but sometimes at a higher price. This is known as "calling" the bonds and frequently happens when interest rates fall, because the company can sell new bonds at a lower interest rate (also called the "coupon") and pay off the older, more expensive bonds with the proceeds of the new sale. By doing so the company may be able to lower their cost of funds considerably. Who buys bonds? Many individuals buy bonds. And of course Investment banks like Goldman Sachs buy bonds. Banks buy bonds. Money market funds often need short-term cash equivalents, so they buy bonds expiring in a short time. People who are very adverse to risk might buy US Treasuries, as they are the standard for safety. Foreign governments whose own economy is very shaky often buy Treasuries. In general, bonds pay a bit more interest than federally insured instruments such as Certificate of Deposit, (CD) because the bond buyer is taking on more risk as compared to buying a CD. Many rating services (Moody's is probably the largest) help bond buyers assess the risks of any bond issue by rating them Moody Bond Ratings Moody's Bond Ratings are intended to characterize the risk of holding a bond. These ratings, or risk assessments, in part determine the interest that an issuer must pay to attract purchasers to the bonds. All information herein was obtained from Moody's Bond Record. The symbols used are AAA, AA, BAA, etc. They symbolize the risk associated with that particular instrument as regards to the payment of principle and the interest. Another rating agency which is not as big, nevertheless famous is Standard & Poor' (Popularly known as S&P). They have different symbols for denoting various degrees of risk associated with the debt instruments.

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Bond Terminology Advance Refunding: The replacement of debt prior to the original call date via the issuance of refunding bonds. Callable Bond: A bond that can be redeemed by the issuer prior to its maturity. Usually a premium is paid to the bond owner when the bond is called. Certificate of Participation (COP): Financing whereby an investor purchases a share of the lease revenues of a program rather than the bond being secured by those revenues. Usually issued by authorities through which capital is raised and lease payments are made. The authority usually uses the proceeds to construct a facility that is leased to the municipality, releasing the municipality from restrictions on the amount of debt that they can incur. Discount Bond: A bond that is valued at less than its face amount. Double Barreled: Bonds secured by the pledge of two or more sources of repayment. Face Value: The stated principal amount of a bond. Also called par value. Bond issued below this price are called below par and the ones which are issued above the face value, are called above par. Par Value: The face value of a bond, generally $1,000. Premium Bond: A bond that is valued at more than its face amount. Principal: The amount owed; the face value of a debt. Revenue Bonds: Bonds secured by the revenues derived from a particular service provided by the issuer. Sinking Fund: A bond with special funds set aside to retire the term bonds of a revenue issued each year according to a set schedule. Usually takes effect 15 years from date of issuance. Bonds are retired through calls, open market purchases, or tenders.

See Options Basics for detailed explanation

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Yield: A measure of the income generated by a bond. The amount of interest paid on a bond divided by the price. Yield to Maturity: The rate of return1 (ROR) anticipated on a bond if it is held until the maturity date. Relationship of Price and Interest Rate The basic relationship between the price of a bond and prevailing market interest rates is an inverse relationship. This is actually pretty straightforward. For example, if you have a 6% bond (this means that it pays $60 annually per $1000 of face value) and interest rates jump to 8%, wouldn't you agree that your bond should be worth less now if you were to sell it? Treasury Debt Instruments The US Treasury Department periodically borrows money and issues IOUs in the form of bills, notes, or bonds ("Treasuries"). The differences are in their maturities and denominations:

Maturity Denomination Minimum

Bill Up to 1 year $1,000 $10,000

Note 1-10 years $1,000 $1,000

Bond 10-30/40 years $1,000 $1,000

Zero-Coupon bonds Not too many years ago every bond had coupons attached to it. Every so often, usually every 6 months, bond owners would take a scissors to the bond, clip out the coupon, and present the coupon to the bond issuer or to a bank for payment. Those were "bearer bonds" meaning the bearer (the person who had physical possession of the bond) owned it. Today, many bonds are issued as "registered" which means even if you don't get to touch the actual bond at all, it will be registered in your name and interest will be mailed to you every 6 months. It is not too common to see such coupons. Registered bonds will not generally have coupons, but may still pay interest each year. It's sort of like the issuer is clipping the coupons for you and mailing you a check. But if they pay interest periodically, they are still called Coupon Bonds, just as if the coupons were attached.

Rate of return is the amount you get back on the principal and is always in percentage term.

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When the bond matures, the issuer redeems the bond and pays you the face amount. You may have paid $1000 for the bond 20 years ago and you have received interest every 6 months for the last 20 years, and you now redeem the matured bond for $1000. A Zero-coupon bond has no coupons and there is no interest paid. But at maturity, the issuer promises to redeem the bond at face value. Obviously, the original cost of a $1000 bond is much less than $1000. The actual price depends on: a) the holding period -- the number of years to maturity, b) the prevailing interest rates, and c) the risk involved (with the bond issuer). The US Treasury also issues Zero Coupon Bonds. The ``Separate Trading of Registered Interest and Principal of Securities'' (a.k.a. STRIPS) program was introduced in February 1986. All new TBonds and T-notes with maturities greater than 10 years are eligible. As of 1987, the securities clear through the Federal Reserve's books entry system. As of December 1988, 65% of the ZEROCOUPON Treasury market consisted of those created under the STRIPS program.

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Derivatives - Basics
A derivative is a financial instrument that does not constitute ownership, but a promise to convey ownership. Examples are options and futures. The simplest example is a call option on a stock. In the case of a call option, the risk is that the person who writes the call (sells it and assumes the risk) may not be in business to live up to their promise when the time comes. In standardized options sold through the Options Clearing House, there are supposed to be sufficient safeguards for the small investor against this. Before discussing derivatives, it's important to describe their basis. All derivatives are based on some underlying cash product hence the name derivative. These "cash" products are: Spot Foreign Exchange: This is the buying and selling of foreign currency at the exchange rates that you see quoted on the news. As these rates change relative to your "home currency" (dollars if you are in the US), so you make or lose money. Commodities: These include grain, pork bellies, coffee beans, orange juice, etc. Equities (termed "stocks" in the US): Generally the common shares of various companies. Bonds of various different varieties (e.g., they may be Eurobonds, domestic bonds, fixed interest / floating rate notes, etc.). Bonds are medium to long-term negotiable debt securities issued by governments, government agencies, federal bodies (states), supra-national organizations such as the World Bank, and companies. Negotiable means that they may be freely traded without reference to the issuer of the security. That they are debt securities means that in the event that the company goes bankrupt. Bondholders will be repaid their debt in full before the holders of unsecuritised debt get any of their principal back. Short term ("money market") negotiable debt securities such as T-Bills (issued by governments), Commercial Paper (issued by companies) or Bankers Acceptances. These are much like bonds, differing mainly in their maturity "Short" term is usually defined as being up to 1 year in maturity. "Medium term" is commonly taken to mean form 1 to 5 years in maturity, and "long term" anything above that. Over the Counter ("OTC") money market products such as loans / deposits. These products are based upon borrowing or lending. They are known as "over the counter" because each trade is an individual contract between the 2 counter parties making the trade. They are neither negotiable nor securitised. Hence if I lend your company money, I cannot trade that loan contract to someone else without your prior consent. Additionally if you default, I will not get paid until holders of your company's debt securities are repaid in full. I will however, be paid in full before the equity holders see a penny.

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Derivative products are contracts, which have been constructed, based on one of the "cash" products described above. Examples of these products include options and futures. Futures are commonly available in the following flavors (defined by the underlying "cash" product): Commodity futures Stock index futures Interest rate futures (including deposit futures, bill futures and government bond futures)

Futures Roughly speaking, a futures contract is an agreement to buy (or sell) some commodity at a fixed price on a fixed date. Futures are commonly available in the following flavors (defined by the underlying "cash" product): Commodity futures A commodity future, for example an orange-juice future contract, gives you the right to buy (or sell) some huge amount of orange juice at a fixed price on some date. Stock index futures Since you can't really buy an index, these are settled in cash. Interest rate futures (including deposit futures, bill futures and government bond futures) These are usually settled in cash as well. Futures are explicitly designed to allow the transfer of risk from those who want less risk to those who want more risk. They do this by offering several features: 1. Liquidity 2. Leverage (a small amount of money controls a much larger amount) A high degree of correlation between changes in the futures price and changes in price of the underlying instrument. This is usually ensured via the mechanism of basis trading. In the case of the commodity future, if I sell you a commodity future then I am promising to deliver X amount of the commodity to you at a given price (fixed now) at a given date in the future. This means that if the price of the future becomes too high relative to the price of the commodity today, I can borrow money to buy the commodity now and sell a futures contract (on margin). If the difference in price between the two is great enough then I will be able to repay the interest and principal on the loan and still have some risk less profit i.e. a pure arbitrage. Conversely, if the price of the future falls too far below that of the commodity, then I can sell the commodity short and purchase the future. I can (presumably) borrow the commodity until the futures delivery date and then cover my short when I take delivery of some of the commodity at the

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futures delivery date. I say presumably borrow the commodity since this is the way bond futures are designed to work; I am not certain that commodities can be borrowed. Either of these 2 arbitrage trades are known as "basis trades" as you are trading the "basis" (don't ask me why it's called that) between the future and the underlying "cash product". Stock Option Basics An option is a contract between a buyer and a seller. The option is connected to something, such as a listed stock, an exchange index, futures contracts, or real estate. For simplicity, this article will discuss only options connected to listed stocks. An option gives its owner the right to buy or sell an underlying asset on or before a given date at a fixed price. For example, you may enjoy the option to buy a certain apartment on or before 31st Dec of this year for $5,00,000. On that date even if the market price is more than $500,000 (Say $600,000), the option write will be compelled to sell the house. On the other hand if the price is less than $500, 000 (say $400,000), the option holder is not obliged to buy the house. Options represent a special kind of financial contract under which the option holder enjoys the right, but has no obligation, to do something. Now let us understand how this instrument originates. The owner of the house may expect that the price of the house will go down (below $500,000). At the same time some buyer expects that the price will go up. Since the owner wants $500,000 for the house, he is willing to write an option. He may sell the option for say $100. Now if the price goes below $500,000 on the expiry date, the buyer will not exercise the option and instead will buy another house for the going market price. The loss is only the price of the option i.e. $100. On the other hand if the price goes up then he will exercise the option and buy the house for $500,000. If the market price is $600,000 he will make a profit of $99,900 ($100,000-100). On the other hand the owner gets lower than the market price. However remember that he was willing to sell it for $500,000 and was afraid that the price may go down. Hence this instrument originates due to varying perceptions of the buyers and sellers. In the real life options are written for shares, index, etc. The key terms and phrases employed in discussing options are as follows. Option holder and option writer: The option holder is the buyer of the option and the writer is the seller of the option. (Remember, option is nothing but a contract which binds both buyer and the seller to do a specific act on a certain date.) Exercise price and the strike price: The price at which the option holder can buy and/or sell the underlying asset is called the exercise or the strike price. In the above example strike price is $5,00,000. Expiration date or Maturity date: The date when the option expires or matures is referred to as the expiration date or maturity date. After this date the option is worth less. In the above example 31st Dec is the expiry date.

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Exercising the option: The act of buying or selling the underlying asset as per the option contract. European and American option: A European option can be exercised only on the date of expiry, where as the American option can be exercised on or before the date of expiry. The option is designated by: 1. 2. 3. 4. Name of the associated stock Strike price Expiration date The premium paid for the option, plus brokers commission.

The two most popular types of options are Calls and Puts. Call Option Example: The Wall Street Journal might list an IBM Oct 90 Call @ $2.00. Translation: This is a Call Option. The company associated with it is IBM. The strike price is $90.00. In other words, if you own this option, you can buy IBM at $90.00, even if it is then trading on the NYSE @ $100.00. The option expires on the third Saturday following the third Friday1 of October in the year it was purchased (an option is worthless and useless once it expires). If you want to buy the option, it will cost you $2.00 plus brokers commissions. If you want to sell the option, you will get $2.00 less commission. In general, options are written on blocks of 100s of shares. So when you buy "1" IBM Oct 90 Call @ $2.00 you actually are buying a contract to buy 100 shares of IBM @ $90 per share ($9,000) on or before the expiration date in October. You will pay $200 plus commission to buy the call. If you wish to exercise your option you call your broker and say you want to exercise your option. Your broker will arrange for the person who sold you your option (For we sys guys and girls a financial fiction: A computer matches up buyers with sellers in a magical way) to sell you 100 shares of IBM for $9,000 plus commission. If you instead wish to sell (sell=write) that option you instruct your broker that you wish to write 1 Call IBM Oct 90s, and the very next day your account will be credited with $200 less commission. If IBM does not reach $90 before the call expires, the option writer gets to keep that $200 (less commission) If the stock does reach above $90, you will probably be "called." If you are called you must deliver the stock. Your broker will sell IBM stock for $9000 (and charge commission). If you owned the stock, that's OK; your shares will simply be sold. If you did not own the stock your broker will buy the stock at market price and immediately sell it at $9000. You pay commissions each way.

Generally the day is the third Saturday following the third Friday.

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If you write a Call option and own the stock that's called "Covered Call Writing." If you don't own the stock its called "Naked Call Writing." It is quite risky to write naked calls, since the price of the stock could zoom up and you would have to buy it at the market price. In fact, some firms will disallow naked calls altogether for some or all customers. That is, they may require a certain level of experience (or a big pile of cash). When the strike price of a call is above the current market price of the associated stock, the call is "out of the money," and when the strike price of a call is below the current market price of the associated stock, the call is "in the money." Note that not all options are available at all prices: certain out-of-the-money options might not be able to be bought or sold. There is no point in writing a Out of Money Call as no one in general will be ready to buy that. Options traders rarely exercise the option and buy (or sell) the underlying security. Instead, they buy back the option (if they originally wrote a put) or sell the option (if the originally bought a call). This saves commissions and all that. For example, you would buy a Feb 70 call today for $7 and, hopefully, sell it tomorrow for $8, rather than actually calling the option (giving you the right to buy stock), buying the underlying stock, then turning around and selling the stock again. Paying commissions on those two stock trades gets expensive . Put Option The other common option is the PUT. If you buy a put from me, you gain the right to sell me your stock at the strike price on or before the expiration date. Puts are almost the mirror-image of calls. Covered puts are a simple means of locking in profits on the covered security, although there are also some tax implications for this hedging move. The expiration of options contributes to the once-per-quarter "triple-witching day." which is a day on which three derivative instruments all expire on the same day. Stock index futures, stock index options and options on individual stocks all expire on this day, and because of this, trading volume is usually especially high on the stock exchanges that day. In 1987, the expiration of key index contracts was changed from the close of trading on that day to the open of trading on that day, which helped reduce the volatility of the markets somewhat by giving specialists more time to match orders. You will frequently hear about both volume and open interest in reference to options (really any derivative contract). Volume is quite simply the number of contracts traded on a given day. The open interest is slightly more complicated. The open interest figure for a given option is the number of contracts outstanding at a given time. The open interest increases (you might say that an open interest is created) when trader A opens a new position by buying an option from trader B who did

Since the commission is some percentage of the price, the price of the stock being more, you will end up paying a lot of commission, if you go for exercising of the option and then reversing the process.

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not previously hold a position in that option (B wrote the option, or in the lingo, was "short" the option). When trader A closes out the position by selling the option, the open interest with either remain the same or go down. If A sells to someone who did not have a position before, or was already long, the open interest does not change. If A sells to someone who had a short position, the open interest decreases by one. LEAPs A Long-term Equity anticipation Security, or "LEAP", is essentially an option with a much longer term than traditional stock or index options. Like options, a stock-related LEAP may be a call or a put, meaning that the owner has the right to purchase or sell shares of the stock at a given price on or before some set, future date. Unlike options, the given date may be up to 2.5 years away. LEAP symbols are three alphabetic characters; those expiring in 1998 begin with W, 1999 with V.

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Exchanges
Market Makers and Specialists Both Market Makers (MMs) and Specialists (specs) make market in stocks. MMs are part of the National Association of Securities Dealers market (NASD), sometimes called Over The Counter (OTC), and specs work on the New York Stock Exchange (NYSE). These people serve almost similar function. (The roles of specialists have been explained in detail in the later sections) The NASDAQ NASDAQ is an abbreviation for the National Association of Securities Dealers Automated Quotation system. It is also commonly, and confusingly, called the OTC market. The NASDAQ market is an interdealer market represented by over 600 securities dealers trading more than 15,000 different issues. These dealers are called market makers (MMs). Unlike the New York Stock Exchange (NYSE), the NASDAQ market does not operate as an auction market (see the article on the NYSE). Instead, market makers are expected to compete against each other to post the best quotes (best bid/ask prices). The New York Stock Exchange The NYSE uses an agency auction market system, which is designed to allow the public to meet the public as much as possible. The majority of volume (approx 88%) occurs with no intervention from the dealer. Specialists (specs) make markets in stocks and work on the NYSE. The responsibility of a spec is to make a fair and orderly market in the issues assigned to them. They must yield to public orders which means they may not trade for their own account when there are public bids and offers. The spec has an affirmative obligation to eliminate imbalances of supply and demand when they occur. The exchange has strict guidelines for trading depth and continuity that must be observed. Specs are subject to fines and censures if they fail to perform this function. NYSE specs have large capital requirements and are overseen by Market Surveillance at the NYSE. Specs are required to make a continuous market. Another auction-based exchange is AMEX (American Stock Exchange), which accounts for 3% of all exchange volume. NYSE accounts for 85%. Over The Counter (OTC) The over the counter market (OTC) is not a central physical marketplace but a collection of brokerdealers scattered across the country. This market is more a way of doing business than a place. Buying and selling in unlisted stocks are matched not through the auction process on the floor of an exchange but through negotiated bidding, over a massive network of telephone and teletype wires that link thousands of securities firms in the U.S and abroad. Example: NASDAQ

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Trading
Let us see, as an investor, how you can or will go about investing and once you give the order for buy or sell, what events happen. Typically, once you instruct your broker about your order, a chain of events set off. Without going into complete detail on each step, let us trace the process. First, let us trace how a round lot order to buy 800 shares of McDonalds. You call up your broker and find out what is the going market price. Say, the price is $60. Now if you put the market order then the chance is that you will get the share for $60. (I am saying chance because, by the time your order gets executed, the price may actually change.). Now say you put the order with the broker. Now the written order is wired to NY office of the brokerage firm. From there it is phoned to a clerk of the firm on the floor of the NYSE. The clerk notifies a member partner of the firm (only members are allowed to trade) via an annunciator board system. After collecting the order from the clerk, the member goes to the specialist who is dealing with MCD and confirms the ask and bid price. If the price is still $60, he executes the order. The member notes the transaction and with whom it was made, an exchange reported the transaction for reporting to the ticker, and the phone clerk phones you saying that the trade has been executed. (Please reread the above once again after going through the entire trading chapter to have a better understanding of the whole process.) After Hours After-hours trading is a form of big-block trading that indeed does occur after the market closes for a period of time. Much of this trading is supported by Instinet, a network operated by Reuters that helps buyers meet sellers (there's no physical exchange where someone like a specialist works). Apparently, (I am not too sure!!!), this trading is NOT part of the reported closing prices you see in the newspapers. The data is apparently reported separately, at least on professional-level data systems. After-hours trading may experience significant deviations in price from the day's close, usually due to announcements made after the markets have closed. But even the little guy can play after hours. The other markets can also affect a stock's price between 4PM and 9:30 AM EST. People tend to forget the global view. When the NYSE closes, the Pacific Exchange in LA opens. Then the Tokyo market opens around dinnertime in the U.S. Tokyo's closing bell marks the beginning of trading in Johannesburg, followed 2 hours later by London. Then, 2 hours before London closes, the NYSE opens back up. All 24 hours are covered by at least one market (the Pacific Exchange from 4 to 7 PM is the only exchange open during those three hours, but it completes the 24 hour day.) With so many multinational companies on many different markets, stock prices are inevitably going to have some discrepancy between the closing and opening bells on the Big Board.

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Bid, Ask, and Spread If you want to buy or sell a stock or other security on the open market, you normally trade via agents on the market scene who specialize in that particular security. These people stand ready to sell you a security for some asking price (the "ask") if you would like to buy it. Or, if you own the security already and would like to sell it, they will buy the security from you for some offer price (the "bid"). The difference between the bid and ask is called the spread. Stocks that are heavily traded tend to have very narrow spreads (e.g., 1/8 of a point), but stocks that are lightly traded can have spreads that are significant, even as high as several dollars. So why is there a spread? The short answer is "profit." The long answer goes to the heart of modern markets, namely the question of liquidity. Liquidity basically means that someone is ready to buy or sell significant quantities of a security at any time. In the stock market, market makers or specialists (depending on the exchange) buy stocks from the public at the bid and sell stocks to the public at the ask (called "making a market in the stock"). At most times (unless the market is crashing, etc.) these people stand ready to make a market in most stocks and often in substantial quantities, thereby maintaining market liquidity. Dealers make their living by taking a large part of the spread on each transaction - they normally are not long-term investors. In fact, they work a lot like the local supermarket, raising and lowering prices on their inventory as the market moves, and making a few cents here and there. And while lettuce eventually spoils, holding a stock that is tailing off with no buyers is analogous. Because dealers in a security get to keep much of the spread, they work fairly hard to keep the spread above zero. This is really quite fair: they provide a valuable service (making a market in the stock and keeping the markets liquid), so it's only reasonable for them to get paid for their services. Of course you may not always agree that the price charged (the spread) is appropriate! Occasionally you may read that there is no bid-ask spread on the NYSE. This is nonsense. Stocks traded on the New York exchange have bid and ask prices just like any other market. However, the NYSE bars the publishing of bid and ask prices by any delayed quote service. Any decent real-time quote service will show the bid and ask prices for an issue traded on the NYSE. Broker Only the members of the exchange (brokers) can participate in trading in the listed securities in the stock exchange. There are various types of brokers depending upon the type of job they perform. Commission Brokers: About one half of all the brokers in NYSE are commission brokers. Their primary function is to buy or sell on behalf of their clients. They charge commission for this from the clients and hence the name. The prominent ones are Merrill Lynch, Pierce, Fenner & Smith, Shearson Lehman Hutton, and Prudential-Bache. Floor Brokers: These are the brokers who actually execute the order on the floor of the Stock Exchange. The commission brokers pass on the order of their clients to these brokers and floor brokers execute the order.

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Specialists: Specialists are the floor brokers who specialize in particular stock(s). They give two way quote for the stock in which they are specializing. The difference between the ask and bid price is the profit margin for the specialists. The main idea behind this is that the specialists will bring liquidity into the market by giving two-way quotes. There are around 500 specialists in NYSE. The specialist in IBM is deCordova, Cooper & Co., and for General Electric it is Strokes, Hoyt & Co. Odd-lot Dealers: Trading on the floor of the exchange is conducted in round, or full, lot of 100 shares. But these brokers deal in lot, which is less than 100, or they deal in odd lots. Registered Traders: There are some 30 brokers who trade among themselves and are not bothered about the public or other members. These are registered brokers. The rule and regulations of Stock Exchange for these brokers are more stringent than the other brokers. Bond brokers: Bond brokers handle trades in the bond issues traded on the exchange. Introducing Broker An Introducing Broker (IB) is a futures broker who delegates the work of the floor operation, trade execution, accounting, etc. to a Futures Commission Merchant (FCM). In this relationship, the FCM maintains the floor operation and the IB maintains the relationship with retail clients. This is efficient because the work of a floor operation vs. the work of maintaining relationships and meeting the needs of retail customers have different requirements. Another way to think of an IB is that of a segmented firm. The IB is not a middleman, but is in a partnership with the clearing firm. The clearing firm manages the floor and back office ops, and the IB is free to concentrate on his/her customers and their trading. Several myths concerning IBs need debunking. First of all, the notion that an introducing broker is a "middleman" or that fees or commissions are necessarily higher is wrong. It's also wrong to say that an IB is a branch office. Yes, an IB may have branch offices, but an IB is not a branch office of a FCM. The IB is in a business partnership with an FCM, each handling their own piece of the work. When it comes to ordering, if you are trading through an IB, it need not be any less efficient than trading with a vertically oriented firm that does everything. When you call an IB with an order, s/he can relay that order directly to the trading floor, or even give clients direct access to the floor themselves. If you call one of the big, vertically integrated firms your order is likely to take as many or more steps than it would with an IB. In terms of commissions, an IB may maintain a low overhead and that lets him/her charge reasonable fees while maintaining a lot of support and specialized service that a big discount firm simply can't provide. There's more to trading than commissions, although most novices don't understand that.

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Discount Brokers A discount broker offers an execution service for a wide variety of trades. In other words, you tell them to buy, sell, short, or whatever, they do exactly what you requested, and nothing more. Their service is primarily a way to save money for people who are looking out for themselves and who do not require or desire any advice or hand-holding about their forays into the markets. However, discount brokering is a highly competitive business. As a result, many of the discount brokers provide virtually all the services of a full-service broker with the exception of giving you unsolicited advice on what or when to buy or sell, but some do provide monthly newsletters with recommendations. Virtually all will execute stock and option trades, including stop or limit orders and odd lots, on the NYSE, AMEX, or NASDAQ. Most can trade bonds and U.S. treasuries. Most will not trade futures; talk to a futures broker. Most have margin accounts available. Most will provide automatic sweep of (non-margin) cash into a money market account, often with checkwriting capability. All can hold your stock in "street-name", but many can take and deliver stock certificates physically, sometimes for a fee. Some trade precious metals and can even deliver them!

The firms can generally be divided into the following categories: 1. "Full-Service Discount": Provides services almost indistinguishable from a full-service broker such as Merrill Lynch at about 1/2 the cost. These provide local branch offices for personal service, newsletters, a personal account representative, and gobs and gobs of literature. 2. "Discount": Same as "Full-Service," but usually don't have local branch offices and as much literature or research departments. Commissions are about 1/3 the price of a fullservice broker. 3. "Deep Discount": Executes stock and option trades only; other services are minimal. Often these charge a flat fee (e.g. $25.00) for any trade of any size. 4. Computer: Same as "Deep Discount", but designed mainly for computer users (either dial-up or via the internet). Some brokers offer an online trading option that is cheaper than talking to a broker.

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Direct Investing and DRIPS DRIPS offer an easy, low-cost way for buying stocks. Various companies allow you to purchase shares directly from the company and thereby avoid brokerage commissions. However, you must purchase the first share through a broker or other conventional means. In all cases, that first share must be registered in your name, not in street name. (A practical restriction here is that for some common kinds of accounts like IRAs (Some retirement benefit fund) you can't participate in a DRIP since the stock has to be held by the custodian.) Once you have that first share, additional shares can be purchased through the DRIP either through dividend reinvestments or directly by sending in a check. Thus the two names for DRIP: Dividend/Direct Re-Investment Plan. The periodic purchase also allows you to automatically dollar-cost-average the purchase of the stock. A handful of companies sell their stock directly to the public without going through an exchange or broker even for the first share. These companies are all exchange listed as well, and tend to be utilities. Free Ride Rules When trading stocks, a "free ride" describes the case when you buy a security at 10 and sell it a day later (or an hour later) at 12, without having the free funds to cover the settlement of the trade at 10. This activity is prohibited by the exchanges (e.g., NYSE Rule 431 forbids member organizations from allowing their customers to day-trade in cash accounts). If you trade in a cash account, you must be able to settle the trade, even if you would take the profit from it in the same day. Example: Buy 1000 XXX at $10 on 7/10 Requires $10,000 free cash available to settle the trade. Sell 1000 XXX at $15 on 7/11 It's a day later, and you will get $15,000 from the sale, but you still must be able to settle the original purchase without the proceeds of the sale for the first trade to be legitimate. The rule on free rides should in no way be interpreted as a prohibition on "day trading" (i.e., trading very rapidly in and out of a stock). You can "day-trade" as much as you want, provided that you can settle the trade. The short answer is that you must use a margin account if you want to daytrade. Being able to settle the trade means that you either have sufficient cash in your account to pay for the shares, or sufficient reserve in your margin account to cover the shares. Note that equity trades settle 3 market days after execution. Therefore, the window on short-term trading is not one day but rather three; i.e., any close of a position before settlement occurs would run into the same issue.

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If you use cash, note that in a cash account you can spend a dollar only once. In other words, if you start the day in cash, you can buy stock and sells that stock -- and then are done trading for the day. If you start in stock you can sell it, spend the cash for another position, sell that position and then you are done. If you use margin, keep in mind that your broker is allowed to delay the credit for your sale until settlement if they so choose, keeping you from using those funds for three days. If they are a market-making firm or are selling their order flow they will likely obstruct your intra-day and short term trading since it cuts into their bottom line. Unlike stocks, options settle the next day, which is both good and bad. Option trading basically requires that the funds be there before you place the trade, unless you like wiring funds around (and paying for the privilege of doing so). Margin Trading Securities can be bought either by cash or some borrowed funds or some mix of that. The primary purpose of borrowing and buying the securities is that the investor simply supplements his/her resources and tries to get more bang for the buck. Borrowing money from bank or the broker for the purpose of securities is called margin. When an investor buys on margin, he simply buys by borrowed funds. Regulation T of the Federal Reserve Board determines the amount that an investor can borrow. Regulation T permits brokers to lend up to fifty percent of the value of the stock or convertible bonds acquired or short sold by the investor, 70 % of the corporate bonds and about 90% of the U.S govt. securities. In stock market parlance, the cash paid by the customer (investor) is the customers margin. Thus if an investor buys corporate share worth $10,000 and puts up $7,000 in cash, his margin is $7,000 or 70%. Margin (%) = Customers equity/Market value of securities. After the initial transaction takes place, the Federal Reserve no longer concerns itself with the investors margin. The effect of fluctuating market prices on the customers margin is largely regulated by stock exchanges and the generally more restrictive policies of the brokerage firms themselves. The NYSE requires that customer maintain equity of 30%. Equity is simply the market value of the customers portfolio less margin debt, or the market value of any securities that were sold short. The Federal Reserve requirements are referred to as the initial margin requirement and that of exchange/brokers guidelines are called maintenance requirements. Lets try an example. Assume that you buy 1000 shares of a $20 stock (net cost = $20,000) and you deposit $10,000 (50 % of $20,000) to meet the initial requirement. At this point your margin account shows a market value of $20,000 and a loan balance (called debit balance) of $10,000. The equity in the account stands at 10,000. With the $20,000 market value, the exchange requires that the equity must be at least $5,000, or 25% of $20,000. So far so good; the account more than conforms to the minimum maintenance rule (25%).

Customers Account
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Stock $20,000

Debt $10,000 Equity $10,000

Margin=10,000/20,000 = 50% Now suppose that the stock falls to $17. Where are we now? Customers Account Stock $17,000 Debt $10,000 Equity $7,000 Margin=7,000/17,000 = 41.20% Note that all the shock of falling price must be absorbed by the customers equity since the debt has not been repaid. Also the lenders (brokers) stake is rising since the borrowed funds represent a larger part of the total value of the shares. The brokers risk is rising. Suppose the stock falls to $13. Lets see what happens. Customers Account Stock $13,000 Debt $10,000 Equity $3,000 Margin=3,000/13,000 = 23% To lift the margin to 30% (As per the exchange requirement) maintenance level requires equity 30 percent of $13,000 or $3,900. Hence, the broker will call the customer to pay $900 as the differential. The other side of the coin is simple enough. Suppose that the stock rises. Lets say to $25. Customers Account Stock $25,000 Debt $10,000 Equity $15,000 Margin=15,000/25,000 = 60% Now what? Either you can take the extra 10% i.e. 5,000 home (Reg. T requires that margin should be only 50%) or now you can borrow more to buy more so that the margin drops to 50%. This is the beauty of margin where in investors play in the market with little money in their pocket.

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Delivery-versus-payment Delivery-versus-payment (DVP) is a method of settlement in which funds and the securities are transferred simultaneously, or, more generally where funds transfer is considered complete only when the securities are delivered and vice versa. Insiders Trading Insider trading refers to transactions in the securities of some company executed by a company insider. Although a company insider might theoretically be anyone who knows material financial information about the company before it becomes public, in practice, the list of company insiders (on whom newspapers print information) is normally restricted to a moderate-sized list of company officers and other senior executives. Smart companies normally warn all employees to be careful when they trade, "just in case". The U.S. Securities and Exchange Commission (SEC) has strict rules in place that dictate when company insiders may execute transactions in their company's securities. All transactions that do not conform to these rules are, in general, prosecutable offenses under US securities law.

Jargon and Terminology Some common jargon that you should understand about trading equities is explained here briefly. AON, "all or none": A buy or sell order with this designation loses normal order priority if the amount of shares available doesn't match or exceed the order size. There may be some specialized circumstances where it could be useful, such as late in the day on a GTC (Good till cancelled) entry (to avoid a fractional fill such as 100 shares of a 1000 share order, with resulting doubling of total commissions when the rest of the order fills the following morning). blue-chip stock: A valuable stock that has proven itself; i.e., has been around for many years and has made piles of money. Examples are IBM, GE, Ford, etc. The name derives from the chips used in poker, blue always being the most valuable. bottom fishing: Purchasing of stock declining in value, or of stocks that have suffered drastic declines in their prices.

For more definitions of terms, visit these on-line glossaries of investment and finance-related terms:

InvestorWords: http://www.investorwords.com The Washington Post's Business Glossary: http://www.washingtonpost.com/wp-srv/business/longterm/glossary/glossary.htm

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day order: Order to buy/sell securities at a certain price that expires if not executed on the day it is placed. diluted shares: A way of characterizing the number of outstanding shares that a publicly held company could have. The diluted shares measure is the sum of the company's normally outstanding shares, the shares that would be outstanding if every warrant & stock option were exercised, and the shares that would be outstanding if every security convertible into the stock (e.g., certain preferred shares) were converted. This is sometimes used when computing earnings per share numbers. A larger number of outstanding shares means lower earnings per share, rather obviously; this is known as "dilution of earnings" or computation of "fully diluted" earnings. DNR, "do not reduce": This is usually assumed unless you specify otherwise, but different brokers may have different practices and some may require you to specify DNR if you want it. What it deals with is how the order is to be/not adjusted when dividends or other distributions occur. For example a $1/share dividend on a stock for which you have entered an order DNR brings the price closer to your bid or takes it further away from your offer. Without the DNR specification, on the ex-dividend date your order price is reduced by the amount of the distribution. FOK, "fill or kill": This means do it now if the stock is available in the crowd or from the specialist, otherwise kill the order altogether. Going long: Buying and holding stock. Going short: selling stock short, i.e., borrowing and selling stock you do not own with the intention of buying it later for less. GTC, "good till cancelled": Order to buy/sell securities at a certain price (a limit order); the limit order stays in the market until you call specifically to cancel it. Some brokers restrict the length of time a GTC can remain open to "end of same month", "no more than 30 days" or some such thing, but with most it becomes a permanent part of the book until it gets executed or you cancel. Overbought [Oversold]: Judgmental adjective describing a market or stock implying That people have been wildly buying [selling] it and that there is very little chance of it moving upward [downward] in the near term. Usually it applies to movement momentum rather than what the security should cost. Over valued, under valued, fairly valued: Judgmental adjectives describing that a market or stock is over/under/fairly priced with respect to what people believe the security is really worth.

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Uptick: Uptick means the next trade is at a higher price than the previous trade. Meaningful for the NYSE and AMEX; not so meaningful for OTC markets (NASDAQ). Certain transactions can only be executed on an Uptick (e.g., shorting). Downtick: Downtick means the next trade is at a lower price than the previous trade. See Uptick. Treasury shares: Shares taken from the company treasury (not the US Treasury!). Often occurs in the context of discussions about how companies fulfill share purchases within DRIP accounts. Plc: An abbreviation of Public Limited Corporation. This means that the company is not American, where "Inc." is used instead. Companies in many different countries use PLC, including Great Britain, South Africa, Australia, Hong Kong, etc. Inc: An abbreviation for Incorporated. Mostly used in the United States.

Clearing Process After a trade has been executed, securities and money must change hands within five business days of the trade date, on what is called the settlement date (Saturdays, Sundays and holidays are excluded). For example, a trade on a Wednesday is settled the following Wednesday. Basically, two tasks are carried out in the clearing process: Trade comparison and settlement. Trade comparisons are made through the facilities of the clearing corporation that receives the report of each transaction from the brokers participating in the transaction. The largest clearing corporation is the National Securities Clearing Corporation (NSCC). The first four days of the clearing period are devoted to the trade comparison process and to resolving any discrepancies in the transaction information provided by parties to a transaction. Unmatched trades are flagged, and advisory notices are sent to the participants who fail to report a transaction reported by the contra side. Much of the process is automated. The second step in the clearing process the final settlement- is also automated and usually carried out through computer book entries. The key change permitting the use of book entries has been the immobilization of securities certificates, which has been made possible by the increased

Immobilization: A basic mechanism to enhance the efficiency and safety of clearing and settlement system in which the physical securities are stored by a depository/ies (Mostly it is a company) in a fixed place and recording the ownership details in electronic form. Owner of the securities are assigned separate accounts. Thereafter the trading is done in electronic form. It entails transfer of shares from the sellers account to the buyers account. (This is very much like a bank where the is transferred from one account to another). The basic purpose of immobilization is to reduce risk which is a constant factor in physical handling of the securities. Dematerialization: A related term to the above. Unlike the above in which the securities are stored in a place, in dematerialization, the physical securities are destroyed and the details are kept in the electronic form (Read computers!!). The trading is done very much in the same way as the previous one.

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willingness of brokers and financial institutions to forgo physical delivery of the certificates. Instead, certificates are immobilized at a securities depository. The principal depository is the Depository Trust Company (DTC) owned jointly by NYSE, AMEX, National Association of securities Dealers (NASD), and its major participants (brokers and banks). The SEC and the Federal Reserve System as a limited trust company regulate the DTC. Netting This is a procedure in which debits (+) and the credit (-) for a particular category are offset against each other so as to arrive at the outstanding netted position. The actual transfer of fund and the securities (Remember??? This is also called settlement) is done on the netted position instead of the all transactions. Example
Date 18-06-98 19-06-98 20-06-98 Broker A A A Transaction Broker Buys from Buys from Sells to B B B Security McDonald McDonald McDonald Amount 100 300 200 Price $30.00 $32.00 $31.00 Total $3,000 $9,600 $6,200

After netting, on the settlement day B has to deliver 200 shares of McDonald for $6,400. Netting is nothing but the outstanding position of each party on the day of settlement. The above is a simple case involving bilateral netting but in reality we see multilateral netting involving hundreds of parties and thousands of securities. Portfolio Management The different types of investment vehicles have different returns and risk associated with them. For example corporate stocks are more risky than govt. bonds but may pay higher return. Sometime the bullions are more risky and some times real estates are more risky. Generally more risk is associated with more return. Portfolio management is mixing different investment vehicles in different proportion so that the return and the risk of the portfolio is up to the customers requirement. Mind it not all have same return expectation nor they have same risk taking attitude. Day, GTC, Limit, and Stop-Loss Orders Day/GTC orders, limit orders, and stop-loss orders are three different types of orders you can place in the financial markets. This article concentrates on stocks. Each type of order has its own purpose and can be combined.

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Day and GTC orders: An order is canceled either when it is executed or at the end of a specific time period. A day order is canceled if it is not executed before the close of business on the same day it was placed. You can also leave the specific time period open when you place an order. This type of order is called a GTC order (good 'til cancelled) and has no set expiration date. Limit orders: Limit orders are placed to guarantee you will not sell a stock for less than the limit price, or buy for more than the limit price, provided that your order is executed. Of course, you might never buy or sell, but if you do, you are guaranteed that price or better. For example, if you want to buy XYZ if it drops down to $30, you can place a limit buy @ $30. If the price falls to $30 the broker will attempt to buy it for $30. If it goes up immediately afterwards you might miss out. Similarly you might want to sell your stock if it goes up to $40, so you place a limit sell @ $40. Stop-loss orders: A stop-loss order, as the name suggests, is designed to stop a loss. If you bought a stock and worry about it falling too low, you might place a stop-loss sell order at $20 to sell that stock when the price hits $20. If the next trade after it hits $20 is 19 1/2, then you would sell at 19 1/2. In effect the stop loss sell turns into a market order as soon as the exchange price hits that figure. Note that the NASDAQ does not officially accept stop loss orders since each market maker sets his own prices. Which of the several market makers would get to apply the stop loss? However, many brokers will simulate stop-loss orders on their own internal systems, often in conjunction with their own market makers. Their internal computers follow one or perhaps several market makers and if one of them quotes a bid, which trips the simulated stop order, the broker will enter a real order (perhaps with a limit - NASDAQ does recognize limits) with that market maker. Of course by that time the price might have fallen, and if there was a limit it might not get filled. All these simulated stop orders are doing is pretending they are entering real stops (these are not official stop loss orders in the sense that a stock exchange stop order is). If you sell a stock short, you can protect yourself against losses if the price goes too high using a stop-loss order. In that case you might place a stop-loss buy order on the short position, which turns into a market order when the price goes up to that figure. Example: Let's combine a stop loss with a limit sell and a day order. XYZ - Stop-Loss Sell Limit @ 30 - Day Order Only The day order part is simple -- the order expires at the end of the day.

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The stop-loss sell portion by itself would convert to a sell at market if the price drops down to $30. But since it is a stop-loss sell limit order, it converts to a limit order @ $30 if the price drops to $30. It is possible the price drops to 29 1/2 and doesn't come back to $30 and so you never do sell the stock. Note the difference between a limit sell @ $30 and a stop-loss sell limit @ $30 -- the first will sell at market if the price is anywhere above $30. The second will not convert to a sell order (a limit order in this case) until the price drops to $30. You can also work these same combinations for short sales and for covering losses of short stock. Note that if you want to use limit orders for the purpose of selling stock short, there is an exchange Uptick rule that says you cannot short a stock while it is falling - you have to wait until the next Uptick to sell. This is designed to prevent traders from forcing the price down too quickly.

Pink Sheet Stocks A company whose shares are traded on the so-called "pink sheets" is commonly one that does not meet the minimal criteria for capitalization and number of shareholders that are required by the NASDAQ and OTC and most exchanges to be listed there. The "pink sheet" designation is a holdover from the days when the quotes for these stocks were printed on pink paper. Process Date Transaction notices from any broker will generally show a date called the process date. This is when the trade went through the broker's computer. This date is nearly always the same as the trade date, but there are exceptions. One exception is an IPO; the IPO reservation could be made a week in advance and until a little after the IPO has gone off, the broker might not know how many shares his firm was allocated so doesn't know how many shares a buyer gets. A day or two after the IPO has gone off, things might settle down. (The IPO syndicate might be allowed to sell say 10% more shares than obligated to sell - and might sell those even after the IPO date "as of" the IPO date.) So a confirmation might list a trade date that is two days before the process date. Other times the broker might have made an error and admit to it, and so correct it "as of" the correct date. So the confirmation slip might show August 15 as the process date of a trade "as of" a trade date of August 12. It happens. Round Lots of Shares For every stock, the company in consolation with Stock Exchange decides the number of stocks in which all the trade will be done. Say IBM decides that this number is 100. All the transactions of IBM stock have to be in 100 stocks or some multiple of this. The lots of 100 or some multiple it are

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called round lots. This is done so that junta does not start buying and selling in 1 or 2 shares as per their whim. This will increase the pressure on the stock market tremendously. Interestingly there are some certificates which are denote the number of shares which are not multiple of 100. So how do they get traded? Some brokers might buy them from you at a discount to the market price and combining them (They trade with many players), make them round lot and sell in the market. The lots, which are not round lots, are called odd lots.

Shorting Stocks (Also called Short sale) Shorting means to sell something you don't own. If I do not own shares of IBM stock but I ask my broker to sell short 100 shares of IBM I have committed shorting. In broker's lingo, I have established a short position in IBM of 100 shares. Or, to really confuse the language, I hold 100 shares of IBM short. One key requirement for short sell is that short sell orders cannot be executed in down tick. (Please see the section on tick, Uptick, and downtick). An example will make it clear. Say you want to sell a stock for $42 and the preceding trade price was 41 .75. Then there is problem. But you cannot do the trade if the trade price was 43. If it were 42, then you have to go further back and see the preceding different price. You can only go for short sell if the preceding different price was less than $42. Remember that this rule is applicable only for the short sell and not for ordinary sell. This is done so as to avoid any price hammering by the brokers and taking the market for a ride. Why would you want to short? Because you believe the price of that stock will go down, and you can soon buy it back at a lower price than you sold it at. When you buy back your short position, you "close your short position." The broker will effectively borrow those shares from another client's account or from the broker's own account, and effectively lend you the shares to sell short. This is all done with mirrors; no stock certificates are issued, no paper changes hands, no lender is identified by name. My account will be credited with the sales price of 100 shares of IBM less broker's commission. But the broker has actually lent me the stock to sell. No way is he going to pay interest on the funds from the short sale. This means that the funds will not be swept into the customary money-market account. Of course there's one exception here: Really big spenders sometimes negotiate a full or partial payment of interest on short sales funds provided sufficient collateral exists in the account and the broker doesn't want to lose the client. People like you and me, who are small fries can not expect to receive any interest on the funds obtained from the short sale. If you sell a stock short, not only will you receive no interest, but also expect the broker to make you put up additional collateral. Why? Well, what happens if the stock price goes way up? You will have to assure the broker that if he needs to return the shares whence he got them (see "mirrors"

These odd shares are generated mostly because of stock dividends. Otherwise the stocks which are issued by the company are in round lots.

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above) you will be able to purchase them and "close your short position." If the price has doubled, you will have to spend twice as much as you received. So your broker will insist you have enough collateral in your account, which can be sold if needed to close your short position. More lingo: Having sufficient collateral in your account that the broker can glom onto at will, means you have "cover" for your short position. As the price goes up you must provide more cover. Since you borrowed these shares, if dividends are declared, you will be responsible for paying those dividends to the fictitious person from whom you borrowed. Too bad. Even if you hold your short position for over a year, your capital gains are taxed as short-term gains. A short squeeze can result when the price of the stock goes up. When the people who have gone short buy the stock to cover their previous short sales, this can cause the price to rise further. It's a death spiral - as the price goes higher, more shorts feel driven to cover themselves, and so on. You can short other securities besides stock. For example, every time I write (sell) an option I don't already own long, I am establishing a short position in that option. The collateral position I must hold in my account generally tracks the price of the underlying stock and not the price of the option itself. So if I write a naked call option on IBM November 70s and receive a mere $100 after commissions, I may be asked to put up collateral in my account of $3,500 or more! And if in November IBM has regained ground and is at $90, I would be forced to buy back (close my short position in the call option) at a cost of about $2000, for a big loss. Selling short is seductively simple. Brokers get commissions by showing you how easy it is to generate short-term funds for your account, but you really can't do much with them. If you are strongly convinced (and perhaps are out to ruin yourselfafter all you are earning in rupee and a big drop in dollar will make a big hole in your pocket) a stock will be going down, buy the out-ofthe-money put instead, if such a put is available. A put's value increases as the stock price falls (but decreases sort of linearly over time) and is strongly leveraged, so a small fall in price of the stock translates to a large increase in value of the put. Let's return to our IBM, market price of 66 (ok, this article needs to be updated.) Let's say I strongly believe that IBM will fall to, oh, 58 by mid-November. I could short-sell IBM stock at 66, buy it back at 58 in mid-November if I'm right, and make about net $660. If instead it goes to 70, and I have to buy at that price, then I lose net $500 or so. That's a 10% gain or an 8% loss or so. Now, I could buy the IBM November 65 put for maybe net $200. If it goes down to 58 in mid November, I sell (close my position) for about $600, for a 300% gain. If it doesn't go below 65, I lose my entire 200 investment. But if you strongly believe IBM will go way down, you should shoot for the 300% gain with the put and not the 10% gain by shorting the stock itself. Depends on how convinced you are.

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Size of the Market The "size of the market" refers to the number of shares (commonly quoted in round lots) that a specialist or market maker is ready to buy or sell. The size of the market information is supplied with a quote on professional data systems. Tick, Uptick, and Downtick The term "tick" refers to a change in a stock's price from one trade to the next. Really what's going on is that a comparison is made between trades reported on the ticker. If the later trade is at a higher price than the earlier trade, that trade is known as an "Uptick" trade because the price went up. If the later trade is at a lower price than the earlier trade, that trade is known as a "downtick" trade because the price went down. Because this measure can only be calculated based on a reliable feed of stock trade data, it is probably only close to reality for trades on exchanges where there is a single specialist for each stock. Trades reported by market makers of the NASDAQ will possibly be out of strict time sequence; so evaluating the "tick" for shares traded over the counter is much trickier when compared to a NYSE-based tick. Something called the "tick indicator" is a market indicator that tries to gauge how many stocks are moving up or down in price. The tick indicator is computed based on the last trade in each stock. Note that certain transactions, namely shorting a stock, can only be executed on an Uptick, so this measure is not just of academic curiosity, it really is used to regulate the markets. Transferring an Account Transferring an account from one brokerage house to another is a simple, painless process. The process is supported by the Automated Customer Account Transfer (ACAT) system. To transfer your account, you fill out an ACAT form in cooperation with your new broker. The new broker will generally require a copy of your statements from the old brokerage house, plus some additional proof of identity. The transfer will be made within about 5-10 business days for regular accounts, and 10-15 business days for IRA and other types of qualified retirement accounts. The paperwork starts the process, but thereafter it's all done electronically.

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Appnedix-1 Services Provided by Goldman Sachs


1) Investment Banking Planning, structuring and executing diverse financing transactions in the public and private markets; advising in merger and acquisition transactions and other corporate restructuring; providing specialized services to, among others, the communications, energy and power, entertainment, financial services, gaming, healthcare, high technology, media, retail, telecommunications and transportation industries; advising governments and governmentrelated entities in major industrial and emerging-market countries on key privatization programs and other strategic initiatives relating to financial markets; devising and executing strategies that enable companies and institutions to capitalize on the value of real estate assets; and facilitating the firm's principal investment activities. 2) Equities Executing block trades of equity securities and related derivative products; assisting investors in planning and implementing strategies to improve investment returns and manage risk; providing clients with information, perspective and guidance on equity markets, individual companies and industries as well as expertise in portfolio strategy and stock selection; assisting companies in raising capital in public and private equity markets; advising governments on privatization state-owned companies; developing innovative products that broaden opportunities for issuers to raise capital; and providing wealthy families and individuals with comprehensive investment services; serving as a unique, central resource for sophisticated investment support services. 3) Fixed Income, Currency and Commodities Making markets in all major fixed income products, foreign exchange and commodities to provide liquidity to clients; advising corporations, governments and institutions on raising capital and achieving other financial objectives in fixed income markets; providing market and product information that enables investors to implement strategies using a broad and growing range of financial products; developing innovative techniques and products to assist investors in achieving varied objectives, including using commodities as investment assets; executing sophisticated hedging strategies using derivatives such as options, futures and swaps; and operating the firm's proprietary fixed income, currency and commodities businesses. 4) Asset Management Designing and managing customized portfolios for investors using equity and fixed income securities, money market instruments, currencies and commodities; designing and managing

Most of the Investment banks provide more or less same kinds of services.

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an expanded group of institutional and retail mutual funds; providing support for brokerdealers that market the Division's U.S. mutual fund products; and providing clients with a full range of reporting and accounting services. 5) Global Investment Research Analyzing specific companies and industries; developing investment ideas and strategies that are used by clients in structuring and managing investment portfolios; providing data and analysis on interest rates, currencies, political events and other developments that affect economic conditions; and marketing investment data, opinion, and strategies to the firm's securities sale and trading professionals and to clients through publications, electronic delivery systems, investor meetings and telephone contact. 6) Global Operations Advising sales and trading professionals on procedures for executing, clearing and settling transactions involving stocks, bonds, currencies, commodities, futures and options; assisting in setting up new offices and businesses and developing new products by applying knowledge of tax issues, market rules and regulations relating to transaction processes; interfacing with securities exchanges, other firms, central banks and regulators; processing, comparing and ensuring accurate and timely settlement of transactions; providing a range of integrated operations services, many of them fee-based, for clients who invest in domestic and international securities. 7) Treasury Maintaining close relationships with banks and other credit-providing institutions worldwide; managing the firm's relationships with rating agencies; developing funding and capital strategies to ensure proper asset/liability management; structuring, implementing and overseeing the administration of new financing transactions and programs to finance the firm's operations in the most cost-effective manner; providing funds settlement and cash management services in support of the firm's global treasury requirements. 8) Controllers Financial analysis and planning, including consulting to partners and managers on ways to increase the profitability of the firm's businesses; proprietary accounting and risk analysis, which monitors the firm's trading positions, produces daily P&L reports on all products and analyzes risk in the firm's inventories; financial and regulatory reporting, which monitors compliance with capital requirements of governmental and securities industry regulators worldwide, compiles financial statements in accordance with Generally Accepted Accounting Principles (GAAP) and prepares regulatory reports for the firm; and management reporting, which monitors the budget and produces monthly P&L statements for the firm and its businesses.

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9) Credit Evaluations of the creditworthiness of clients including industrial corporations, financial institutions, and sovereign governments worldwide; analysis of the credit rating implications of various financial transactions, including debt and equity offerings, share restructure, and mergers and acquisitions; advising clients on the credit rating agency process; assessment of credit risks and setting exposure limits on a wide range of trading and hedging transactions; monitoring of the firm's credit exposure to trading counter parties; and assistance in the solicitation, structuring and review of client commercial paper programs. 10) Tax Advising the firm's professionals on the tax implications of transactions for the firm and of new products in development; tax planning for the firm and its partners; tax compliance work for the firm's partners and business entities; assisting the Human Resources Department in handling tax-related matters for international employees. 11) Legal Advising management on the impact of legislative, judicial and regulatory developments worldwide that affect the firm's businesses and operations; handling the legal aspects of major financing and contractual commitments; advising the firm with respect to the development of new products; coordinating the work of outside counsel; representing the firm in litigation brought by or against the firm and in investigations by governmental and self-regulatory authorities worldwide. 12) Compliance A variety of services to ensure that the supervisory authority and responsibilities assigned to individuals throughout the firm are properly exercised: training and education programs, as well as planning, coordinating, maintaining, and monitoring certain surveillance mechanisms to support the firm's supervision and compliance functions.

Most of the above have been taken from the home page of Goldman Sachs, http://WWW.gs.com

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Appendix - 2 Investment Process

Investor (Seller)

Investor (Buyer)

Investment Bank 2 7 1 7

Commission Broker 2

Commission Broker 1

6 Floor Broker

5 Custodian/Depositor y 8 Clearing House

STOCK EXCHANGE

Company

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1,2 The buyer gives written order for buying some particular scrip in some particular quantity. On the other hand the seller gives the order for sell of his securities. (Here for simplicity let us assume that the amounts are equal. In the actual market place there are many brokers and many investors. The brokers and Stock Exchange are conduits in which the buyers and sellers requirement are met. 3 The broker of buyer contacts some floor broker who is specialist in that scrip in Stock Exchange and puts the order for buying. 4 The broker of the seller goes to the floor broker and puts the sell order. The floor broker confirms the transaction to both the parties i.e. brokers who in turn inform the same to their clients. This transaction is noted by Stock Exchange for clearing process. 5 The details of the transaction (who is buying and who is selling, what stock, how much and at what price) are sent to the clearinghouse. 6,7 On the payment day, the seller has to give the stocks and take payment. Similarly the buyer has to pay and take delivery of the stocks. Need less to say that all these are done through the broker. 8 In case the stock is dematerialized or immobilized, the details of the trade is made known to the depository. And the number of shares sold debits the account of the seller and the number of shares he has bought credits that of the buyer. However the payment part is still handled by the clearinghouse. 9 The depository lets the company know of the changes in the holding and the company updates its book so that buyer can be given the dividend. The right hand corner shows the box indicating investment banks. The investment banks invest for their clients who put their money with the investment banks. The trading procedure however remains the same.

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Appnedix-3 Balance Sheet Format


December 31, 2000, and December 31, 2001 Assets Current Assets: Cash and Securities Receivables Inventories Prepaid Expenses Permanent Investments: Investment in other companies Realty held for investment Fixed tangible assets: Buildings Land Machinery and Equipments Furniture and Fixtures Fixed Intangible Assets: Goodwill Patents Deferred Charges to Expense: Organization Costs Total Assets Liabilities and Equity Current Liabilities: Account Payable Accrued Wages Taxes Payable Long Term Liabilities: Long Term notes Bonds Stock Holders Equity: Capital Stock Additional paid-in capital Retained earnings

Total Liabilities and Equity

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References
1. Security Analysis and Portfolio Management by Donald E. Fischer, Ronald J. Jordan (5th Edition, Prentice Hall India) 2. Security Analysis by Graham and Dodd 3. Financial Management by Prasanna Chandra (3rd Edition, Tata McGraw-Hill) 4. Global Financial System: A compilation of Harvard Business School

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