Chapter 1 - Fundamentals of Investments Flashcards
2 Forms of Underwriting
1) Best Efforts: underwriter agrees to sell as much as possible. Risk resides with the firm - any shares not sold are returned to the company.
2) Firm Commitment: underwriter agrees to buy the entire issuance of stock. Risk resides with the underwriter
10K & 10Q
- 10K: annual report of financial statements filed with SEC. 10K is audited.
- 10Q: quarterly report “ “ 10Q is NOT audited.
Types of Orders
1) Market Order: timing and speed of execution more important than price. Appropriate for stocks that are not thinly traded (illiquid).
2) Limit Order: price at which trade is executed is more important than timing. Appropriate for thinly traded (infrequently, volatile) stocks.
3) Stop Order: price hits a certain level and turns into a Market Order.
4) Stop-Loss Limit Order: investor sets two prices - stop-loss price & limit price. Once the first price, the stop-loss, is reached, the order turns to a Limit Order. The investor, then, will not go beyond the second price set, the limit price.
Thinly Traded
Securities that are not easily sold; require a significant price change to sell; illiquid; trade with low volume; greater risk
Short-Selling
Sell at a higher price in hopes of purchasing back the stock at a lower price. Sell high & buy low.
Margin Definitions
- Initial Margin: amount of equity must contribute for a margin transaction. Margin requirement - 50%.
- Maintenance Margin: minimum amount of equity required before a margin call
- Margin Position: represents the current equity position of the investment
Margin Call Price
Demand for additional capital/securities when investor’s equity in a margin account falls below the required minimum.
Formula to determine price investor will receive a margin call:
Margin Call = Loan/(1-Maintenance Margin)
*MEMORIZE - not provided for exam
Research Reports - MorningStar & Value Line
- Morningstar: ranks Mutual Funds. Ranking 1-5 stars.
1 = low ranking, 5 = highest ranking - Value Line: ranks Stocks. Ranking 1-5 for timeliness and safety.
1 = highest ranking (buy), 5 = lowest (sell)
Dividend Dates
- Dividends declared by the Board of Directors. Paid quarterly.
- Ex-Dividend Date: date stock trades without the dividend.
If you sell stock on this date, then you’ll receive a dividend.
If you buy stock, there’s no dividend. - Date of Record: date you must be a shareholder to receive a dividend.
One business day after the Ex-Dividend Date. - TO receive dividend, investor must purchase stock prior to Ex-Dividend Date or 2 business days prior to Date of Record.
- Cash Dividend = Cap Gain treatment; taxable upon receipt
- Stock Dividends: taxable once stock is sold
Stock Split
Increase number of shares & reducing the price of them.
2-for-1 split: 100 shares at $50 per shares -> 200 shares at $50
3-for-2 split: 100 shares at $60 per share -> 150 shares at $40
Essentially, more shares & decr. price per share
- Shares x Stock Split (3/2) –> Bigger #
- $ Price / Stock Split (3/2) –> Smaller $
Security Regulations (*Exam Tip: know this flashcard)
- Securities Act of 1933: Regulates the issuance of new securities - Primary Market (Primary Market deals with company’s who directly originate stocks. This is when they are first being offered to the public - IPO - and also company’s second offerings). Requires new issues are accompanied by a prospectus for new securities before purchase.
- Securities Exchange Act of 1934: Regulates Secondary Market & trading. (Secondary Market is what we know to be the “stock market”. Every exchange is apart of it. Trading is between investors only and does not directly involve the companies originate the stocks (ex. Amazon). Trading on the secondary market is with already originated stocks that are being exchanged between investors). Created the SEC - enforce compliance & security regulations.
- Investment Company Act of 1940: Authorized SEC to regulate managed investment companies, variable life products, and UIT’s.
- Investment Advisors Act of 1940: Requires investment advisors to register with SEC/state. Regulates the actions of investment advisors.
- Securities Investors Protection Act of 1970: Established SIPC to protect investors for losses from brokerage firm failure. Protects accounts regardless of citizenship
- Insider Trading and Securities Fraud Enforcement Act of 1988: Defines an insider as anyone with information that is not available to the public; cannot trade on that info
Mutual Fund vs ETF
Mutual Fund (index fund):
- sales occur directly between investors and the fund (unlike ETFs which are traded on the Secondary Market)
- typically, actively managed (although they CAN track indexes like ETFs although, more commonly are actively managed)
- more expensive than ETF’s (because they are actively managed, more associated trading costs or fees)
- commonly managed by financial institutions such as Vanguard, or BlackRock, either directly or through a brokerage firm
- can be purchased in fractional shares. Although, require full purchase price is required and can’t be shorted.
- only purchase once at the end of each day
ETFs:
- Secondary Market trading: trade freely on the open market throughout the day between others investors like a stock
- more passively managed
- track indexes
- more cost-effective since trade on exchanges like share of stock
- CAN be purchased on margin or shorted (whereas index funds require the full purchase price and can’t be shorted)
Closed vs Open-End Funds vs UIT’s
*All 3 based on NAV
Closed-End: actively managed; issues a fixed number of shares through an IPO to raise capital for its investments
- shares can then trade on Secondary Market but no new shares will be created
- many muni bonds are closed-end
- Usually sold at either a premium or discount to NAV
Open-End: (almost synonymous for MFs)
- usually passively managed; consists of well-diversified portfolio; can issue new shares
- NOT traded on secondary market. Rather, are only traded directly from the company that issues
Unit-Investment Trusts (UITs): an investment company that buys or holds a group of securities and makes them available to investors as redeemable units.
- Holds most muni bonds until maturity
- Passively managed by a portfolio manager
- NO additions to investments once the trust has been structured
- Portfolio is self-liquidating
- Shares are NOT traded on the open market
12b-1 Fees (MF’s)
- Fees charged based on daily fund assets and used for marketing expenses & distribution costs.
- an aside: MF commissions are paid using either a front load or a back load
Key Documents
1) Prospectus: Must be issues by an investment company prior to selling shares. Outline the business operations, mgmt team, fees, and risks of stock.
2) Red Herring: Preliminary prospectus used to determine investors’ interest in the security
3) Annual Report: Sent directly to shareholders. Contains message from Chairman of the Board on progress of past year & outlook for coming year.
Behavioral Finance:
4 Basic Premises:
1) Investors are Rational
2) Markets are Efficient
3) The Mean-Variance Portfolio Theory Governs
4) Returns are Determined by Risk
