Book 3 (Investments) Flashcards
Difference between MMDA & MMF
Money Market Deposit Account (MMDA):
- Offered by banks
- FDIC insured (250k)
Money Market Mutual Funds (MMMF):
- Offered by open-ended investment company
- NOT FDIC insured
Difference between Money Market Deposit Account and Money market account
an MMDA is a vehicle offered by the bank.
“Money market account” is generalized and could be referring to assets that hold various vehicles
List Credit risk (lowest to highest)
I. CD w/ 6mo. maturity
II. Tax-exempt money market account
III. Money market fund
IV. T-Bills
IV. T-Bills (no default risk)
I. CD w/ 6mo. maturity
III. Money market fund
II. Tax-exempt money market account
True or False
Yankee Bonds are registered w/ the SEC
True
Bond definition
A debt security which obligates the issuer to pay interest (usually semiannualy) and to repay the principal amount when the debt matures at the end of its term.
T-Bills are sold on a ____ ____ basis
Discounted yield
Accretion
Accumulation of a discount bonds discount over the life of the bond
Keywords to look for in questions:
Treasury ____ / _____ / _____
T-Bills:
3,6,12 month terms
No risk
T-Notes:
1-10 year terms
PRIme risk
T-Bonds:
10-30 year terms
PRIme risk
Original Issue Discount -> Zero-Coupon Bond -> T-Bill
OID = bond discounted from par
Zero-coupon Bond = Accreted (phantom/accrued) interest
T-Bill = Best example of a zero-coupon bond
Similarity & Difference between EE, I, & HH Bonds
Similarity: ALL are exempt from State & Local tax
Differences:
EE and I Bonds are not subject to income tax until redeemed/matured (but have the option if wanted to)
HH Bonds are taxed on interest each year
What is unique about TIPS?
Six percentage interest rate but not a fixed amount interest payments (the face value is adjusting for inflation)
What bond is almost identical to a T bill
Treasury STRIPS
- only difference is that it’s a direct obligation to the federal government
EE bonds can no longer be exchanged into ____ bonds
HH
Mortgage Backed Security
- Backed by mortgage payments
- Payments include principal & interest
- Risk depends on issuer
Ex) GNMA (Ginnie-Mac)
- Issued by US Gov’t
FNMA (Fannie-Mac)
- Issued by Gov’t sponsored company
Synonym
Synonym for High-Yield Bond (corporate)
Junk bond (BB or lower)
When is it likely that a bond is called
Interest rates dropped (Issuers can now reissue their bonds at lower rates)
“OID tax-exempt obligation” (another way of just saying OID) bond interest could either be ____ or ____
Accreted or Paid
Accreted = zero-coupon bond (phantom income)
Paid = a discounted coupon bond
Note: an OID doesn’t have to be a zero-coupon bond, it’s just very common that it is
Bond Rating Agencies
1) S&P (Standard & Poors)
2) Moody’s
Main difference between GNMA and FNMA?
GNMA = Fully taxable
FNMA = Fed taxable, State & Local exempt
Used to finance import/export transactions?
Banker’s Acceptance
Describe each:
10-Q
10-K
Red Herring
Prospectus
Corporate Annual Report
10-Q = quarterly report to SEC
10-K = annual report to SEC
Red Herring = Preliminary** prospectus**
Prospectus = Report for potential buyers of a new issue
Corporate Annual Report = distributed annually to SH
Which entity would most likely buy Preferred Stock paying high dividends?
1) Pension Plans
- For income
2) Individual in a low tax bracket
- Pay little/no tax on dividends
3) C-Corp
- 50% dividend tax exclusion
Fact about Mutual Funds (how they are setup)
Mutual Funds are actually investment companies. It is setup as a company/trust to pool investor cash and invest in it’s portfolio.
Ex) Vanguard 500 Index Fund is legally setup as a trust
Which type of investment can always be purchased at NAV
No-load mutual funds (Mutual funds can impose a sales charge)
Which investment is best associated w/ this phrase: “Shares are purchased and redeemed directly w/ the issuer”?
Mutual fund
Why is an Index Fund tax efficient?
Turnover (selling) of stock is minimal
What is an ADR?
American Depository Receipt
- a receipt for shares of a foreign-based corporation
Unit Investment Trusts (UITs)
- Investment company
- Unmanaged, passive portfolio handled by independent trustee
- Collects money, then eventually repays principal to unit holders (not shareholders)
- Self-liquidates
Mutual funds:
Closed-end
VS
Open-end
Closed-end = traded like stock (trading price)
Open-end = bought and sold directly from mutual fund company (NAV)
Hedge Fund AUM requirement
Not required to register w/ SEC unless AUM >= $100million
What is GIC?
Guaranteed Investment Contract
- Similar to CDs, but issued by insurance companies
- Popular for defined benefit plans
- 2-5yr term, guaranteed interest
REIT
VS
Non-Public REIT
(Public) REIT = traded & liquid
Non-Public REIT = illiquid
Real Estate Limited Partnership = illiquid
Types of REITs
Equity REIT:
- Income-producing properties then leased to others
Mortgage REIT:
- make loans to develop property or finance construction
=> Default Risk
=> Purchasing Power Risk
REITs are prohibited from investing in what investment vehicle?
Limited Partnerships
- LPs are typically used as tax shelters
REIT
VS
RELP
REIT
- Portfolio investment (like a stock)
- Actively traded on stock exchanges
- Board of Directors
- Must invest at least 75% in real estate to wualify for conduit treatment
- Normally distribute 90% of all NIT
RELP
- Direct participation investment
- Generally not marketable
- General Partners
If a REMIC (Real Estate Mortgage Investment Conduit) is established as a corp, how is its income taxed?
Pass-through entity
This is a unique REMIC rule
Current Yield (CY) equation
Annual Payment / Current Mkt. Price of Bond
Intrinsic Value of a put option
IV = POEM
Exercise price - Market price
LEAPs
Long-Term Equity Anticipation Securities
- allows options buyers to assume positions for long-term market movements
Ex) Michael Burry
Warrant vs Call option
Warrant
- issued by corp
- longer maturities
- not standardized
Call option
- created by individual
- generally <9 months
- standardized
Difference between Options & Futures
Options
Obligation: Buyer has the right
Upfront Cost: Premium
Risk/Reward: Limited risk for buyers
Futures
Obligation: Both parties have an obligation
Upfront Cost: Margin required
Risk/Reward: BOTH unlimited risk
How can a “long position” be interpreted in different ways?
Long position (general trading) - buying a stock and hoping it will increase.
Long Hedge position (Futures) - buying a contract out of fear it will increase.
Benefits of Collectibles (stamps, coins, antiques, etc.)
- Little to no regulation on market
- returns generally negatively correlated to returns on financial assets (diversifier/reduce risk)
What is another term for “enjoyment” or “aesthetic value”?
Income in kind
Which tangible assets are taxed at 28% capital gains rate?
1) Collectibles
2) Precious metals like gold and silver
(gold & silver coins, futures, ETFs, mutual funds, bullions)
Private Placement (Regulation D)
- Private offering
- Exempt from formal registration
- Sold to max 35 “non-accredited” investors and unlimited “accredited” investors
- Investors must sign investment letter (with help of a purchaser representative)
Accredited
VS
Non-accredited investor
Accredited = Sophisticated & 1-2-3
$1,000,000 net worth (excluding home)
$200,000 annual income (individual)
$300,000 annual income (joint)
Non-accredited = Sophisticated only
Qualified Purchaser (Private placement)
person that owns at least $5M in investments
3 things to think of when you think of Futures contract
1) Contract (not securities)
2) Mainly commodities
3) Hedge
On July 30th, an XYZ DEC 55 call has a premium of $6 1/2, and XYZ shares are trading at a market price of $58.
What is the intrinsic value and time value of this call?
(call) IV = Mkt. price - Exercise price
IV = $58 - $55 = $3
Time Value = Premium - IV
$6 1/2 - $3 = $3 1/2 or $3.50
Synonyms for Unsystematic risk
- Diversifiable
- Nonsystematic
Types of Unsystematic risk
1) Business Risk = firm operations (new tech, labor strike)
2) Financial Risk = Credit risk/Default risk of the firm
Why are foreign markets typically less efficient than US markets?
Less analysts follow the stocks
Liquidity describes…
BOTH transaction speed (marketability) and stability of the price
Marketability refers to…
only transaction speed
YTM Formula
VS
YTC Formula
YTM
PV = same
PMT = same
N = maturity date
FV = Par
I/YR = Solve
YTC
PV = same
PMT = same
N = call date
FV = call price
I/YR = Solve
Current Yield Formula
Current Yield = Annual Int. Pmt. / Current Bond Price
Taxable Equivalent Yield (TEY)
VS.
Tax-Exempt Yield (After-Tax Yield (ATY))
TEY = Tax-Exempt Yield / (1 - tax rate)
Tax-Exempt Yield (ATY) = TEY x (1 - tax rate)
What to look for in a bond “best choice” comparison?
Muni-Bond (in-state) as the benchmark
What is an interest-bearing bond?
a bond that…
1) pays semi-annual interest
2) at the end of the period (in arrears)
3) issued @ par
Which bonds have a duration equal to their maturities
Zero-coupon bonds: Logical because the bondholder does not receive cash flow before the bond matures. Because they have no coupons ($ coming in), their prices fluctuate more than that of coupon bonds.
Explain the aspects of the Constant Growth Dividend Model (CGDM) (2 equations)
See top 2 equations of formula sheet
1 of them is used to find the IV of the stock (V)
1 of them is used to find the expected return % (r)
When would Capitalized Earnings be a good evaluation model?
For a good candidate, such as a corporation w/ stable earnings, steady growth, and a risk profile that is not expected to change
Hierarchy of equity valuation models
Capitalized Earnings Model
- Dividend Growth Models
- Zero-growth Model
- Constant Growth Model
- Dividend Discount Model
Dividend Discount Model Shortcuts
(when stocks have 2 stages of growth, either accelerating or decelerating growth rate over years)
Step 1) Calculate the IV using the CGM (first formula on formula sheet)
- make sure to use the last growth rate
Step 2)
1st Rate = 6% ——–> Higher or Lower —–> Pick next lowest
2nd Rate = 8%
If a company does not pay a dividend, but has free cash flow, what formula would you use?
Same as the Dividend Discount Model, except replace the D1 with Free Cash Flow (FCF1)
FCF1 / (r-g)
ROE Formula
Earning per share / Common Shares
Which category of stocks typically has a high dividend payout?
Utility Stocks
Client wants 24k a month and can earn 8% (Beg. of each year). What should the PV be?
24k / .08 = 300k
+24k as a Beg Payment
324k PV
24k PMT
8% I/YR
Stochastic Model
Monte Carlo Analysis
- Best/Worst case scenarios
(Think SimC)
Modern Portfolio Theory (MPT)
Seeks to quantify relationship between risk and return
(emphasis on diversification!)
Key principles of MPT?
- Diversification
- Efficient frontier
- Risk & Return tradeoff
- Correlation
Capital Market Line represents what? How about the slope of the line?
CML = portfolios that optimally combine risk-free asseets and risky assets
Slope of CML = Sharpe ratio
Visualize the Efficient Frontier graph
X-axis = Risk (Std Dev.)
Y-axis = Expected return
Modern Portfolio Theory
Macro aspect =
Micro aspect =
Macro = Capital Market Line (CML)
- Risk & return of portfolio
- Uses Std. Dev.
Micro = Security Market Line (SML)
- Risk & return of individual security OR portfolio
- Uses Beta
Synonym for Security Market Line (SML)
Capital Asset Pricing Model (CAPM)
ri = rf + (rm-rf) x Betai
Determine the investor’s expected return
Breakdown of the Required Rate of Return formula:
ri = rf + (rm-rf) x Betai
ri = rf + (rm-rf) x Betai
1) Market risk premium = (rm-rf)
2) Stock risk premium = (rm-rf) x Betai
What type of investors typically favor EMH theory?
Passive investors
Efficient Market Hypothesis forms
Weak = suggest that investors can use Fundamental analysis for superior results
Semi-Strong = suggests that Fundamental & Technical analysis are already baked in. Only by using insider information will you get superior results
Strong = Everything is already baked in
Fundamental Analysis
Purpose: Determine FMV/IV of a stock
Components: “FIRE”
Financials, Industry, Ratios, Economic moats (competetive advantage)
Goal: Identify undervalued/overvalued stocks
=> Long-term investment decisions
1) Top-down approach = Economic outlook -> industry -> company
2) Bottom-up approach = Company -> industry -> economic outlook
Technical Analysis
Purpose: Forecast future price movements
Components: Charts, indicators, petterns, history, trends
Goal: Identify trends/patterns to buy/sell
=> short to medium investment decisions
- completely contradicts EMH
The Dow Theory is an _______ measure of securities prices
Aggregate
(Therefore, purpose is to show the direction of the overall market)
Because the Dow Theory measures the trends of the market, what could you say about its relationship to EMH and MPT?
It contradicts EMH & MPT
Using trends = Technical analysis
Note on Major Benchmarks:
Dow Jones
S&P 500
Russell 2000
Wilshire 5000
NASDAQ
EAFE
Dow Jones (price-weighted) = 30 industrial, 20 transportation, 15 utility (most widely quoted, but narrowest measure)
S&P 500 (float-weighted) = the largest issues on the NYSE
Russell 2000 (capitalization-weighted) = index of stock price performance of smallest 2000 stocks in the Russell 3000
Wilshire 5000 (value-weighted) = broadest measure of overall market
NASDAQ (capitalization-weighted) = broadest measure of OTC trading
Understanding Ex-Dividend dates
To be listed in the corporation’s books as a holder of record, thus receiving the dividend, the investor must purchase the stock before the ex-dividend date.
If Wednesday, Dec. 27th is the date-of-record for ABC Inc., when must an investor purchase ABC to be entitled to receive the cash dividend?
Dec. 22nd must be the purchase date
When are Sharpe and Treynor ratios meaningless? (and Alpha)
When they have no benchmark (could be a fund, portfolio, or index)
What does each mean?
Fund A w/ alpha of 3
Fund B w/ alpha of 0
Fund C w/ alpha of -2
Assuming the funds are similar…
Fund A = return was 3% above the expected return based on the risk taken
Fund B = as expected returns
Fund C = return was** 2% below expected return** based on risk taken
Symbol for Correlation Coefficient
p (or R)
R^2 = coeeficient of determination (determines if Beta is reliable)
What is the IR ratio and what does it tell you?
IR = Rp - Rb / Std. Dev
Tells you about the portfolio manager’s ability to generate excess returns and his consistency
Treynor & Sharpe compares ( ) return of an asset against ( ).
Information Ratio compares ( ) return of an asset against ( ).
Excess return against a risk-free asset
Active return against a benchmark
Only actively traded securities are marginable, not _______ or ________
Not Mutual funds or Options
Shortcut for Maintenance Margin call price
2/3 x price per share (initial)
Then, look for the next highest number
Symbol for Correlation coeffeicient
p or R
Meaning of p…
Correlation coefficient = +1.0
Correlation coefficient = 0
Correlation coefficient = -1.0
+1.0 = max risk (perfectly positive correlation)
0 = no relationship
-1.0 = no risk (perfectly negative correlation)
Given:
- correlation coefficient = 0.5
- Fund A 20% risk
- Fund B 12% risk
- Portfolio value is 57% Fund A, 43% Fund B
What is the Std. Dev.?
Shortcut:
(20% + 12% = 32%)
32% / 2 = 16%
Because the correlation coefficient is less than 1.0, the Std. Dev. is the next lowest from 16%
so really the only thing that matters in the “given” facts is the correlation coefficient
A portfolio w/ a beta of +1 has which type of risk?
+1.0 beta indicates that the portfolio/fund moves in the same direction at the same rate as the market.
=> Market Risk
==> Systematic Risk
What is the optimum risk-adjusted return?
Fund 1) Annual 24%, beta 2
Fund 2) Annual 6%, beta 0.5
Fund 3) Annual 12%, beta 1.2
Fund 4) Annual 8%, beta 0.8
1) 24%/2 = 12%
2) 6%/0.5 = 12%
3) 12%/1.2 = 10%
4) 8%/0.8 = 10%
The stock market suffered a one-day decline of 375pts. What is the beta coefficient for the day?
Beta for the market is always +1 (bc it is the benchmark for portfolios)
Formula
Coefficient of variation (basic)
Std. Dev. / Mean Return
Typical response to a Japanese Yen exchange to US Dollar question (exchange rate risk)
…….. was** revalued**
A mutual fund has a beta of 1.05 in relation to S&P. What percentage would it increase if the S&P increased by 15%?
1.05 = 5% over benchmark
=> 15% x 1.05 = 15.75%
A mutual fund has a beta of 2.4 in relation to S&P. What percentage would it increase if the S&P decreased by 10%?
2.4 = 140% over benchmark
=> -10% x 2.4 = -24%
Synonym for Geometric Mean
Time-Weighted Return:
PV = -1 ALWAYS
N = 4
FV = (1.15)(1.09)(0.935)(1.18)
I/YR = Solve
Biggest mistake made in calculating a dollar-weighted return?
The calculation assumes that the reinvestment rate is constant. If interest is spent or reinvested at a lower/higher rate, the yield will be different than the IRR
Total Return
VS
Nominal Return
VS
Real Rate of Return
Total Return = annual return including appreciation or loss and dividends or interest
Nominal Return = specific-period return (not adjusted for inflation)
Real Rate of Return = specific-period return (adjusted for inflation)
Weakness of HPR calculation
Fails to consider timing of when cash flows occurred
Risk of buying a stock on margin?
Downside risk is greater than the upside gain for the same rate of return
HPR
Holding Period Return
Single Stock:
(End Value - Begin. Value +/- Int./Div.) / Begin. Value
Calculate YTM
Given:
- Bond selling for $875
- 8% coupon
- Mature in 7yrs
PV = -875
N = 14
PMT = ($80/2) = 40
FV = 1,000
I/YR = …… x 2 = …….
Upward movement in a Yield Curve indicates what?
Interest Rates Inc
Duration Dec
CDs
vs
Brokered-CDs (Extra word -> extra risk)
CDs:
Reinvestment rate risk
Purchase power risk
Brokered-CDs:
Reinvestment rate risk
Interest rate risk (bc they are traded)
Purchase power risk
Which entities would normally purchase STRIPS or zero-coupon bonds?
Tax-deferred entities (pensions/IRAs/annuities) because the phantom income is not recognized each year
Best way to buy a foreign security?
Purchase an individual security using ADRs (uses USD)
Index Funds =
Tax efficient
Intrinsic value of Real Estate property equation
Gross rental receipts
+ Nonrental income
= Potential Gross Income (PGI)
- Vacancy and collection losses
- Operating expenses (exclude int & depr)
= Net Operating Income (property’s cashflow)
REITs generally operate as —— arangements.
Distributions from REITs are ——- ——– and may qualify for QBI deduction.
Pass-Through arrangements
Ordinary Dividends
Black-Scholes option valuation model (values the call option of a non-dividend paying stock)
Think “Call Up”:
If any of these go up, that is good for the call option…
- Time remaining to expiration
- Interest rate
- Volatility of the stock
- Price of the stock
If exercise price (strike price) goes up, NOT GOOD
LEAP options
Expiration range: 9mo - 3yrs
Once exercised, starts a new clock for LTCG treatment (must hold for more than 1yr)
Active vs. Passive Investing
Buy & Hold =
Dollar Cost Averaging =
Dow Theory =
Tactical Asset Allocation =
Strategic Asset Allocation =
Buy & Hold = Passive
Dollar Cost Averaging = Passive
Dow Theory = Active
Tactical Asset Allocation = Active
Strategic Asset Allocation = Passive
Yankee Bond
Foreign issued
Dollar denominated
Original Issue Discount (OID) = phantom income
Original Issue Tax-Exempt Discount = not subject to phantom income
The deed of trust between an issuer of bonds and the trustee covers:
I. Property pledged
II. Working capital and Current Ratio
III. Call provisions
IV. Any provision for a sinking fund
ADRs
(American Depository Receipts)
Foreign issued
Dollar denominated
Difference between ADR & Yankee Bond
ADR = ownership shares of foreign company
Yankee Bond = debt instruments issued by foreign company
Buy Call = hope stock goes up
Buy Put = hope stock goes down
Buy Straddle = hope it moves either way (up or down)
What is the callable duration of a BB rated bond with a 10-year call provision and a 20-year maturity. The bond has a 5% coupon and is selling for $990 when comparable bonds are paying 6%?
A) 7.82
B) 8.02
C) 9.90
D) 10.00
E) 12.62
Step 1) Think which maturity should I look at?
=> “callable duration” = 10-year maturity
Step 2) Because the bond is paying a coupon (receiving income back faster), the duration must be less than 10 years
Step 3) Shortcut Method to solve = Pick number less than 10, but not too close to it!
ANSWER: B) 8.02
A stock increases in value by 10%, then 8% and then loses 3% in the final year. What is the arithmetic mean and what is the geometric mean?
Arithmetic = 10% + 8% - 3% = 15% / 3 = 5%
Geometric (Time-Weighted):
PV = -1
N = 3
FV = (1.10)(1.08)(0.97)
I/YR = 4.8418%
Std. Dev. measures ——– of returns
Measure of total risk
Beta measures ——– of returns.
Measure of systematic risk
Std. Dev. measures variability of returns
Beta measures volatility of returns
Time-Weighted Return
= Geometric mean
= Manager performance
%
Dollar-Weighted Return
= IRR/NPV
= Absolute dollar amounts
$$
If positive yield curve is shifting to negative (int. rates rapidly rising), what investments would you recommend to clients?
Bonds with the shortest maturity
If negative yield curve is shifting to positive (int. rates rapidly decreasing), what investments would you recommend to clients?
Bonds with the highest maturity
Immunization of a bond portfolio
Passive investment strategy to protect against interest rate volatility
Goal = Match duration to investor’s pre-selected time horizon
