CFP Investments Flashcards
Unsystematic risk
aka nonsystematic
diversifiable
curved line on the risk/return graph
business risk - nature of firms operation, ie bad mgmt
financial risk - how the firm finances its assets, ex loss due to heavy debt financing
CAN BE ELIMINATED THROUGH DIVERSIFIED PORTFOLIO
Systematic risk
Non diversifiable - it’s a function of the SYSTEM
Inescapable
Flat horizontal line on the risk/return graph
PRIME
Purchasing power - loss of power through inflation
Reinvestment risk
Interest rate
Market risk
Exchange rate
Brokered CDs
THINK: Extra word, extra risk
issued by bank but traded through brokerage firm rather than issued by savings institution
subject to interest rate risk bc they are traded (negotiable)
CDs risk
CDs are subject to purchasing power and reinvestment risk
Not interest rate risk or market risk
MMDA vs MMMF
money market demand account - insured by FDIC
money market mutual fund = not insured
open end
can be taxable or tax free
avg maturity 90 d
contain Tbills, CD’s, commercial paper, etc
Commercial paper
Short term promissory note from corporation
Bankers acceptance
securities to finance import/export
Eurodollar
Deposit in foreign bank denominated in $
Yankee dollar
Issued in US by foreign entity
denominated in $
Risk hierarchy example
Tbill (0) < 6 mo CD < MM Fund < Tax exempt MM Acct
MM fund not insured, includes comm paper
MM acct includes municipal debt
OID
original issue discount bond
discounted from Par at issue
most are zero coupon
no interest paid until maturity
discount accreted over bond’s life and included as taxable interest income (phantom)
Bond Yield Ladder
Discount
Y Yield to call >
M Yield to maturity >
C Current yield >
A Annual coupon rate / nominal yield >
C current yield >
M Yield to Maturity >
Y Yield to Call
Premium
Current yield of bond
Going market rate
Annual interest $ / Current price
can use to solve for market price!
Market price of bond
Annual interest $ / Current yield
rearrange the current yield formula!
Treasury bills, notes, bonds
Fed securities have FED tax!
No state or local
Bills, notes and bonds are marketable securities
Bills: No Risk, 3-12 mos, quoted in terms of discounted yld
Notes: 1-10 years, 1-100K, quoted in coupon rate
Risk: RIP reinvestment interest rate purchasing power
Bonds: 10-30 years, 1K-1M, quoted in coupon rate
STRIPS
P&I “stripped” apart
zero coupon treasuries
annual phantom income
direct oblig of govt
popular w/investors who want known payment on specific date
bought at discount
*normally purchased by tax deferred entity like pension/IRA/annuity
TIPS
inflation protected
marketable
face value adjusted for inflation
fixed coupon rate but int payments ^ as principal ^
tax 2 parts: (annually)
fixed interest & increase in principal
both ord income tax
final sale can be capital gain
NO State/local tax
EE bonds & I bonds
NON MARKETABLE (Treasury Direct)
Issued at FACE value
Taxed the same, fed only, no state & local
Can CHOOSE to have interest taxed each year, most don’t
Interest rate:
EE based on 10 yr treasury Note
I based on fixed base rate + inflation adj amount
Taxable at redemption (vs TIPS taxable annually)
Tax free if used for education, based on AGI
EE bond ownership
UTMA or Parents
UTMA owned by child, ordinary income at redemption
EE “education” bonds normally owned by parent
Tax free if the AGI less than phaseout at redemption
MBS
GNMA guaranteed, no Default risk
FNMA/FHLMC freddie not guaranteed, backed implicitly
taxed at fed & state
Risk: Interest rate & Reinvestment
interest rates go down, homeowners pay down principal, principal has to be invested at lower rate
interest rates go up, people stick with existing mortgages and GNMA holder stuck with investment at lower than market rates
Municipal bonds
Tax exempt for state of residency
General obligation - less risky can raise taxes
vs Revenue bond - more risky backed by specific revenue stream (ie tolls)
if INSURED, less risky
Assured Guarantee and Berkshire
CMO
collateralized mortgage obligation
specific type of MBS with tranches
cash flow basis - smooth payments vs actual principal
Z tranch
no coupon, most risk
only receives cash flow after other tranches satisfied
Bond risks
D efault (only corporate/municipal, not treasury)
R einvestment
I nterest rate
P urchasing power
no Market risk, no Exchange rate risk
no R with zeroes
Convertible value of bond
(Par value / CP conversion price ) * current share price
Normally issued at lower yields than straight bonds bc of conversion privilege
FLOOR value is greater of bond value or conversion value
Bond Intrinsic Value
FV = Par value
PMT = coupon amount / 2 if semi annual
N = # of years to maturity
I = comparable debt rate
Put Bond
allowed to sell back to issuer
in return for put privilege, buyer sacrifices some yield
think: “put down”
convertible privilege also decreases yield
Preferred stock
Has longer duration than bonds (infinite/perpetual)
More risk than bonds
Pays FIXED income
Bond interest is deductible but preferred stock dividends are not (assume this is to the corporation)
USED BY CORPORATE ENTITIES with excess cash
if they buy bonds all interest is taxable, preferred stock at least 50% excluded from tax
ADR
american depository receipt
for shares of a foreign corporation held in US bank
quoted in USD
dividends paid in USD
dividends declared in foreign currency
exchange rate risk remains
investors get foreign tax credit
Callable bonds
Issuer has right to call back (redeem at a predetermined price prior to maturity)
Likely to call back if interest rates DROP
can then resell bonds at a lower rate
pay the call premium
ETF vs mutual fund
ETFS lower expense ratio
Can trade options on ETF. MF not marginable and cannot be sold short.
Trade ETFs at market price (marketable). MF only @EOD.
ETFs will have capital gain at some point if appreciates
NOT liquid (stable) due to market risk
No sales load but brokerage commission
Tax efficient because gains can be deferred by transferring to redeeming shareholders vs selling
Index funds trade at NAV but ETFs may trade at a premium/discount, usually close to NAV
Unit Investment Trust (UIT)
Think: Set IT and forget IT
Passive
Frozen
Self-liquidating - distributed to UNIT holders (not shareholders)
Redeemed at NAV
have stated expiration date
“units” bought and sold on secondary markets
NOT purchased on a national exchange
License needed to sell mutual funds
Series 6
Series 7: stocks and bonds
Series 6:
Mutual funds (closed-end funds on the initial offering only)
Variable annuities
Variable life insurance
Unit investment trusts (UITs)
Municipal fund securities [e.g., 529 savings plans, local government investment pools (LGIPs)]
However, holders of the Series 6 license are not permitted to sell corporate or municipal securities, direct participation programs, stocks, or options.
Series 7:
everything above plus
products include common and preferred stock, bonds, exchange-traded funds (ETFs), real estate investment trusts (REITs), and options.
Open end vs closed end
open end: traditional mutual fund
NOT marketable
closed end investment company: one time stock issuance, no new shares, traded on an exchange
Bond ratings
S&P - all caps
investment grade: AAA, AA, A, BBB (better bad bond)
speculative: BB (bad bond) junk/high yield
Moody’s - NOT all caps
investment grade: Aaa, Aa, A, Baa
speculative: Ba and lower
High yield corporate bond
NOT a good recommendation
this is like a junk bond with a high yield to compensate
Global vs International
Global includes US
International is foreign only
REIT
type of closed end fund
sell shares, use $ to buy property, also leveraged w/loans, can sell shares to get out
MARKETABLE compared to actual real estate
Equity REIT - income producing (rental income)
Mortgage REIT - property development - inflation is BAD bc income based on spread between lending rate and borrowing rate
generally operate as pass thru investments
Real estate value: NOI
Gross rental receipts
+ Non rental income
= Potential gross income
- Vacancy and collection losses (% of PGI)
= Effective gross income
- Operating expenses (EXCL: interest/deprec)
= NOI cash flow
IV = NOI / cap rate
Real estate intrinsic value
IV = NOI / cap rate
RELP
Real estate limited partnership
popular in 80’s until 1986 limited deductibility of passive losses
passive loss rules
not marketable
managed by general partner
REMIC
Real estate mortgage investment conduit
more flexibility than CMOs
rank of risk levels vs CMOs at AAA grade
used for MBS pools
limited life, self liquidating
MAY eventually replace CMOs
Derivatives / options intrinsic value
CANNOT BE ZERO!
COME call option Market - Exercise
POEM put options Exercise - Market
What is IV?
minimum price the option will command as an option
Positive: In the money
Negative: out of the money
Premium is the market price of option
Premium approaches IV as it approaches experiation date
Time premium = Option market price - IV
Put option
Right to put / sell shares at specific price
Buy puts when bearish (think “put down”)
Stock goes down, owner can buy at lower price and deliver at higher price
Writer / seller is bullish
Earns premium income
Thinks stock will not go down and option will expire
Call option
Write to buy / call shares at specific price
Buy calls when bullish
Stock goes up, able to buy shares at lower price
Writer/seller is bearish
Riskiest option position
Selling Naked call-unlimited loss potential
Selling Naked put - Limited loss potential (stock cannot go below zero)
Nothing with puts is unlimited, always a zero dollar floor
Protective put / hedge
Buying/owning a stock
AND
buying a put for the same stock
Put acts as insurance against decline in underlying stock
Option value wrt stock volatility
the more volatile a stock, the higher the price of a call option due to potential for stock to go up
Volatile stock more attractive to speculator than stable stock
IF you see prices that don’t indicate volatility then the biggest factor is TIME
Short time to expiration - premium due to volatility/speculative value
Long time to expiration - premium due to time value
Call Option taxation
Writer / seller:
If lapse/expiration: Premium rec’d is STCG
IF exercise: Premium added to sale price of stock (LTCG or STCG depending on stock)
Holder/buyer:
Premium paid is a non deductible expense
At exercise, premium included in basis of stock
If not exercised, produces a STCLoss
SPLIT INTO TWO TXNS: Stock & Premium
Put option taxation
If it lapses, premium rec’d by writer is STCG
Options: Straddle
Buying Call and Buying Put
A long straddle options strategy occurs when an investor simultaneously purchases a call and put option on the same underlying asset with the same strike price and expiration date. An investor will often use this strategy when they believe the price of the underlying asset will move significantly out of a specific range, but they are unsure of which direction the move will take.
Options: Spread (low risk)
Buying Call and Selling Call (Bull Call Spread)
Buying Put and Selling Put (Bear Put Spread)
Spreads involve buying one (or more) options and simultaneously selling another option (or options).
Both options will have the same expiration date and underlying asset.
Different exercise prices
Options: (Protective) Collar
Buy a put / write a call
limiting profit but limiting loss
A protective collar strategy is performed by purchasing an out-of-the-money (OTM) put option and simultaneously writing an OTM call option (of the same expiration) when you already own the underlying asset.
This strategy is often used by investors after a long position in a stock has experienced substantial gains. This allows investors to have downside protection as the long put helps lock in the potential sale price. However, the trade-off is that they may be obligated to sell shares at a higher price, thereby forgoing the possibility of further profits.
LEAPs
Long-term Equity Anticipation
long term options (9 mos to 3 yrs)
allows for holding positions for anticipated long term market movements (ex: S&P 500 Index option is useful hedge for manager whose funds mimic the index)
Taxed at LT rates if held > 1 year
ST if sold within a year of exercise
Warrants
like a call option for corporate common stock
issued by corporations not individuals
warrant terms NOT standardized
maturities of several years vs 9 mos
Short sales
anticipating a decline
borrows on margin (security is borrowed)
sells the borrowed stock
when share price goes down they buy the stock to cover the short
cancel the short position by returning the security
Net proceeds from initial short sale held by broker
No funds immediately available
No time limit. Dividends declared must be covered by short seller.
Futures
BUY LONG
If you are LONG means you want/need to buy the commodity/financial (bullish)
Kelloggs/General Mills long on corn
Buys a contract today’s prices to hedge against higher prices in future
Sell SHORT
If you are SHORT, want to sell (bearish)
Corn farmer short on corn
Sells hedge at today’s prices in case it goes down
Someone owning large Euro portfolio worried about it would SHORT the Euro
Futures trading
commodities
financial futures
foreign currency
contracts settled by delivery OR offset (typical)
delivery - actual delivery (pork bellies)
offset - buyers sell and sellers buy opposite of initial transaction
speculating is VERY RISKY due to high margin requirements
used by businesses to HEDGE /mitigate against business risk
Spot price: current market price
Open interest: # of futures contracts trading
Daily limit: max price change per day based on prior day
Collectibles
Tax rate 28%
includes GOLD ETF and Crypto
Basis is whatever the value is at death. Might step DOWN.
Private Placement / Reg D
Not a public offering
Does not require SEC registration
Accredited investor 1/2/3 test
$1m net worth indiv / $200k indiv annual income / $300k joint
excluding primary residence
Non-accredited must be “sophisticated”
MAXIMUM of 35
“Qualified” investor has $5m in investments
ex: Angel investing
Correlation coefficient and risk
+1 perfectly positively correlated (move exactly together) - no reduction of risk
-1 perfectly negatively correlated (move exactly opposite) risk is eliminated in theory. portfolio std dev=0
between 0-1: risk is less than the individual assets
if covariance is 0 then coefficient must be 0 (and vice versa)
Coefficient of variation
Measure of relative variability to compare two investments
CV indicates risk per expected unit of return
STD DEV / Mean Return
Higher result > Higher risk
Covaration vs Correlation Coefficient
Both express extent to which the movements of stocks in same portfolio are similar or not
Covariance considers infinite possibility of outcomes
Coefficient falls w/in range +1 to -1
Liquidity
Marketability
Liquid = fast (marketable) + stable
Illiquid = potential loss of principle
Marketability only refers to speed
Note:CFP may also use to refer to whether something is sold on a market
Liquid assets: STABLE & MARKETABLE
CD maturing soon/short term
Laddered CDs
Life insurance cash value
Government bond fund
Open end MMMF ??
NOT STABLE, but MARKETABLE:
Open end mutual funds (prices can change)
Growth fund
Money market fund
closed end funds
ETFs
brokered CDs
REITS
Not marketable:
savings/checking
money market accounts
open end mutual funds
EE bonds
I bonds
Not stable & not marketable:
RELP
Non Public REIT
Mean or Std Dev of returns
How to calculate on calculator
Return 1 (SIGMA + key)
Return 2 (SIGMA + key)
Return 3 (SIGMA + key)
mean: Gold 7
std dev: Gold 8
CV
Coefficient of Variation
risk per unit of expected return
relative variability to compare different investments
std dev / mean
HIGHER CV means more risky
Std dev vs Beta
Std dev measures
VARIABILITY of returns used in a
NON DIVERSIFIED portfolio and a measure of
TOTAL RISK
Beta measures
VOLATILITY of returns used in a
DIVERSIFIED portfolio and is a measure of
SYSTEMATIC risk
In finance, variability measures how spread out an asset’s returns are likely to be. Volatility measures how much returns deviate from average over a set period of time.
Beta vs market
volatility of security’s return relative to market
market as a whole = Beta of 1
higher beta = higher risk (and greater potential return)
beta < 1 return fluctuates less than market (0.75 is 75% as volatile as market)
beta > 1 return fluctuates more than market (1.5 is 50% more)
negative beta means stock moves in opposite direction of market
Risk adjusted return
to standardize across mutual funds for risk
return / beta
highest risk adjusted return is best
Risk capacity vs tolerance
tolerance = comfort level
capacity = amount one MUST take to reach financial goals
Geometric mean
AKA Time Weighted Return
used to evaluate performance of portfolio manager
measures performance - income and price changes - as a % of capital at work
eliminates the effect of additions and withdrawals and timing
On formula sheet, bottom right
Shortcut
1. add 1 to each return
2. multiply all #’s in step 1
3. Step 2 = FV
4. PV = -1
5. n = # of years of investment
6. solve for I
Time weighted return vs
Dollar weighted return (IRR)
Dollar weighted measures chagne in total dollar value of portfolio including +/- capital and gains/losses
allows for comparison against financial goals but not manager to manager (only through time weighted return)
Time weighted factors %’s
Dollar weighted factors cash flow ($) amounts
IRR concept
discount rate at which PV of future cash flows equals cost of investment
an investments “effective” return
when NPV is zero discount rate is IRR
when IRR exceeds expected return, investment is acceptable
want IRR > expected rate
IRR calculation
enter cash flows for EVERY period including zeroes with the CFj button
then Solve for IRR/YR
If payments more frequent than annual either multiply to get annual rate
OR start with setting N number of P/YR
Holding Period Return
Total return / price of investment (OOP cost)
Income from sale + div/int
- Initial outlay (non-margin amount)
- (Margin loan payback + margin interest)
Divided By
Initial outlay
TEY
Taxable EQUIVALENT Yield
Interest rate on taxable bonds required to provide same after tax return as a municipal security
TEY = tax-exempt yield / (1- tax you don’t pay)
or
(1-marginal tax rate)
Without additional detail use federal rate
For state situations, if someone is buying an IN STATE municipal bond, then it would 1- both fed + state (+ local) to compare
After Tax HPR
After figuring out the gain, multiply by 1-tax rate,
then divide by the investment amount
HPR value for different time frames
HPR doesn’t consider timing
if > 1 year it overstates return
if < 1 year it understates return
Duration concepts
Length of time for investor to be paid back (breakeven)
ALLOWS COMPARISON PRICES OF BONDS WITH EQUAL COUPON, DIFFERENT TERMS
Duration = Maturity for 0 coupon
Low coupon > Longer to pay back
Higher duration
Higher volatility
Greater interest rate change sensitivity
High coupon > Faster to payback
Shorter duration
Less volatility
Lower int rate change sensitivity
Any bond with a coupon:
Duration < Maturity
Interest rates vs Bond prices
INterest means INverse
Rates go up
Prices go down
Rates go down
Prices go up
Immunization of bond portfolio
If interest rates are going up, Shorten duration (UPS)
If interest rates are FALling, LENthen duration (FALLEN)
Immunization is a passive strategy
Immunized (neutralized against int rate changes) if average duration = pre selected time horizon for the goal
PAY ATTENTION
do not match to YTM timeframe but to average DURATION
Shifting yield curve
from inverted to normal
Always select the longest maturity to lock in long term rates even if the return is slightly less than other answers
from normal to inverted
choose SHORTEST timeframe/maturity
TIME is the most important factor in duration questions.
Efficient frontier (Markowitz) vs CML
Intersection of indifference curve and efficient frontier is the optimal portfolio
above the curve - not feasible/unattainable
below the curve - not efficient
CML expression of CAPM macro level
straight line tangent to the efficient frontier CURVEd line.
intersection is the OPTIMAL risky portfolio - proportional % of all possible risky assets
Intersection of CML and expected return is the risk free rate (100% tbills)
SML
security market line
used to value any asset whether indiv security or portfolio
formula is the expected r formula
aka CAPM
Dividend growth model valuation
Value = D1 (D0+g) /
expected return - growth rate
may have to solve for r
IF MULTIPLE growth rates use the last value to calculate, then pick the lower value
Dividend payout ratio
Common dividends paid / Earnings per share
EPS = ROE per share x Book value per share
Earnings per share
ROE per share * book value per share
Return on equity ROE
EPS (net income) / Common Equity (net worth/book value per share)
Margin maintenance call amount
maintenance $ amount = ( (1-initial)/(1-maint)) * initial price
R-squared
coefficient of determination
square of the correlation coefficient
to what degree is movement of fund determined by market as a whole
R2 of S&P index fund is .99
R2 of Fidelity nursing home fund is .2
higher means well diversified so use beta (Alpha or Treynor)
if low need to use Sharpe b/c portfolio not diversified
always pick the highest return
Efficient markets hypothesis EMH
favored by those who believe in passive strategy. NO value in technical analysis.
prices incorporate new information, so any changes will occur in a random walk
Random walk means price changes are unpredictable and patterns are accidental
Any active strategy would not add value
Strong form reflects ALL information. No tech or fundamental analysis can improve results.
Semi-strong form reflects all PUBLIC information. No tech or fundamental analysis can improve results. INSIDER information might.
Weak form - historical price data already reflected in current prices, cannot be used to predict future. Tech analysis will not help. FUNDAMENTAL analysis might.
Technical vs Fundamental Analysis
Tech analysis - studying moving averages and other charts.
NOT focused on company’s financials
Fundamental analysis - studying financial statements, Int rates, GDP, Inflation, Unemployment
Ratio analysis
One ratio can be misleading
Set of ratios can be misleading without benchmarks
Do:
Compare INDIVIDUAL ratios for a firm over time
Compare INDIVIDUAL ratios to INDUSTRY averages
Anomalies
P/E effect
January
long weekend
small firm effect
neglected firm effect
Value Line
Charting / Chartists
Technical analysis
believe in patterns consistent enough to provide some degree of predictability
Resistance Level (top bound)
Support Level (lower bound)
Sharpe / Alpha Jensen / Treynor
when R2 are mixed (some below 60/some above 60)
If R2 are mixed, use the fund with the highest SHARPE number
Par value of stock after a split
If split is 5:2 then multiply par value times 2/5
Ex-dividend date
Day BEFORE the “date of record” of the corp
Investor must own stock BEFORE the ex-dividend date
Look out for weekends and holidays
Reg T
Reg T - standard initial margin requirement 50%
set by Federal Reserve Board
Maintenance margins set by FINRA usually 25%
Are options marginable?
NO
Maintenance margin % - amount due
Amount of equity required to maintain position on margin
Current stock value * maintenance % (total amt required)
minus
Actual equity = current stock value minus amount on margin
=
amount due
Dollar cost averaging
Passive strategy
Dow Jones
PRICE weighted
30 industrial, 20 transportation, 15 utility
DJIA is the 30 industrial
widely quoted but narrowest measure
A price-weighted index is a type of stock market index in which each component of the index is weighted according to its current share price. In price-weighted indices, companies with a high share price have a greater weight than those with a low share price.
A stock with a higher price will be given more weight than a stock with a lower price and will thus have a greater influence on the index’s performance.
Price-weighted indexes are useful because the index value will be equal to (or at least proportionate to) the average stock price for the companies included in the index. This allows the construction of indexes that will track the average stock price performance of a specific sector or market.
S&P 500
cap-weighted and FLOAT-weighted (book says float)
broad measure of NYSE
largest issues on NYSE plus a few OTC issues
With this method a float factor is assigned to each stock to account for the proportion of outstanding shares that are held by the general public, as opposed to “closely held” shares owned by the government, royalty, or company insiders (see float). For example, if for some stock 15% of shares are closely held, and the other 85% are publicly held, the float factor will be 0.85, by which the company’s market capitalization will be multiplied before weighting its value against the rest of the index.
In other words, the number of shares used for calculation is the number of shares “floating”, rather than outstanding.
Russell 2000
SMALL CAP
popular capitalization weighted index
smallest 2000 stocks in the Russell 3000
cap-weighted aka value-weighted
Wilshire 5000
BROADEST measure of activity and movement of the market
VALUE WEIGHTED
by total market value of outstanding shares
7000 issues on NYSE, AMEX and OTC market
cap weighted aka value weighted
Value Line Index
Think NOT value weighted
instead EQUALLY weighted
1700 issues on NYSE, AMEX and OTC market
Calculate phantom interest payments on zero-coupon bond
1st: determine original yield to maturity
PV = NEGATIVE purchase price of bond
FV = 1000
N = # of years
PMT = 0
Solve for I
2nd: apply yield to determine PMT - assumes it applies for every year
PV = value of bond (POSITIVE)
FV = 1000
N = # of years
I = answer from above
Solve for PMT
