Assignment 3 - Investment Strategy Flashcards
- theory that seeks to achieve the highest level of return for an acceptable level of risk
- evaluates total portf. risk rather than the risk presented by each component
- based on diversification - pooling diff. inv. instruments to most optimally balance risk and return given fluctuations of mkts over the long run
- advocates blending of several different kinds of inv. in order to balance risks w/ a targeted return for investor
- takes into consideration the investor’s tolerance for risk, fin. constraints, overall inv. strat., and obj.
Modern Portfolio Theory (MPT)
- theory that states that common stk prices already reflect all info available to buyers and sellers
- mkt partic. cannot use this info to buy low and sell high
- stk prices automatically adjust quick enough and instantaneously so that nobody can stay ahead of the chg w/ any rational approach
Efficient Mkt Hypothesis (MEH)
systematic risks versus unsystematic risks
- SYSTEMATIC - cannot be reduced by diversifying one’s portfolio
- UNSYSTEMATIC - can be diversified, so if 1 group of inv. goes up, the other group goes down.
based on long term historical averages for an asset
Expected Returns
variation of returns of an asset
Risk
(3) Forms of Efficient Mkt Hypo.
- Weak
- Semistrong
- Strong
- Form of Efficient Mkt Hypo
- security analysis is the only form of stock “science” that can identify stocks that are temporarily undervalued and overvalued, and thus allow investors to profit
Weak Form
- Form of Efficient Mkt Hypo
- states that only info that can result in rational stk pick profiting is insider trading -based info.
- since this info isn’t made public, insiders find out first and are ahead of the game
Semistrong
- Form of Efficient Mkt Hypo
- states that stk prices already reflect all info and thus nothing can give an indiv. trader an “edge”
Strong
assuming a known business risk in hopes of a considerable gain
involves the weighing of risk versus reward
Purchasing securities or other assets that have large fluctuations in value, from which the investor expects to realize realtively large profits over a short period of time
stock speculation
creates risk where none previously existed
Gambling
unsystematic risk
Risk involving the nature of the industry in which a firm operates and the mgmt and operations of the firm itself
can be managed by diversification
business risk
This occurs when there is an increase in mkt i/r and the decline in bond prices is less than the corresponding increase in bond prices for the same amt of decline in the mkt i/r
bond convexity
measure that divides a portf’s excess return by its standard deviation as a measure of risk
useful when comparing 1 inv. or portf. w/ others
Sharpe Ratio
Theoretical model designed to measure the ER on an indiv. security or inv. portf. considering the security’s or portf’s inv. risk as measured by its beta
displays returns and risk combos of a risk-free asset and the broad mkt index of common stocks
Capital Asset Pricing Model (CAPM)
Computed # that shows how a security or portf. performed, given its level of risk as shown by its beta, as compared w/ the stk mkt as a whole
alpha
- Inv. approach that involves holding a well-diversified portf. of securities w/o making many active trading decisions
- best illustrated by ‘indexing’ and not trying to beat the ‘market’
- implies that there is low inv. manager risk
passive investing
term for the chg in an inv.’s price or value in one year + any CF for the year (such as divs, int, or rents)
Total Return
- The weighted avg maturity of a bond’s CFs
- measures price sensitivity to i/r risk by multiplying a chg in i/r times the # of yrs left until maturity
bond duration
- graph that seeks to highlight the best possible combos of stks and bonds inv. at the lowest risk
efficient frontier
systematic risk involving how i/r affect stk prices
an increase in rates = decrease stk prices
high quality fin. assets are most affected by changes in i/r
Interest Rate Risk
- risk that occurs when rate are lower than when bond or stk was issued
- bonds or preferred stk are redeemed by their issuers prior to matureity
- investor provided w/ a principal sum which she must reinvest at a lower rate
- “calling the bond” prior to maturity
Reinv. Risk
- Risk that occurs when securities and other inv. mature at a time when the mkt i/r are lower than those provided by maturing inv.
- inv. may be forced to reinvest proceeds at a lower i/r yield
maturity risk
- systematic risk that occurs when price levels in the econ. rise causing the purchasing power of the same amt of money to decline
- when prices rise = purchasing power declines
purchasing power risk
systematic risk that is assumed by the investor in foreign inv. and foreign currency.
the strength of the currency relative to the $ fluctuates creating a risk that there may be a gain or loss due to this
exchg rate/currency risk
unsystematic risk
risk that involves the issuers of inv. may run into financial difficulties such as bankruptcy and may not be able to fulfill financial commitments
financial risk
unsystematic risk
risk of low or lack of performance by an inv. company or mgr which results in low or negative returns to the inv.
inv. mgr risk
unsystematic risk
risk that an asset may not be marketable or liquid at the time sale is desired
liquidity/marketability risk
volatility of stock in relation to its index
beta
this displays how much of a portf. is allocated to risky assets and how much to safe ones
Capital Allocation Line (CAL)
“R-Squared” indicates the fraction of the variance that is explained by an independent variable and the Beta
higher the R-squared = more reliable the independent variable and the beta
ranges b/w -1 and 1, with 1 indicated a perfect correlation and -1 indicates an inverse correlation
Coefficient of Determination
- for returns on 2 inv. -
- 1 = returns move in the same directions
- -1 = returns move in opposite directions.
Correlation Coefficent
term for nominal yields on bonds
coupon rate
- this number indicates the degree to which the returns of 2 assets move with each other
- = moves together
- = moves opposite
covariance
term for nominal yields on PS
dividend rates
- a statistical measure showing the change over time of component items relative to a base date
- may represnt the market
- not an avg
index
- condition under which an investor can dispose of an inv. quickly and can also receive approx. the amt put into it.
liquidity
- condition under which an investor can find a ready mkt in the event she’d like to sell an inv. in a short time
marketability
active inv. strat. of buying low and selling high by forecasting bull and bear mkt
market timing
bell-shaped frequency distrib. curve w/ an equal range of items above and below the avg.
normal distribution
the difference b/w an asset’s ER and that of a risk free asset effectively the “payoff” to an investor for selecting a riskier asset
risk premium
analyzing the fundamental aspects of indiv. securities in attempting to select undervalued securities in the mkt or securiteis w/ above-avg growth potential
security selection
a measure of the distance from the avg of a series of returns
standard deviation
the distance fromt he avg of returns, including both gains and losses
variance
way to measure annual rates of return
annual interest or div. divided by inv’s par or FV
nominal yield
way to measure annual rates of return
annual inv. income divided by inv’s current price or value
current yield
considered the most accurate measure of annual inv. return
Yield to Maturity
this results from the appreciation of value of assets
capital gains
advantages of realizing capital gains
- not taxed until realized or recognized by sale of the asset, so investor can avoid taxation indefinitely
- investor can choose best inv. to sell for both the inv and tax considerations
- income taxes on capital gains are lower than those on ordinary income
- numerous planning strats are available to avoid or defer cap. gains taxes
disadv. of captial gains
- involves higher degree of inv. risk than interest or div. returns
- lock-in may occur where the person fears selling appreciated assets for profit due to anticipated cap gains taxes
- this investing may require more skill b/c achieving the gains in the first place is difficult
- way to measure inv. gains over time
- annual rate at which an initial inv. will accumulate to = the final value of inv. at the end of the period considered, assuming reinv. of CFs received during the period
geometric avg
- way to measure inv. gains over time
- the rate determined by the sum of the total returns divided by the # of yrs analyzed
- does NOT involve the compounding of returns
arithmetic avg
examples of taxable ordinary income
- some inv. income is full taxable as ordinary income
- interest on CDs
- taxable MMF
- corp. bonds
- U.S. T-Bonds
this tax is calculated by
multiplying the current yield by 1 - inv’s highest marginal income tax rate
after-tax yield
tax-exempt income and taxable equivalent yield
the A/T income for tax-exempt inv. = the current yield
municipal bond
basic inv. objective of most indiv.
earn the highest possible A/T rate of return on their investment funds
Factors that s/b considered in choosing different categories of inv.
- security of principal and income
- rate of return
- maketability and liquidity
- diversification
- tax status
- size of inv. units or denominations
- possible use as collateral for loans
- protection against creditors’ claims
- bond or PS’s callability
- freedom from care
- this type of risk can be reduced by diversification
- called - nonmkt risks or firm-specific risks
unsystematic risk
types of unsystematic risks
- financial (or credit) risk
- business risk
- liquidity and marketability risk
- inv. manager risk
- this type of risk remains AFTER diversification
- also referred to as mkt risks which implies price fluctuations for a whole securities mkt, regardless of the financial soundness or inv. merits or indiv. securities
systematic risk
types of systematic risk
- Int. Rate Risk
- Purchasing Power Risk
- Exchg. Rate Risk
- Political Risk
- Tax Risk
a systematic risk that arises from uncertainty concerning possible unfavorable changes in the gov’t, cultural and business climates of a country
policy changes will have an immediate effect on this
political risk
systematic risk that is posed by possible unfavorable changes in the tax laws
tax risk
when securities are callable, the issuers (e.g. municipalities) can pay them off (redeem them) before maturity under certain conditions.
this may save int. expense for the issuer
for the holder, the risk is that now they have to reinv. the principal at the present and possible lower mkt yields
redemption/call risk
Yield to Maturity (for a bond selling at a discount)
Yield to Maturity (for a bond selling at a premium)
the situation where an investor is reluctant to sell a security for fear of cap gains taxation
cap gains lock-in prob
this theoretical model shows the return in an indiv. inv. or portf. that exceeds what could have been earned in risk-free assets
it is the extra return an investor receives for taking an inv. risk
Equity risk premium
this measure divides excess return by the portf’s beta.
useful when comparing 1 inv. or portf. w/ others
Treynor Ratio
