Book 3 Pages 101 - End Flashcards
an index in which the value of the index is equal to the sum of the prices of the securities in the index divided by a pre-determined dvisior
price weighted index
true or false?
a price weighted index accurately reflects the movement of the underlying market values
false
true or false?
an equal but opposite change in the prices of two stocks would offset each other in a price weighted index
true
which index is an example of a price weighted index?
Dow Jones Industrial Average
the dow jones industrial average consists of mostly ____ _____ stocks
blue chip
true or false?
the dow jones industrial average fails to account for shares outstanding
true
which index is an example of a market capitalization weighted index?
S&P 500
what is the S&P 500 mostly used as a benchmark for?m
US large cap equity
what index is used as a benchmark for small cap stocks?
russell 2000
used as a measure of the US Broad Market securities
Wilshire 500
used as a measure for international securities
Morgan Stanley International Eurpoe, Australia, and Far East Index (MSCIEAFE)
an index based on geometric returns from ~1,700 stocks
value line index
indices that track emerging markets, government debt, and corporate debt asset classes
JP Morgan Indices
first offering of stock to general public by a corporation
IPO - initial public offering
group of investment banks that collectively underwrite a new issue
Syndicate
what is the primary market in regards to issuing securities?
where the initial sale of new securities to the public takes place
what is it called when you assist in the sale of new issues?
underwriting
when the underwriter purchases the entire issue of securities at a specified price and resells at a higher price
firm commitment
when an underwriter purchases securities remaining after an initial offering at a predetermined price
standby underwriting
when an underwriter sells as much of the issue as possible and remainder to the issuing company
best efforts underwriting
true or false?
under firm commitment the risk is shifted to the underwriter
true
true or false?
under standby underwriting all the risk if shifted to the underwriter
false, it is shared between the underwriter and issuing corp
true or false?
under best-efforts underwriting no risk is shifted to the underwriter
true
avoids registration requirements of an IPO
private placement
what is the most popular security when dealing with private placements?
bonds
provides investors with a method of buying and selling previously issued securities
secondary market
an exchange market where listed securities are traded
first market
give an example of first markets
NYSE
an over the counter market with unlisted securities
second market
give an example of a second market
NASDAQ
when stocks trade on both the organized exchanges and OTC
third market
traders who trade without the help of brokers
fourth market
true or false?
fourth market is generally used by institutions who deal in very large volume
true
give an example of a fourth market
INSTINET
executed immediately at the market price
market order
true or false?
market orders have the highest priority
true
order to purchase security at or below specified price or to sell security at or above specified price
limit order
___ priced purchase limit orders take priority over ___ priced limit orders
higher ; lower
___ priced sale limit orders take priority over _____ priced limit orders
lower ; higher
an order to create a limit order if the price of the security reaches a specified level
stop limit order
stocks trading in amounts evenly divisible by 100
round lots
any trade less than 100 shares
odd lot
what is this called .01%
1 basis point
if a bond’s yield drops from 3.35% to 3.22% how many basis points did the bond’s yield drop?
13 basis points
how do you calculate current yield on a bond?
annual interest payments / market price
if Jeff has a bond with an annual coupon of 4.25% that is currently trading at $965, what is the bond’s current yield?
42.5 / 965 = 4.40%
the internal rate of return for cash flows associated with the bond, including the purchase price, coupon, and maturity value
yield to maturity
the longer the term to maturity, the ___ a bond’s price volatility
greater
bonds with ___ coupon rates are more stable when interest rates change than bonds with ____ coupon rates
higher ; lower
a zero coupon bond will be ___ price volatile than a bond with a 4% coupon
more
if a bond gets its rating improved (AA to AAA or other) then the bond’s yield will ____
decrease
bonds with ___ coupon rates and ____ maturities will be most price sensitive to interest rate changes
lower ; longer
states that long term rates consist of many short term rates and their long term rates will be the average or geometric mean of short term rates
unbiased expectations theory
what is the most volatile bond?
a long term zero coupon bond
argues that the yield curve should always slope upward and that any other shape is only a temporary aberration
liquidity preference theory
based on the concept that longer term bonds are more price sensitive to interest rate changes than shorter term bond
liquidity preference theory
implies that investors pay a premium (i.e. lower yields) for shorter maturity bonds to avoid the higher interest rate risk associated with long-term bonds
liquidity preference theory
relies on the concepts of supply and demand for various maturities of borrowing and lending ; these different maturities of borrowing and lending make up different markets
market segmentation theory
states that different institutional investors have different maturity needs that lead them to restrict their bond selections to only predetermined maturity segments
market segmentation theory
determines the weighted average number of years until an investment is recovered
duration
how do you calculate the duration of a bond?
taking the time weighted present value of all cash flows and divide it by the current market price
the coupon rate and duration of a bond have a(n)____ relationship
inverse
true or false?
zero coupon bonds will always have a duration equal to their time to maturity
true
true or false?
a bond with coupon payments will always have a duration less than its time to maturity
true
the duration and YTM of a bond have a(n) ____ relationship
inverse
higher quality bonds (lower yield) will have ____ duration than lower quality bonds (high yield)
greater
an absolute measure of the interest sensitivity of a bond
Macaulay duration
refers to the degree which duration changes as a result of changes in YTM
convexity
the larger the convexity the ___ the change in duration
larger
when is convexity likely to be the greatest?
low coupon bonds
long maturity bonds
low YTM bonds
the coupon rate and convexity of a bond have a(n) ______ relationship
inverse
the term to maturity and convexity of a bond have a(n) ______ relationship
direct
the YTM and convexity of a bond have a(n) ______ relationship
direct
how do you calculate a percent change in the price of a bond?
negative Duration x [ the change in YTM as decimal / (1 + YTM)]
calculate the percent change in the price of the following bond: maturity = 5 years YTM changes from 4.5% to 3.5% annual Coupon rate is 6% (paid annual) Current price is $1,065.85 face value is $1,000
first calculate duration using CF Keys
CF 0 = 0 CF 1 = 60 CF 2 = 120 CF 3 = 180 CF 4 = 240 CF 5 = 300 I = 4.5% NPV = $4,779.28
NPV / Current Price = 4.484 = duration
-4.484 x [ change in YTM / (1+.045) = 4.29%
or you could also use TVM keys
a relative measure for comparing different durations of bonds
modified duration
how do you calculate modified duration?
regular duration / (1 + (YTM / # of coupon payments in a year)
Jose’s bond has a current market value of $821.87 and Macaulay duration of 4.6. If the bond’s yield changes from 3.5% to 4%, what is the percent change in price of the bond?
-2.2%
the present value of future cash flows discounted at a risk adjusted interest rate (IRR)
intrinsic value of a stock
assume an investor can invest in a company who will pay a dividend of $1 in year 1 and increase the dividend by $1 for each of the next 3 years. Assume the stock can be sold at the end of year 4 for $40. How much would an investor be willing to pay if their required rate of return was 12%
use CF keys and NPV
$32.58 is the answer
used to determine the price for a security in which dividends are growing at a constant rate
constant growth dividend discount model
what is the formula for the constant growth dividend discount model?
D1 / (r-g)
assume francis corp stock is currently paying a dividend of $2 and the dividend will grow at a constant 7% rate. What should be the security’s intrinsic value if the investor’s required return is 11%?
d1 = $2 (1+.07) = 2.14
2.14/ (.11-.07) = $53.50
under the constant growth dividend discount model, the value of the common stock will ____ if the required rate of return increases
decrease
under the constant growth dividend discount model, the value of the common stock will ____ if the required rate of return decreases
increase
under the constant growth dividend discount model, the value of the common stock will ____ if the dividend growth rate increases
increase
under the constant growth dividend discount model, the value of the common stock will ____ if the dividend growth rate decreases
decrease
assume francis corp pays a $2 dividend and the investors required return is 11%, what is the value of francis corp’s stock
$18.18
$2 / 11%
how do you calculate the intrinsic value of a stock if there is no dividend growth rate?
Dividend paid / rate of return
assumes the growth rate of the stock’s dividend is not constant but rater changes
multistage growth dividend discount model
when is the multistage growth dividend discount model most appropriate to use?
when a company is going through it’s growth phase
XYZ corp has a current dividend of $2 per share. This dividend is expected to increase 6% for the next 3 years and then 7% thereafter. Assume the investor’s required rate of return is 9%. What is the intrinsic value of the stock?
first find the dividend in year 4 D1 = $2 x 1.06 = $2.12 D2 = $2.12 x 1.06 = $2.25 D3 = $2.25 x 1.06 = $2.39 D4 = $2.39 x 1.07 = $2.56
$2.56 / (.09 - .07) = $128
then plug into cash flow keys
CF 1 = D1
CF 2= D2
CF 3 = D3 + Value of stock at year 4 ($128)
this model should be used when a firm is not currently paying a dividend
Discounted Free Cash Flow Model
what is the formula for the discounted free cash flow model?
Free cash flow to equity(1) / r - g
free cash flow to equity(1) = FCFE(0) x (1+g) / (r-g)
PLV corp has an estimated FCFE for next year of $3 per share. In addition its FCFE is expected to grow at a constant 3% per year. The client’s required rate of return is 10%, what is the stock’s intrinsic value
$3 / (.10-.03) = $42.86
how do you calculate the value of a stock using the capitalized earnings approach?
earnings of company / discount (AKA capitalization) rate
refers to the amount of equity within a company
book value
true or false?
book value depicts an accurate measure of the value of the company
false
a real estate valuation approach that is most appropriate when there are several properties in a market that have been sold that have similar characteristics as the property being valued
the sales comparison approach
a real estate valuation approach that estimates the value of the property by determining how much it would cost to replace the property and then making any adjustments for depreciation or deterioration of the property
the cost approach
when is the cost approach most appropriate to use?
when evaluating special use buildings such as a church or when evaluating newly constructed property
bases the value of the property on the income that can be generated from the property
the income capitalization approach
what are the two methods under the income capitalization approach?
direct capitalization
discounted cash flow analysis
how do you calculate the direct capitalization method?
net operating income / discount rate
where net operating income is the net income before depreciation and mortgage debt service
what is the implied capitalization rate of a property that recently sold for $12 million and generated net operating income of $2.16 million per year?
18%
$2.16 million / $12million
when is the discounted cash flow analysis for real estate most appropriate?
when it is not reasonable to assume income will remain constant for the foreseeable future (i.e. when income is expected to fluctuate)
the process of determining the FMV or intrinsic value of a security
fundamental analysis
analyzing, in order, the economy, the specific industry, then the specific company
top down
analyzing, in order, a specific company, specific industry, then the economy
bottom up
what are some factors considered by fundamental analysis?
economy stock market tendencies monetary policy fiscal policy money supply interest rates and business cycles industry analysis
stocks that can be drastically affected by changes in the economy
cyclical stocks
stocks that are relatively unaffected by changes in economic conditions
defensive stocks
true or false?
declines in interest rates have preceded many of the economic recoveries
true
true or false?
rises in interest rates have preceded many of the recessionary periods
true
the sum of demand deposits, coins, traveler’s checks, and currency
M1
the sum of demand deposits, coins, traveler’s checks, currency, savings accounts, time deposits under $100k, and balances in retail money market mutual funds
M2
who controls the money supply?
the federal reserve bank
when the money supply increases resulting in the circulation of more money
loose/expansionary monetary policy
when the money supply decreases resulting in less circulation of money and less money for banks to lend
tight/restrictive monetary policy
federal government taxation, expenditures, and debt management are called ____ policy
fiscal
as tax rates increase, a corporation’s after-tax income will _______
decline
as tax rates increase, a corporation may not be able to pay ______ which may cause the stock price to _____
dividends ; decline
as tax rates increase, the demand for tax free investments ____
increases
occurs when government expenditures exceed revenues
deficit spending
corporate earnings will benefit from a(n) ____ in government expenditures
increase
under easy or loose fiscal policy taxation ______
decreases
under easy or loose fiscal policy government spending ______
increases
under tight or restrictive fiscal policy taxation ______
increases
under tight or restrictive fiscal policy government spending ______
decreases
what are the stages of an industry life cycle?
rapid growth declining growth maturity decline deletion
what happens to debt management under easy or loose fiscal policy?
buy government securities
what happens to debt management under tight or restrictive fiscal policy?
sell government securities
provide insight into a company’s ability to convert assets into cash without sustaining a loss on the transaction
liquidity ratios
how to calculate the current ratio
current assets / current liabilities
measures the ability of a firm to meet its short term obligation
current ratio
how to calculate the quick ratio
(current assets - inventory) / current liabilities
measures the company’s effectiveness in managing its business operations
active ratios
indicates the speed with which inventory is turned into cash
inventory turnover ratio
how to calculate inventory turnover ratio
cost of goods sold / average inventory
companies that have low inventory turnover may have ___ inventory costs
higher
measures how often the company is able to turn over its receivables
accounts receivable turnover
how to calculate accounts receivable turnover
sales / average accounts receivable
the higher the accounts receivable ratio, the ____ the company receives cash to service its short term obligations
quicker
indicates the sales per dollar investment of fixed assets
fixed asset turnover
how to calculate fixed assets turnover
sales / fixed assets
provide different measures of a company’s earning capacity
profitability ratios
how to calculate operating profit margin
earnings before interest and taxes / sales
how to calculate net profit margin
net income / sales
how to calculate ROA
net income / total assets
how to calculate ROE
net income / equity
ratio that indicates the net income generated per dollar of investment in the company
ROE
how to calculate the debt ratio
total debt / total assets
how to calculate the debt to equity ratio
total debt / total equity
what are 3 important ratios for bondholders to pay attention to?
inventory turnover
accounts receivable turnover
times interest earned ratio
indicates the number of times a company can service its debt
times interest earned ratio
how to calculate the times interest earned ratio
earnings before interest and taxes / annual interest expense
what are 5 important ratios for stockholders to pay attention to?
ROE ROA Gross profit margin dividend payout ratio P/E ratio
indicates what portion of earnings has been paid to stockholders in the form of dividends
dividend payout ratio
how to calculate the dividend payout ratio
dividends / earnings
calculate the dividend payout ratio in the following example:
ABC pays a dividend of $1 per share
ABC earns $4 per share
1/4 = 25%
indicates what the market is willing to pay for a dollar of earnings
P/E ratio
how to calculate P/E ratio
price per share / earnings per share
a higher P/E ratio could indicate a(n) ____ stock
overpriced
indicates how much an investor is paying for a specific revenue stream
price/sales
a measure of relative valuation that can be used to compare companies with different growth rates
PEG ratio
how to calculate the PEG ratio
(price/earnings) / growth
proponents of the PEG ratio believe that companies with a low PEG ratio will have ______ rates of returns
higher
an attempt to determine the demand side of the supply/demand equation for a particular stock or set of stocks
technical analysis
based on the belief that studying the history of security trades will help predict future price movements
technical analysis
true or false?
technical analysis and the efficient market hypothesis are in direct contradiction with each other
trueq
type of movement that represents large trends that last anywhere from 1-4 years
primary moves
moves that are considered bull/bear markets
primary moves
moves that are temporary, generally less than two months
intermediate moves
used as indicators of trends in the market
moving averages
what is on of the more popular moving averages to follow?
200 day moving average
states that a trend will generally continue until a major event occurs to change the direction of the market
relative strength analysis
states that most of investors are generally wrong regarding investment decisions and predictions
contrary opinion theory
theory/indicator based on the assumption that the small individual investor is always wrong
odd lot theory
under odd lot theory, if a small investor is selling a security its is probably a good time to ____ the security
buy
theory that states that increased short selling is a sign that the market is near a trough and will soon turn around
short interest theory
how to calculate the confidence index
average yield of high-grade bond / average yield of low grade bonds
bondholders have a tendency to shift their bond holdings to a higher graded bond when the market is _____
weak
the closer the confidence index gets to 1, the ____ the market is getting
stronger
increasing levels of debt (margin) in brokerage accounts is an indicator that investors believe the market to be ____
strengthening/bull
value investing focuses on the ____ in the P/E ratio
Price (numerator)
growth investing focuses on the ____ in P/E ratio
earnings (denominator)
true or false?
growth stocks usually have a high dividend payout ratio
false
a written document that sets forth a client’s objectives and limitations on the investment manager
investment policy statement
the process of comparing the performance of an investor’s portfolio with the relevant market’s performance over the same period of time
benchmarking
states that the composition and weighting of the components of the benchmark must be clearly delineateed
unambiguous
states that the option to invest in the benchmark is available
investable
states that analysts should be able to calculate the benchmark’s return on a frequent basis
measurable
states that the benchmark must be consistent with the manager’s investment philosophy and style
appropriate
states that the manager has current investment knowledge of the securities that make up the benchmark
reflective of current investment opinions
states that the benchmark should be constructed before the beginning of the evaluation period
specified in advance
a method of financial analysis that attempts to forecast how investment returns on different asset classes vary over time by using thousands of simulations to produce probability distributions for various outcomes
stochastic modeling
a computer generated distribution technique used to model uncertainty
monte carlo analysis
measures the relative measure of risk adjusted performance of a portfolio based on total risk
sharpe ratio
sharpe ratio uses _____ as a measure of portfolio risk
standard deviation
how to calculate the sharpe ratio
(return of portfolio - risk free rate) / standard deviation of portfolio
the treynor ratio uses _______ as a measure of porfolio risk
beta
how to calculate the treynor ratio
(return of portfolio - risk free rate) / beta
measures how well the managed portfolio performed to an unmanaged portfolio of equal risk when comparing actual return to expected return
alpha
how to calculate alpha
return of portfolio - [risk free rate + (return of market - risk free rate) x beta]
true or false?
alpha is a relative measure of performance
false, it’s an absolute measure
calculate alpha on the following portfolio: portfolio return = 12% beta = .6 market return = 15% risk free return = 3%
1.8%
measures the portfolio’s average rate of return in excess of a comparison (benchmark) portfolio divided by standard deviation of the excess return
information ratio
how to calculate the information ratio
alpha / standard deviation
measures the consistency with which a manager beats a benchmark
information ratio
a relative measure of total risk per unit of expected return
coefficient variation
used to compare investments with varying rates of return and standard deviations
coefficient of variation
how to calculate the coefficient of variation
standard deviation of asset / expected return of asset
which of the following stocks has more total risk per unit of expected return:
ABC stock has an expected return of 5.95% and standard deviation of 4.35%
XYZ stock has an expected return of 10% and standard deviation of 6%
calculate the coefficient of variation (standard deviation / expected return)
4.35 / 5.95 = .7311
6 / 10 = .6
so ABC is more risky per unit of expected return
true or false?
a positive alpha indicates the portfolio manager outperformed the benchmark
true
Franklin has a separately managed account with a large cap growth investment objective. The account returned 7.75% over the past year. During the same time period, the DJIA has returned 6.45%. The risk free rate is 1.85%. The account has a beta of 1.12. Did the managed portfolio outperform the benchmark return on a risk adjusted basis, if so by how much?
Yes by .75%
calculate alpha
7.75% - (1.85% + (6.45% - 1.85%) x 1.12))
the process of purchasing securities over time by investing a predetermined amount at regular intervals
dollar cost averaging
what is the goal of dollar cost averaging?
to reduce the effects of market price fluctuations
purchasing additional shares only when the market price of the shares declines
averaging down
the investor purchases the same number of shares everytime
share averaging
plans where dividends are reinvested back into the investment from which they were earned
Dividend reinvestment plans (DRIPs)
accomplished by establishing a portfolio of bonds with staggered maturities
laddered portfolio
initially acquiring a portfolio of bonds consisting of both very long-term and very short-term maturites
barbell/dumbbell strategy
investors purchasing a series of bonds with similar maturities that are focused around one point in time
bullet strategy
an active portfolio management strategy that emphasizes and over allocates certain economic sectors or industries in response to the next expected phase of the business cycle
sector rotation
individuals who engage in short selling are ____ about the future direction of the marke
bearish
what is Elayne’s profit in the following scenario:
she believes that ABC stock is overpriced. She short sell 20 shares when ABC is trading at $100 per shares. 3 months later ABC can be purchased at $85 per share. Elayne repurchases 20 shares at that time
$100 - $85 = $15
$15 x 20 shares = $300
when an investor takes a short position with the same market value as a long position
shorting against the box
give an example of shorting against the box
Larry owns 100 shares of ABC stock, he then sells 100 shares of ABC stock short
when is a short sell considered not constructive?
short sale is closed on or before the 30th day following the tax year that the short sale was entered into and
the long position is held (unhedged) for a period of at least 60 days after the close of the short postion
represents the amount that the investor is required to fund in the margin account
initial margin
who sets the initial margin requirement
federal reserve
what does the federal reserve set the initial margin requirement to
50%
the level at which an investor will be required to add funds to the margin account
maintenance margin
the loan amount owed to the broker ; this amount includes the original amount borrowed plus any accumulated interest
debit balance
the value of the security less the debit balance
equity
what is the formulate for determining when a margin call will occur
debit balance / (1 - maintenance margin)
Harry pays $20,000 to purchase shares of ABC company trading at $25. If Harry uses a margin account (50% initial margin) to purchase this stock, he can buy 1,600 shares (20,000 x 2 / $25). An amount of $20,000 is borrowed from the broker. Harry is concerned about receiving a margin call. At what point would he receive a margin call if the maintenance margin is 35%?
$25 x 50% / (1 - 35%) $19.23
$19.23 is the price per share
Harry pays $20,000 to purchase shares of ABC company trading at $25. If Harry uses a margin account (50% initial margin) to purchase this stock, he can buy 1,600 shares (20,000 x 2 / $25). An amount of $20,000 is borrowed from the broker. If the stock priced dropped to $15, how much money would Harry be required to deposit to meet the margin call?
first find required equity $15 x .35 = $5.25 next find current equity $15 - $12.50 (initial margin or loan amount) = $2.50 then find the difference between the two $5.25 - $2.50 = $2.75
$2.75 is the price per share to maintain the equity postion
used to protect a bond portfolio from interest rate risk and reinvestment rate risk
portfolio immunization
true or false?
for a bond portfolio to be immunized the duration should be equal to the time horizon of the investor’s goals
true
the process of selling one debt instrument and replacing it with another with the goal of increasing the overall rate of return
bond swapping
a swap that involves exchanging bonds with identical characteristics (credit rating, maturity, coupon payment, call features, etc.) selling for different prices
substitution swap
a swap that involves the exchange of one type of bond (example: government bond) with another type of bond (example: corporate bond)
intermarket spread swap
when does an intermarket spread swap occur?
when investors believe one type of bond is currently mispriced in relation to the other
a swap that involves exchanging long term bonds for short term bonds or vice versa
rate anticipation swap
if interest rates are expected to increase then you should swap ______ term bonds for _____ term bonds
long term ; short term
if interest rates are expected to decrease then you should swap ______ term bonds for _____ term bonds
short term ; long term
a swap that involves exchanging a lower YTM bond with a higher YTM bond
pure yield pickup swap
swaps that are motivated by current tax law
tax swap
occurs if the taxpayer sells or exchanges stock or securities for a loss and within 30 days before or after the date of the sale or exchange, acquires similar securities
a wash sale
used to manage risk associated with changes in interest rates
interest rate swaps
Company A enters into a fixed for floating swap with Company B on $100,000 of notional principal. Company A agrees to pay a fixed 5% ; Company B agrees to pay one-year London Interbank Offered Rate (LIBOR) less 1%. At the end of the first year, one-year LIBOR is 6.8%. What will each company have to pay each other?
Company A’s liability = 5% x $100,000 = $5,000
Company B’s liability = 5.8% x $100,0000 = $5,800
So company A nets $800
true or false?
Liability investing is usually better used in non-taxable accounts
true
true or false?
it makes the most sense to hold non-taxable bonds such as muni bonds in a tax-deferred account
false
what are the 6 steps of the investment planning process?
- determine if client has means and commitment to invest
- Determine the time horizon for investment based on the client’s financial objectives
- Determine the appropriate level of risk and return for the portfolio based on the investor’s risk tolerance and required return
- Select investments suitable to the investor’s time horizon, return requirements, and risk tolerance
- compare actual returns vs. expected returns
- adjust and rebalance the client’s porfolio
the _____ _______ of the client are the driving force behind an investment plan
financial goals
