Equity Instrument Features for CFA Level I

What this chapter covers

Equity Instrument Features: topics in the order to study them

1. 1Types of Equity SecuritiesStart here because common, preferred, callable, convertible and other share features are the base vocabulary for every later topic.
2. 2Private vs Public Equity SecuritiesOnce you know the security types, compare how they differ in liquidity, disclosure, valuation and the investor base when traded privately or publicly.
3. 3Depository Receipts and Foreign ListingsThis builds on public equity by showing how investors access foreign companies through direct listings, global depository receipts and American depository receipts.
4. 4Return Characteristics of Equity SecuritiesWith the instruments clear, you can now study price change, dividend income and total return, including currency effects on foreign holdings.
5. 5Equity Risk and the Role of Equity in Company FinancingFinish with risk and the issuer's view, which ties together the investor claims, residual rights and book value of equity.

How to prepare Equity Instrument Features

1. Read each topic once for the big picture, then write a one-line definition for every security type and feature in your own words.
2. Build a comparison grid for common versus preferred shares covering voting rights, dividends, claim on assets and risk. Add rows for callable, putable, convertible and participating features.
3. Make a second grid for private versus public equity and a third for direct listing, depository receipt and global registered share, listing who owns the shares and who holds the voting rights.
4. Practise the total return formula with two or three numbers, including a case with a foreign currency, until you can split price return, dividend yield and currency effect without hesitation.
5. Link each feature to its risk: ask who is paid first in liquidation, whose return is capped, and who bears price volatility. This logic helps you eliminate options.
6. Do timed three-option practice questions at about 90 seconds each, then review every wrong answer and note the exact feature or wording that fooled you.
7. Revise the grids the day before the exam and test yourself by covering the answers.

Common mistakes in Equity Instrument Features

• Mixing up who benefits from callable and putable features.

  Fix: Remember that the party who can act holds the option: the issuer calls, the investor puts. Then the benefit follows the option holder.

• Assuming preferred shares always have fixed, guaranteed dividends and no voting rights.

  Fix: Read the question for the stated features. Preferred dividends can be skipped, and some structures differ, so rely on what the stem says.

• Confusing the holder of a depository receipt with the holder of the underlying shares.

  Fix: Picture the chain: foreign shares sit with a custodian, the depository bank issues receipts, and the investor holds receipts in a local market and currency.

• Ignoring currency when calculating the return on a foreign equity.

  Fix: Whenever exchange rates appear, convert the start and end values into your home currency before computing the return.

• Treating book value of equity as market value.

  Fix: Book value comes from the balance sheet (assets − liabilities); market value is share price times shares outstanding. Check which one the question asks for.

• Overlooking that private equity is not just a smaller version of public equity.

  Fix: Compare the two on a fixed checklist: liquidity, disclosure, valuation, investor base and how the shares are traded.

Last-day revision: Equity Instrument Features

• ✓Common shareholders hold the residual claim: they are paid after creditors and preferred shareholders.
• ✓Common shares usually carry voting rights; preferred shares usually do not.
• ✓Preferred shares usually pay a fixed dividend and rank ahead of common shares for dividends and liquidation.
• ✓Cumulative preferred shares accumulate unpaid dividends that must be paid before common dividends.
• ✓Participating preferred shares can receive extra dividends beyond the stated rate under set conditions.
• ✓Convertible preferred shares can be exchanged for common shares at a set ratio, which benefits the holder.
• ✓Callable shares benefit the issuer; putable shares benefit the holder.
• ✓Private equity is less liquid and has less disclosure than public equity, and valuation is harder.
• ✓Depository receipts trade in the local market of the investor while the underlying shares are held by a custodian bank.
• ✓Total return = (P1 − P0 + D1) ÷ P0, made up of price change and dividend yield.
• ✓For foreign holdings, the investor's return also includes the currency movement.
• ✓Equity gives a company permanent capital with no required repayment, and book value of equity = assets − liabilities.

Equity Instrument Features practice questions

• Compared with a company's callable preference shares, its common shares are most likely to offer investors:
• Which component of an equity investor's total return is most likely to come from a company's decision to repurchase its own shares rather th…
• A company repurchases some of its common shares and holds them rather than cancelling them. These shares are best described as:
• A stock is bought at 50.00. After one year it pays a dividend of 2.00 and trades at 56.00. After a second year it pays a dividend of 2.50 an…
• A foreign company wants its shares to trade in a US market through a depository receipt program that does not require it to comply with full…
• A founder-owned company with 10 shareholders is considering listing on a stock exchange. Which outcome is most likely after the listing?
• A depository receipt (DR) is best described as a security that:
• A company's book value of equity is most accurately described as:

Equity Instrument Features in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

• CS ProfessionalListing and Issuance of Securities
• CFA Level IIIPrivate Equity
• CFA Level IIPrivate Company Valuation
• CS ExecutiveSecurity Analysis