BU - Investments Flashcards
2 Parts of the financial markets
Money Markets - short term debt instruments
Capital markets - Long-term debt & equity
Examples of financial markets
stock market
bond market
commodities market
foreign exchange market
2 parts of Capital Market
Primary market
- new securities are issued and sold to the public
- IPOs
- Issuing firm receives the proceeds
- Regulated by the securities act of 1933
Secondary market
- previously issued new securities sold among investors
- issuing firm is no longer directly involved
- regulated by the securities act of 1934
Efficient Market Theory (EMT)
states that the stock market is efficient and therefore all stocks reflect all relevant information and are priced in equilibrium
Examples of secondary markets
Organized exchange: new york stock exchange
Over the counter market: NASDAQ
What kind of investors accept the efficient market theory?
Passive investors and would like buy index funds
What are the 3 forms of EMT
Strong
Semi-strong
Weak
What is random walk?
Random walk theory suggests that changes in stock prices have the same distribution and are independent of each other. Therefore, it assumes the past movement or trend of a stock price or market cannot be used to predict its future movement.
What are the 3 attributes to describe and differentiate the 3 forms?
Inside information - Semi strong and weak
Fundamental analysis - Weak
technical analysis - none
What anomalies to the EMT cannot be explained away by EMT believers?
Low P/E Effect - Low P/E likely generate more returns and outperform
Small Firm Effect - small firms tend to outperform larger companies
Neglected Firm Effect - prior neglected stocks generate more return over time, while prior best performers underperform
January Effect - small companies stock generate more return in the first 2-3 weeks in January
Value Line Phenomenon - Most popular - stocks with below average balance sheets outperform growth stocks due to investor belief in companies’ potential
Weekend Effect - stock prices fall on Monday, closing less than the previous Friday
IDK: If presented with a HPR question involving margin, where do you adjust?
Adjust all the entries to reflect the correct cash flow and subtract the margin interest in the numerator
Time-weighted return
Global standard for fund performance
Geometric rate of return = [(1+return 1) x (1+return2) x (1+return3)…]^n - 1
Dollar Weighted Return
Appropriate for a client with their own particular cash flows
This return is affected by the timing of cash flows
What is the appropriate discount rate applied to NPV calculations?
investor’s required rate of return
Net Present Value
discount rate is the investors required rate of return
Calculated using uneven cash flow keys
If the result is + or = go for it, will likely get better than expected returns
If the result is - do not go for it, will likely get less than expected returns
Internal Rate of Return
Calculated using the TVM keys
Weakness is that is assumes the reinvestment rate is the IRR
Yield to Maturity and Yield to Call are examples of IRR
Which is the superior model: NPV or IRR
NPV
Investment Risks
Total Risk = Systematic Risk + Unsystematic Risk
- Total risk is measured by standard deviation
- Systematic risk is quantified by beta
- Unsystematic risk is referred to as Firm-specific
Systematic Risks (cement)
Systematic risk cannot be eliminated through diversification
Purchasing Power Risk (inflation)
Reinvestment Risk
Interest Rate Risk
Market Risk
Exchange Rate Risk
Unsystematic Risks (unload, risks you can unload)
Unsystematic risk can be eliminated through diversification
Business Risk
Financial Risk
Default or Credit Risk
Regulation Risk
Sovereignty Risk
Relationship of Risk & Return
Risk is measured by standard deviation
The greater the standard deviation (risk), the greater the variance of expected return
Low standard deviations provider lower returns
Low risk investments
Cash or money market securities
Treasury securities
Investment grade bonds
Higher risk investments
Common or preferred stock
Junk bonds (high yield bonds)
Options, futures and forwards
Small cap and growth oriented funds
Factors that influence an investor’s capacity for risk
Time horizon
liquidity needs
total investable assets
Currency Exchange
Devalue is when $1: 1 euro moves to $1.50: 1 euro. I have to use more $ to purchase euro
Revalue is when $1: 1 euro moves to $1: 1.50 euro. I can get more for $1
Replace the exchange value with a product - ex: $1: 1 apple or $1: 2 apples
Hedging
To Buy: to buy the power, do you want to control the outcome
To Sell: to sell the power, do you careless
Long: to buy the product
Short: to sell the product
Intrinsic Value Keys
N = X x2 FV = X PMT= X /2 I= X /2 PV= ?
If the yield increases, then the price must decrease, and the other way around
YTM Keys
N = X x2 FV = X PMT= X /2 PV= (X) I= ? x2
YTC Keys
N = # of years until called x2 FV = callable price PMT= X /2 PV= (current price) I= ? x2
3 Forms of Yield Curve
Upward sloping: positive, normal, where the rates of short-term paper are lower than the rates on longer term paper
Flat: rates of short-term and long term are similar
Downward sloping: negative, inverted, where the rates of short-term are higher than the rates on longer term paper
An inversion in the yield curve indicative of a …
Looming recession in the next 6-12 months, has been 100% correct
Business Cycle Phases and points
Phases: expansion and contraction
Points: trough and Peak
Expansion: increasing GDP & decreasing unemployment
Contraction: decreasing GDP & increasing unemployment
Recession is ____
2 consecutive quarters with negative GDP
Fiscal Policy
Controlled by Congress
Tools are taxation and government spending
Increasing government spending are used to promote economic growth and/or recovery
Government will sell Treasury Securities to slow down economic growth
Monetary policy
Controlled by the Federal Reserve Bank
Mandates: sustainable long-term growth (GDP 2.5-3.5%), price levels (core inflation 2-2.5%) and full employment (unemployment 4% or less)
Tools: Discount rate, Reserve Requirement and open market activities
If the Fed issues a “tight” policy, what happens
Discount Rate will be increased, increasing the cost of borrowing
Reserve requirements will be increased, decreasing the amounts that can be lent
The Fed will sell treasuries, to pull money from the market
If the Fed issues an “easy” policy, what happens
Decrease the discount rate - lowers the cost of borrowing
Decrease the reserve requirements - increasing the amounts to be lent
Buy securities from the market - this puts money back into circulation
Monetary tools in order of easy to implement
Buy/sell securities
Adjusting the discount rate
Adjusting the reserve requirement
Duration
Calculates the time to recoup your money on a bond investment (effective maturity)
Weighted average of the PV of the future cash flows of a bond or bond portfolio
The higher the coupon the lower the duration
Matching duration of fixed income to an investor’s time horizon immunizes those assets
Used to estimate changes in bond prices based on hypothetical changes in prevailing rates
Overestimates risks from rising interest rates and underestimates benefits from lowering interest rates
Durations Movement
The longer the duration and the lower the coupon - more sensitive to changes in rate
The short the duration and the higher the coupon - less sensitive to changes in rate
Duration is a linear estimate that tends to overestimate the impacts
Convexity is more complex and more accurate
Distribution Curve
68%
95%
99%
Skewness & Kurtosis
Positively skewed has outliers in the upper or the right tail (stock market)
Negatively skewed has outliers in the lower or the left tail
Kurtosis is how high or low the peak is
mesokurtic = normal distribution
Leptokurtic = slender distribution (Lipo = skinny :)
Platykurtic = broad distribution (play = broadway)
Wash Sale
Trigged when a taxpayer realizes a loss on the sale of a security and acquires a “substantially identical” security within 61 days
Ramifications: loss on a sold security will be disallowed, the disallowed loss will be added to the basis of the new securities purchased.
Substantially Identical
Bonds - difficult to violate unless you buy the exact same bond or bond fund
Stocks - Convertible bonds and call options
Convertible bonds can convert to the stock which was sold for a loss
Purchasing a call option that can be exercised into the same stock that was sold
Stock Option Contracts: Intrinsic Valu
COME = Call Option MP - EP POEM = Put Option EP - MP
PIT = Premium - Intrinsic Value = Time Premium
Intrinsic Value can never be zero
When the intrinsic value is + then the contract is “in the money”, when they are equal it is “at the money”, otherwise it is “out of the money”
Stock Options Definitions
Buyer is the long or holder
Seller is the short or writer
Buyer of a call contract = has the right to purchase shares
Buyer of a put contract = has the right to sell shares
Seller of a call contract = has the obligation to sell shares
Seller of a put contract = has the obligation to buy shares
Covered Call = long the stock & short the call (hold the stock & selling the stock), used to generate income
Naked Call = unlimited risk, you don’t own the stock & selling it (short the call)
Protective Put - portfolio insurance
Collar: protects put protects against price decrease, the call premium use to offset the cost of the put
Straddle: used to capitalize on volatility regardless of direction
Spread: Benefit from stability
Futures: Definitions
Spot Price: the current market value of the item in today’s market
Contracts are standardized
Long Position: anyone who owns something
Short Position: anyone who has to buy something
If you are long - you need a short hedge so you sell future contracts
If you are short- you need a long hedge so you buy future contracts
Determinant of an Options Contract’s total price
Intrinsic Value (market price of stock and exercise price of option contract)
Time Premium (risk free rate of return, time to expiration and standard deviation of stock)
Rebalancing Approaches
Constant Ratio: adjusts the portfolio back to its target weights
Variable Ratio: stacks the proportions in favor of assets that have performed poorly in recent periods, This plan not only departs from your original plan, but is also a form of market timing.
Commissioners at the SEC have the authority to do
- Interpret federal securities laws
- Amend existing rules
- Propose new rules to address changing market conditions, and/or
- Enforce rules and laws.
Federal securities legislation is created by Congress.
To be considered an investment adviser under the “Advisers Act,” a three-prong test must be met:
- The individual or firm advises as to the value of securities, or as to the advisability of investing in or selling securities, through publications or writings and, in fact, they hold themselves out to the general public as providing such advice.
- The individual or firm is engaged in the business of advising others, by providing general or specific advice or issues reports about securities.
- The individual or firm receives compensation for advisory services.
Exams
Series 6: Investment Company Product/Variable Contracts
Series 7: General Securities
Series 62: Corporate Securities
Series 63: to sell securities in any of the 41 states that require state-level rep registration
Series 72: Government Securities
Required elements of a registration statement
- A description of the company’s properties and business,
- A description of the security to be offered for sale,
- Information about the management of the company, and
- Financial statements certified by independent accountants.
Part I is the prospectus - the legal offering document that must be delivered to everyone who is offered or buys the securities and must include audited financial statements
Part II contains add’l information and exhibits that the company does not have to deliver to investors but must file with the SEC
Form S-1
Red Herring
The preliminary prospectus that is used by securities professionals to obtain indications of interest as the SEC reviews a registration statement
20-day waiting period
AUM Size according to the Dodd-Frank Act of 2010
Small adviser is 0-25MM - prohibited to register with SEC, and must register in the state
mid-size adviser is 25-100MM - if in NY or WY must register with SEC, otherwise register in the state
Large adviser is 100MM+ - must register with the SEC when reaches $110M, and not register with the state
Eurodollar CDs
are large, short-term CDs denominated in U.S. dollars and issued by banks outside the United States.
They are negotiable, meaning that they can be traded.
they are not have federal deposit insurance
Euro dollar deposits are not negotiable
TIPS
TIPS’ principal is adjusted every six months to reflect the inflation rate.
Government marketable securities
T-Bills = less than 1 year Current Price = Face Value × [1 - ((Days to Maturity ÷ 360) × Discount Yield)]
T-Notes = 1-10 Years
T-Bonds = 10-30 years
Commercial Paper Features:
- Denominations of $100,000 or more
- Maturities of up to 270 days
- Large institutional investors
- Terms are non-negotiable
- Issuer may prepay the note
is an unsecured (not backed by any assets) short-term promissory note issued by both financial and non-financial companies.
Current Yield is calculated by…
Annual coupon rate / market price of bond
Revenue bonds may be issued for the following reasons:
- financing publicly owned utilities,
- financing quasi-utilities, like transportation,
- financing by levying a tax on properties that benefit from the expenditure, for example a new sewer system,
- Industrial Development Bonds are used to finance the purchase or construction of industrial facilities
Revenue Bonds are backed by revenues from a designated project, authority, or agency or by the proceeds from a specific tax.
Muni Bonds
General Obligation Bonds: issued by state and local agencies and backed by the full faith and credit of the agency.
Revenue Bonds: backed by the revenue from designated project, authority and agency
Market Indices
DOW Jones is price weighted
Standard & Poors 500 is value weighted
Russell 2000 is small companies
Wilshire 5000 is a very broad-based index made up of stocks from NYSE, American Stock Exchange and NASDAQ
Preferred Stock
Rights: to information, to buy/sell, to dividends arrears & priority to dividends
Participating preferred stockholders are entitled to fixed rate of cash dividends
Cumulative preferred stock gives owner the right to accumulate dividend payments skipped
Valuations of stock (3)
Market
Book
Par
Preemptive Right
grants existing stockholders the right of first refusal on any new stock and maintain previous fraction of outstanding shares; prevents dilution of control
Warrants
Issued by the firm and allow the holder the ability to purchase additional shares
They give the holder the option to purchase shares at an exercise price. The exercise price is set initially to be substantially higher than the prevailing market price. The value of the warrant will fluctuate along with the underlying stock and can be sold in a secondary market.
Rights (Stock)
also known as subscription warrants
issued to give existing stockholders their preemptive right to subscribe to a new issue of common stock before the general public is given an opportunity.
Rights exercise prices are set below the current market prices
major hedge fund categories
Arbitrage/Relative Value
Quantitative Long/Short
Macro funds
Income is free from taxation for REITs if
90% of their income is distributed to shareholders
And at least 75% of a REIT’s assets and income must be derived from real estate equity or mortgages.
Arbitrage/Relative Value Funds
- Investment Strategy: Seek out basic mispriced securities.
- Use of Leverage: A high degree of leverage is used to capitalize on otherwise small pricing differences.
- Risk Control: Necessary to eliminate broad market risk in order to capitalize on relative mispricing.
Closed-end Fund
market prices are published daily in the financial media
a fund’s net asset values are published weekly and are based on the closing market price for the previous Friday.
A closed-end fund’s shares are considered to be trading at discount when their market price per share is less than their NAV.
The fund’s shares are considered to be trading at a premium when the shares’ market price is greater than the NAV.
No-Load funds and Load funds
No-load funds, charge lower transaction costs and generally provide fewer services, are beneficial for investors who have some investment knowledge and an understanding of how mutual funds work.
Do not charge commissions
Load funds are beneficial for investors who are seeking advice or guidance from a broker or adviser and do not mind paying a sales charge.
Charge commission
A taxpayer who wants to litigate either in a _____________ or in the _________must first pay the deficiency.
- U.S. District Court*
- U.S. Court of Federal Claims*
Trial Courts
US Tax Court
US Court of Federal Claims
US District Courts
correlation coefficient is greater than zero…
correlation coefficient is zero…
correlation coefficient is less than zero…
indicates the securities in the portfolio are moving in tandem
movement of one security in comparison to the other in the portfolio is not predictable
movement of one security as against the other is exactly opposite, indicating the most diversified situation.
Black-Scholes-Merton formula shows
that the fair value of an option is determined by the following five factors:
stock price
exercise price
risk-free rate
life of the option
the volatility of the common stock
BAPM & CAPM
BAPM is based on the interaction between information traders and noise traders and also considers value expressive measures
CAPM only considers information traders, and uses utilitarian factors in determining supply and demand for a stock
Securities Act of 1933
AKA “Truth in Securities Law” or “The Paper Act”
Two basic objectives:
- Requiring that investors receive financial and other significant information concerning securities being offered for public sale; and
- Prohibiting deceit, misrepresentations, and other fraud in the sale of securities.
The ‘33 Act applies to the primary market, where securities go through an initial public offering (IPO) process.
Securities Act of 1934
Congress created SEC to regulate the secondary market - Register, regulate and oversee:
Brokerage Firms: firms that charge a fee/commission for executing orders submitted by another firm
Transfer Agents: person who maintains the records of registered securities
Clearing agencies: facilitate the validation, delivery and settlement of securities transactions
Self Regulatory Organizations (SROs): FINRA is an SRO and is accountable to the SEC for the various stock exchanges: NYSE, American Stock Exchange.
Empowers the SEC with disciplinary powers and to require parodic reporting by companies with public securities
The Sarbanes-Oxley Act of 2002 recast and expanded the powers of the SEC, giving the SEC even more authority to regulate a larger group of professionals, including lawyers.
SEC
Created to promote stability and protect investors
Comprises of 5 presidentially appointed Commissioners, 4 divisions and 18 offices; Has 11 regional and district offices
Meet to interpret federal securities laws, amend existing rules, propose new rules to address changing market conditions and/or enforce rules and laws.
Investment Company Act of 1940 (Advisors Act)
regulates investment advisors (ABCs)
_A_dvice is given on investments and in the _B_usiness of offering advice and _C_ompensation is received for the advice
regulates the organization of companies, including mutual funds, that engage in primarily in investing, reinvesting and trading in securities, and whose own securities are offered to the public
In place to minimize conflicts of interest
Requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and regular basis
This act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments
Does not include banks, lawyers, accountant, teacher, engineer, bona fide newspaper
The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”) passed in 2010, made important amendments to the registration rules outlined in the Investment Advisers Act of 1940.
FINRA
under SEC oversight, protects investors and market integrity and administers exams and licenses
must become securities licensed to buy/sell securities on behalf of clients
RIAs under the Advisors Act of 1940 are held to fiduciary standard, FINRA licenses are held to a suitability standard
1938 Maloney Act Amendments to the Securities Exchange Act of 1934
Orders
Market Orders - instructed to buy/sell immediately, broker is obligated to act in “best efforts”
Limit Order - investor sets a price to sell above or buy below, may or may not be executed
Stop-Limit -activates a market order at a certain price and then limits the transaction from going beyond an unwanted price
Fill-or-kill - get cancelled if the broker is unable to fully execute them immediately
initial margin requirement
the minimum percentage of the purchase price that must come from the investor’s own funds
hypothecation agreement
grants the brokerage firm the right to pledge the investor’s securities as collateral for bank loans, provided that securities are purchased using a margin account. Most brokerage firms also expect investors to allow them to lend their securities to others who wish to sell them short.
Strangle
Purchase of one option and sale of another with same expiration dates but different strike prices
Long Strangles are debit transactions
Short Strangles are credit transactions because premiums are received
Straddle
Put and Call are bought with the same expiration date and exercise price
Short straddles with profit from small price movements around the exercise price
Spreads
Purchase of one option and sale of another similar but different option
Calculate today’s value of a TBill
Face Value × [1 - ((Days to Maturity ÷ 360) X Yield)] = Current Price
$1,000 × [1 – ((120 ÷ 360) × 0.0275)] = $990.83
contingent deferred sales charge (CDSC)
may be assessed to an investor that sells the fund prior to an agreed-upon holding period
As long as ____ of REIT income is distributed to shareholders, that income is free from taxation to the REIT.
90%
At least 75% of a REIT’s assets and income must be derived from real estate equity or mortgages.
CML v SML measurements
CML standard deviation
SML uses CAPM, Beta
