Chapter 10: Basics of Investing Flashcards
1
Q
What often determines liquidity?
A
The presence of a secondary market.
2
Q
What is another term for growth?
A
Capital appreciation.
3
Q
What type of yield curve is particularly problematic for a fixed income investor trying to outpace inflation?
A
Flat yield curve.
4
Q
What is volatility?
A
The extent to which the market value should be expected to fluctuate.
5
Q
Which institutions sell GICs?
A
Banks, deposit brokers, credit unions, trusts, etc.
6
Q
What are the 2 guarantees that GICs offer?
A
Guarantee of principal
Guaranteed rate of return
7
Q
If a GIC has a term for longer than 5 years, what is it often called?
A
Term deposit
8
Q
How does a market value adjustment for early withdrawals from a GIC work?
A
The FI will retroactively recalculate the interest payable. If interest rates have fallen, the client will have their GIC recalculated from the beginning using the lower interest rate. If rates have risen, the FI will penalize the client by reducing their return because the FI will now have to provide the new higher rate to a new client.
9
Q
What is a GIC ladder?
A
A series of GICs, usually including maturity dates between 1 and 5 years.
10
Q
What is a variation on GICs that allows for potential higher returns?
A
Market-Linked or Index-Linked GIC
Indexed GIC is also an option
11
Q
Which type of GICs offer tax deferral? How?
A
Market-linked GICs, because the final return is not certain until the end of the term (therefore the return is not taxed until the end of the term).
12
Q
How does taxation work on a GIC?
A
No tax is assessed in the year of purchase (unless the maturity is within that year) . Interest income (and tax) is assessed every year on the anniversary date.
13
Q
How can you easily determine the amount of interest income you’ll have on a GIC in any given year?
A
Solve for the FV of the investment in the year in question as well as the year prior. The difference between the two values is the interest for the year.
Example: if the FV in year 5 is $1216.65 and the FV in year 4 is $1169.89, the interest assessed in year 5 is $46.79 (the amount of income that will need to be reported).
14
Q
Which tax slip is received for interest income from a GIC?
A
T5
15
Q
How does a corporation owning a GIC report interest income?
A
Taxation is calculated using the accrual method. The corp will be taxed at the corp’s year-end, on interest earned to that point.
For example, if a corp purchases a $1,000 GIC paying 4% and there are 122 days until the corp’s year end…
($1,000 x 4% x 122/365) = $13.37 of interest.
16
Q
What does the term “security” mean?
A
Claim against something.
17
Q
What are the 3 promises securities can offer?
A
- Debt - if the business fails, the debt holders will be assured of some seniority when the assets of the business are being liquidated
- Assets - lesser form of security as far as seniority
- Cash flow - many securities attach an additional promise of a certain amount of cash flow
18
Q
What is the role of the investment dealer?
A
Deal with both publicly-traded companies and closely-held companies as well as governments and crown corporations. Provide a mechanism for these institutions to raise capital.
19
Q
Why does an investor face greater risk when investing in a closely-held (not public) company?
A
Less disclosure and regulatory requirements.
20
Q
What is the difference between a “bought deal” and “best efforts” deal?
A
In a bought deal (which is easier and more common), the investment dealer buys the securities from the issuer and then attempts to place those securities with its own clients.
In a best efforts deal, the investment dealer acts as a middle-man and tries to sell securities still owned by the issuer.
21
Q
What is the term for the process of an investment dealer issuing securities on behalf of a corporation?
A
An offering
22
Q
What is a corporation required to produce when making a public offering?
A
A prospectus
23
Q
Why is the primary market important (and what is it)?
A
When securities are first created and sold through a public offering, this is said to happen on the primary markets. Primary markets offer the potential for corporations to raise capital.
24
Q
How does an investor divest of a security acquired on the primary market?
A
Selling it on a secondary market.
25
Which role do securities dealers have in secondary markets?
They connect buyers with sellers and often serve as market makers by buying and selling securities to fill orders submitted by investors.
26
What is a market maker?
Investment dealer that buys and sells securities to fill orders submitted by investors, allowing investors instant liquidity or instant access to securities.
27
What are OTC markets?
Over-the-counter markets. Most bonds and derivatives are traded on OTC markets.
28
What is a reserve price in a securities auction?
Some auctions of securities involve a reserve price. If the highest bidder doesn't hit that price, the security will not be sold at all.
29
What is a Dutch auction?
Bidders identify both the price and volume of shares they wish to purchase, which can be useful in setting the initial price of a security before an IPO.
30
How is the price of an IPO typically determined?
Usually based on an underwriting process by the securities dealer, then confirmed through the issuance of a red herring prospectus.
31
What is a red herring prospectus?
First/preliminary prospectus for an IPO. Allows prospective buyers to express interest in a security being offered, confirming the securities dealer's underwriting process.
32
How do investment dealers make money when creating an IPO?
Charge firms to create the IPO, then charge investors a commission when securities are bought and sold. Often make a profit on the spread between the price at which they acquire a security and the price at which they dispose of a security.
33
What is a bond?
Debt security with a claim against an asset that normally provides cash flow to the investor.
Typically issued at par value, pay a stream of semi-annual payments (coupons) and pay a maturity value at their maturity.
34
How do you determine the value of a bond?
Based on the combination of the FV of the coupon payments and PV of the par value. Price is based on the PV of those amounts.
35
How should you set your financial calculator when calculating the PV of a normal bond?
P/Y and C/Y to 2 as normal bonds always provide a semi-annual return. PMT should be /2 of the annual coupon.
36
If interest rates rise/fall, what will a bond sell at?
Rise - discount to its par value
| Fall - premium to its par value
37
What are the 3 factors that would normally cause bonds to have differing yields?
Term to maturity (long-term bonds present greater risk)
Credit rating of issuer
Characteristics of the bond
38
Which ratings (Moody's) are considered "investment grade" issuers?
AAA, AA, A, BAA
39
Which ratings (Moody's) are considered "speculative" issuers? (Junk bonds)
BAA, B, CAA, CA, C
40
When might a borrower have to repay a bond prematurely?
If the lender puts a condition in place that requires the loan to be repaid if the borrower's rating falls.
41
What is the yield curve?
Graphical expression of yield to maturity of fixed income investments, especially bonds. Developed as a tool for bond investors to understand what types of yields were being offered at differing maturities.
42
What type of indicator is the yield curve?
Leading indicator
43
What are the 3 basic types of yield curves? Describe each.
1. Normal (positive) yield curve - sign of a healthy and predictable investing environment where short-term investments provide a lower yield and yield increases as term to maturity increases
2. Inverted yield curve - sign of unusual events, usually precursor to a recession. Generated when investors believe the stability of bonds is worth acquiring, even at a premium. This willingness to purchase bonds at a premium drives bond prices up, creating a corresponding decline in bond yields.
3. Flat yield curve - created when investors are uncertain about the economy.
44
What is a steep yield curve?
Indicates a sharp rise in bond yields, generally indicative of investor enthusiasm.
45
What causes an inverted yield curve?
If investors are willing to pay a premium to acquire bonds (as bonds are considered more stable), this drives bond prices up which creates a corresponding decline in bond yields. In this case, the long-term bond yields may fall below the yields of short-term bond. Investors are willing to sacrifice yield in exchange for stability.
46
What may cause a flat yield curve?
Uncertainty about the economy, a flight to quality (such as in the case of an inverted yield curve), or relatively high short-term interest rates stemming from monetary policy.
47
What often precedes an inverted yield curve and is usually a leading indicator of a recession?
A flat yield curve
48
How is duration different from maturity?
Maturity indicates the amount of time that will pass until the bond matures. Duration is the extent to which a bond's price will fluctuate in response to a change in interest rates. (Percentage change in a bond's price for a 1% change in interest rates)
49
How can you solve for the price of a bond after a 1% increase in interest rates if the duration is 5.095 and its current price is $101.586?
$101.586 (current price) - duration (5.095%) = $96.410
50
What does an immunized bond portfolio contain?
A combination of high and low durations, with an average duration that matches the fund manager's objectives.
51
What is the term for diversification of bond durations?
Immunization
52
What are zero-coupon bonds? What's another name for them?
Zero-coupon bonds (strip bonds). Not actually issued by the issuer - ordinary bonds are purchased and then the coupons are sold, each for their respective PVs (leaving a bond with no coupon).
53
What does STRIPS stand for with respect to strip bonds?
Separate Trading of Registered Interest and Principal Securities
54
Which type of bond is typically sold as a strip bond?
A high-quality bond, such as a government bond.
55
How are strip bonds taxed?
Does not generate a capital gain, even though it doesn't pay interest. Instead, it's taxed as a prescribed debt instrument (in the same way as a GIC).
56
What is the duration of a strip bond?
Always equal to its term-to-maturity.
57
Are strip bonds risky?
Since their duration is equal to their term-to-maturity, they are extremely volatile as far as their day-to-day price is concerned. However, since the actual par value is fixed, they can provide a bit of stability in a portfolio (if the investor is willing to only consider the maturity value).
58
What are the 2 ways to calculate the yield of a strip bond?
Can use 2 as the P/YR since it's a bond, but can also use 1 as the P/YR since it lacks coupons.
59
What is a callable/redeemable bond?
A bond that may be callable at some point in the future. These types of bonds offer a higher return since it's riskier for the investor. The issuer has more flexibility, just at a higher price. Typically also a "call premium" attached to a callable bond (an extra premium if they call the bond).
60
How do you calculate the price of a callable bond?
- Assume that the bond will be called when doing calculation.
- Sell based on yield-to-call rather than yield-to-maturity.
- Call premium should be added to the par value of the bond.
61
Why are callable bonds attractive to investors?
Normally provide slightly higher returns than non-callable bonds.
62
What is a retractable bond?
One that allows the investor to retract the bond prior to maturity after a certain period.
63
What is a convertible bond?
Bond that can be converted into common shares at some point after they are issued. Issued with a conversion ratio. Bond prices are tied to the price of the underlying equity. More volatile than ordinary bonds, but not as risky as equity.
64
What is an extendible bond?
Bond with the option to extend the maturity, normally with a slightly higher coupon during the extended period.
65
What is a mortgage bond?
Safest corporate-issued bond as it provides the most senior form of debt. Normally, a specific asset is attached to the mortgage bond, but any other company assets can be claimed as well. Typically offer lower coupon rates due to the security.
66
What is a debenture?
Often used by junior issuers who may lack assets against which financing can be secured (can also be issued by senior companies though). Issuer promises a higher return to make up for the lack of assets to secure financing against.
67
Who can issue government bonds?
Federal, provincial, and municipal governments, as well as crown agencies such as utilities providers.
68
How do you calculate the taxation of a bond?
If you buy a bond at a premium, you'll have a considerable amount of interest income and a capital loss at maturity.
If you buy a bond at a discount, you'll have less interest income and a capital gain at maturity.
69
Working from left to right, what do each of these figures represent in the listing for a publicly traded bond?
7.220 739,000 4.57706 124.788 127.060 4.36923
```
Coupon rate
# of bonds issued in this series
Yield to the buyer at bid price
Bid price
Ask price
Yield to the buyer at ask price
```
70
If a bond has a rating of BBBh,what does that mean?
This rating is from Dominion's Bond Rating Service. BBB is adequate quality (from DBRS) and the h is a letter grade standing for high quality relative to other issuers at the same level of credit. BBBh means the company is in the upper third of quality of issuers of adequate quality bonds.
71
What does it mean if a bond has a bid price of $124.788?
It is selling at a premium to par value ($100). Seller would receive $12,478.80 for 100 units of the bond (100 x 124.788).
72
Why do bonds have a bid and ask price?
The investment dealer facilitating the transaction keeps the spread.
73
What is the difference between an individual investor and a professional manager buying and selling bonds?
Institutional investors have more bargaining power and can pay less for bonds they acquire (and demand a higher price for bonds they sell).
74
Why were Canada Savings Bonds so popular?
They could be purchased through payroll deduction.
75
How did CPBs differ from CSBs?
Canada Savings Bonds were redeemable at any point (with no interest paid in the first 3 months). CPBs were not redeemable at any point, only on their anniversary date. CPBs would offer a higher rate of return to compensate for the lower liquidity.
76
When did the Government of Canada announce they will no longer issue CSBs or CPBs?
In the 2017 Federal Budget
77
What are the 3 rights of common shareholders?
1. Right to dividends
2. Voting rights
3. Equity rights
78
Why does the Board of Directors of a company have to weigh the value of keeping shareholders satisfied through paying dividends against the value of reinvesting in the corporation?
If a dividend is paid out to shareholders, it doesn't necessarily improve the value of the business. If a company reinvests profits into the business, this increases the value of the company (and its shares by extension). However, corporations that don't pay dividends will often see their share price drop, something that can make a company vulnerable for takeover.
79
In which situation are voting rights a key attribute for a share?
For private companies or for potential institutional investors.
80
How do you determine shareholder equity?
Subtract liabilities from assets to determine the company's book value (net assets).
81
What often happens to a company's share price when it is acquired?
Since the acquiring company will have to purchase all or most of the acquired company's stock, this demand will subsequently increase the share price of the stock. Takeover bids tend to be a "jackpot" for existing shareholders.
82
How often are dividends of publicly traded North American companies paid?
Generally paid quarterly.
83
When must a shareholder have purchased a share in order to receive a dividend? What is this date called?
Two days before the dividend record date. This is called the ex-dividend date.
84
How are dividends paid?
Often as cash, sometimes as a "stock dividend". In this case, the dividend is paid as shares rather than cash.
85
What is a DRIP?
Dividend Reinvestment Plan. Often offered by investment dealers, allows shareholders to forgo the receipt of dividend payments, and instead direct those dividends to the purchase of additional shares, usually fractions of shares. Typically, dealers do not charge a commission on the purchase of shares done under the DRIP.
86
How do preferred shares differ from common shares?
Issued in the same way as common shares, but do not provide any voting rights. Instead, they provide dividends that are contractually guaranteed. It's possible for preferred shareholders to receive missed dividends in arrears.
87
What type of feature is often associated with a preferred share?
Callable/redemption feature
88
Based on the typical issue price of a preferred share, how much would the dividend be if the preferred share yield is 6%?
Typically issued at $25. The yield of 6% is paid out quarterly, resulting in a dividend of ($25 x 6% / 4) = $0.375
89
How are dividends from Canadian preferred shares taxed?
In the same manner as dividends from common shares with a gross-up and tax credit.
90
Do preferred shares fluctuate in value?
Only in the same way as bonds since their performance does not rely on the performance of the issuer (although they can fall due to the viability of the issuer and lack of demand). Their performance relies on dividend yields, much like bonds rely on interest rates.
91
How do you calculate the price of a preferred share with a dividend yield of 4.5% when current yields are 5.1%?
$25 x 4.5% / 4 = $0.281 per quarter per share
$0.281 x 4 / 5.1%
= $22.04
92
How does the calculation of a preferred share using a financial calculator differ from the calculation of a bond?
You have to use a xP/Y of 999 or any high number since it is a perpetuity.
93
What is the purpose of money market instruments?
Means of raising short-term capital.
94
How are money market instruments normally purchased and redeemed?
Purchased at a discount and redeemed at par
95
What is the normal par value of a money market instrument?
$100
96
What are typical terms for money market instruments?
90, 180, or 360 days
97
What generally provides the risk-free rate of return?
90-day T-bill
98
How is the return of a money market instrument taxed?
As interest income, even though it has the feel of a capital gain it is still a prescribed debt instrument.
99
Can T-bills generate capital gains/losses?
If it is sold on the secondary market and the purchase price is altered because of a fluctuation in interest rates.
100
What are the (3) most common types of money market instruments?
1. Treasury bills
2. Commercial paper
3. Banker's acceptances
101
What is commercial paper?
Similar to T-bills in that they are short-term and highly liquid, but are issued by corporations. These can range from being low-risk to very risky depending on the issuer's financial situation or if any asset backs the commercial paper.
102
What is a bankers' acceptance?
Issued by banks. Generally riskier than T-bills but safer than commercial paper.
103
How do you calculate the yield on a 90 day T-Bill purchased for $99.60?
[(Par value - purchase price) / purchase price ] x (365/days to maturity)
= 1.63%
Can solve on calculator by using 4 P/Y C/Y and 90/365 for xP/Y
104
How does yield-to-maturity differ from current yield?
YTM measures the overall return generated by a security from the date of purchase to the maturity date. Current yield measures the annual income generated by a security.
105
Simply put, what is a derivative?
Rather than an instrument issued by a FI as a means of raising capital, it is a contract created between 2 or more parties that fixes some terms of sale at some date or some point in the future. Most are based on a financial instrument.
106
What was the original type of derivative?
Based on commodities, now called "futures" contracts.
107
What is a futures contract?
A contract where one party agrees to purchase something at some point in the future at a specified price. This originated with farmers selling commodities and wanting to guarantee (or lock-in) the price that they would receive for the product.
108
What do the buyer and seller of a futures contract each promise?
The buyer agrees to purchase an underlying item at a specified price. The seller promises to deliver a specified product at a specified date and sell it at a certain price.
109
What is the term that described the risk of one party not living up to their promise in a derivatives contract?
Counterparty risk.
110
What do holders of put and call options each hope for?
Holders of put options hope for a drop in the share price, holders of call options hope for an increase in the share price.
111
What is an in-the-money call?
A call option where the underlying security's price is above the strike price.
112
Which types of call options are riskier for the option writer?
Naked calls as opposed to covered calls. A naked call is when the option writer does not hold the underlying shares and would need to purchase them in the market to sell them to the option holder at the strike price.
113
What does a put option writer have to do if the option is exercised by the holder?
Buy the underlying shares from the holder at the strike price.
114
What are reasons why derivatives are used?
- Speculation
- Insurance/hedging
- Income
- Business risk
- Trading strategies
- Leverage
115
How can an investor hedge their investment using options?
If the investor has a long position in a stock, they may also purchase put options. That way, if the share price increases, they make money. If the share price drops, they can make money by being able to sell their shares at a specified price.
116
What are two common trading strategies based on derivatives contracts?
1. Spread
| 2. Straddle
117
What is the "spread" derivatives trading strategy?
Two similar (but not identical) derivatives are purchased at the same time (such as ones with different expiry dates or strike prices). The idea is that the price for the derivatives will change over time, making a profit off the change in price of the underlying derivatives.
118
What is the "straddle" derivatives trading strategy?
Usually purchase a put option and call option simultaneously. Investor is betting on the volatility of the underlying security so they make money one way or another.
119
What was previously the only way to buy and sell securities?
Through traditional stockbrokers in a full-service account. A client would take a cheque to their stockbroker, the broker would build a portfolio of securities. The client would pay a commission for each set of securities purchased, and the broker would send an order to their trading desk to purchase board lots of the security in question.
120
What does it mean if a full-service account is a managed account?
The broker has chosen the securities and designed the client's portfolio. A non-managed account is the opposite.
121
What is a discretionary account?
The broker can execute transactions without the client's consent.
122
When would a bid-ask spread be narrow or wide?
The spread tends to be more narrow with heavily traded shares and wider with lightly traded shares.
123
What is a board lot?
Traditional block of 100 shares of a company. For cheaper shares, a board lot could be 1000 shares or, for more expensive shares, 10.
124
If a client has an additional $50 worth of shares purchased under a DRIP, how would this impact the client's ACB for the shares?
Their ACB for the share would increase by $50 since the $50 dividend is still fully taxed (despite the investor never receiving the cash).
125
What is an add lot?
Lots of shares in units other than 100.
126
Why are odd lots becoming increasingly common?
Due to the ability of computers to manage these transactions.
127
What is value averaging?
Alternative to dollar-cost averaging where an investor invests more or less each period based on the value of their investment.
Example: if in month 1 an investor invests $100 and it subsequently loses 10%, they would then invest $110 the next month to make up for that loss. May invest more or less depending on the performance of their investment.
128
What is an all or none order?
The buyer will only have their order filled if the number of securities requested is available. This type of order must be accompanies by a time limit and a price and will expire if not all conditions are met.
129
What is a day order?
An order that is only valid on the trading day that it is placed. If the security in question is not available at the order price, then it will expire at the end of the trading day.
130
What type of order would you place if you don't want your order to expire?
Good till cancelled order. Will remain active until it is cancelled or filled.
131
What is a good through order?
An order that will be executed at a certain price within some time frame (such as a week or a month).
132
What is a limit order?
An order that will only be placed once the security's price hits the price in the limit order (ask price).
133
What is a market order?
Simply put, buying the security in question at the price it's trading at, at the earliest opportunity.
134
What is a partial fill?
The broker could not fill an order, so it was partially filled.
135
What is a professional order?
Securities dealers must identify that they are a securities professional when ordering securities. Their order will only be filled after all client orders are filled (to ensure that clients will receive the best price).
136
What is a stop buy order?
An order executed when the price hits a certain threshold. Done when an investor believes they may want to buy a security, but not at the peak of a rally.
137
What is the difference between a limit order and a stop order?
A limit order uses a price to designate the least acceptable amount for the transaction to take place. A stop uses a price merely to trigger an actual order when the specified price has been traded.
138
What is the purpose of a stop loss order?
Executed when the price falls to a certain level, at which point the dealer will sell the security on behalf of an investor. This prevents the investor from selling a security at a rock bottom price.
139
How do Morningstar ratings work?
```
The bottom 10% of funds get 1 star
The second lowest 22.5% get 2 stars
The middle 35% get 3 stars
The second highest 22.5% get 4 stars
The top 10% get 5 stars
```
140
What are 3 useful benchmarks for comparing an investment's performance?
Market index, similar funds, needed returns.
141
What could happen if a planner projects a rate of return that is too low?
The investor is likely going to have to put away more assets on an ongoing basis than might actually be necessary, causing the investor's lifestyle to suffer in the short-term.
142
Why would a planner use real rates of return rather than nominal?
The consequences of fluctuating inflation are reduced. Generally, interest rates on fixed income instruments will go up with higher inflation and equities generally perform well with inflation (as inflation is usually caused by economic growth).
143
Who pioneered modern portfolio theory?
Harry Markowitz in 1952
144
What is the theory behind modern portfolio theory?
Prior to 1952, shares were almost entirely bought and sold on a gut feeling, perception of management, or some other intangible. Harry Markowitz developed a theory that incorporated risk modelling and overall portfolio design into the determination of how a share is bought and sold.
145
What is the Capital Asset Pricing Model (CAPM)?
Early model developed by Harry Markowitz to calculate the expected return of an asset given its risk.
Expected return = risk-free rate + beta x market risk premium
Where the market risk premium = the expected market return - risk-free rate
146
What is Beta and Alpha?
Beta represents the risk of one particular stock, Alpha represents the risk of the market as a whole (also refers to excess return of an investment).
147
What are the 3 common mathematical models applied to the concept of standard deviation?
1. Sharpe ratio
2. Treynor ratio
3. Jensen's Measure
148
What is the Sharpe Ratio?
Measure that compares the return per unit of deviation (risk) in an investment. A higher Sharpe Ratio indicates that an investor would receive a greater return per unit of risk.
149
How do you calculate the Sharpe Ratio?
(Return - risk-free return) / standard deviation
150
What is the Treynor Ratio?
The precursor to the Sharpe Ratio, it measures the return beyond what could have been earned in a risk-free investment.
151
How do you calculate the Treynor Ratio?
(Investment return - risk-free return) / beta
152
What is Jensen's Measure (Jensen's Alpha)?
Used to calculate an investment fund's (doesn't work for individual securities) ability to generate returns in excess of the market's returns.
153
How do you calculate Jensen's Measure?
= portfolio return - (risk free rate + beta x (market return - risk free return))
154
What does it mean if Jensen's Measure for a fund is 0.16?
The investment manager of the fund was able to generate returns 1.6% beyond what the market generated, adjusted for the level of risk.
155
What does it mean if a fund has a lower Sharpe ratio but higher Treynor and Jensen numbers than another fund?
The fund does not generate better returns for the risk taken (Sharpe), but does generate better returns for each unit of systemic risk taken (Treynor) and generates returns beyond what the market generates at the same risk level as the market (Jensen).
156
What are the different methods of diversifying your investments?
Diversify by...
- Asset class
- Geography
- Sector
- Regulatory regime
- Tax structure
- Investing style
- Time
157
What is the main disadvantage of diversification?
The investor who does NOT diversify can be richly rewarded if they choose well.
158
What are the primary investing styles?
- Growth vs value
- Buy and hold
- Fundamental vs technical vs quantitative
- Active vs passive
- Bottom up vs top down
- DIY vs professional
- DCA vs lump sum
- Leveraged investing vs unleveraged
- Large cap vs small cap
159
What are the identifying features of a growth stock?
Pay little or no dividends, often a newer company, normally high P/E ratio (20x or greater).
160
What are the identifying features of value stocks?
Regular dividend payers, often in more mature industries, P/E ratios tend to be lower (12x or less) depending on the particular industry and region.
161
How is quantitative analysis different from technical analysis?
Technical analysis is concerned with a share price's movement over time, either in a certain direction, or in a certain pattern. Quantitative analysis applies mathematical formulas to arrive at a correct price for a security, often done through computer algorithms.
162
Which hypothesis does passive investment theory rely on?
Market efficiency hypothesis - all securities are already priced correctly as all known information has been taken into account, there are no bargains to be had.
163
What is tracking error?
The discrepancy between passively managed investments and the indices they attempt to replicate.
164
What is another term for Smart Beta and what is this?
Factor-based investing. This is a passive strategy that will employ a "tilt" by favoring certain sectors, industries, etc.
165
What are the different market caps?
```
Mega cap: $200bn +
Large cap: $10bn to $200bn
Mid cap: $2bn to $10bn
Small Cap: $300M to $2bn
Micro cap: $50M to $300M
```
166
What does prospect theory reveal?
Investors are loss averse and will take a chance to avoid a loss, while taking the same chance to create a larger gain is not attractive.
167
What is a heuristic?
A mechanism that we use to make a decision or analysis without necessarily going through all the steps normally involved in decision making.
168
What are common heuristic behaviors that investors may display?
- Availability
- Hindsight
- Induction
- Conjunction
- Confirmation
- Contamination
- Affect
- Scope neglect
- Overconfidence in calibration
- Bystander apathy
- Herd mentality
- Mental accounting
- Prospect theory
- Smart people/experts
- Endowment effect
- Sunk costs
- Opportunity costs
- Gambler's fallacy
169
Describe the heuristic of availability...
From the period of 2002 to 2007, an investor averaged a 10% annual return. Since they were able to obtain that return at one time, they figure they will still be able to do so today (consider the hot housing market).
170
Describe the heuristic of induction...
Investing in small cap stocks simply because they have had higher returns than large cap stocks in the past, with no regard for whether this is actually the best investment choice.
171
Describe the heuristic of conjunction...
Similar to the concept of "availability", a person may assume the stock markets will continue to behave in the same manner that they have in the past.
172
Describe the heuristic of confirmation...
Example: an investor notices that interest rates have remained level in each of the previous 4 announcements by the Bank and ACB Co. shares have increased by 5% each week following the announcement. The investor buys shares in ABC Co. expecting a 5% gain over the next week when the Bank announces no change to interest rates once again.
173
Describe the heuristic of contamination...
Example: an investor purchases shares in a company simply because they know someone who has been working there who has been extremely busy and assumes that the company must be doing well.
174
Describe the heuristic of affect...
Example: parents saved for retirement using GICs, so the child figures they will be able to do the same.
175
Describe the heuristic of scope neglect...
Example: someone who only purchases groceries on sale, but does not consider the impacts of a longer financing term when financing a major purchase like a car. Or someone who spends a considerable amount of time doing analysis for their $10,000 stock portfolio but spends almost no time on their $100,000 retirement portfolio
176
Describe the heuristic of overconfidence in calibration...
An example would be a financial plan that shows an average annual return of 6% and the client expects their portfolio to obtain that return on an ongoing basis despite making no effort to review the plan.
177
Describe the heuristic of herd mentality...
Doing something because everyone else does it. An example would be investing in cryptocurrency because all of your friends are.
178
Describe the heuristic of mental accounting...
An example of mental accounting would be someone treating a bonus differently than their regular paycheque since they "didn't have to work for the money" and investing or spending it differently than their regular paycheques.
179
Describe the heuristic of the endowment effect...
We tend to overvalue the things that we put work or thought into. An example would be a person who thinks their house is worth more than someone else's without any good reason to believe that.
180
Describe the heuristic of sunk costs...
A willingness to spend more on something because you've already put money into it. An example would be someone who is willing to spend money to fix something (rather than just buy a new one) because they've already spent money to fix it before and don't want that money to have gone to waste.
181
Describe the heuristic of gambler's fallacy...
The belief that the probability for an outcome after a series of outcomes is not the same as the probability of a single outcome.
(Example: someone who buys a scratch card thing they'll win because the last 5 they bought didn't win)
182
Do studies find that we are more willing to take risks to avoid losses or take risks to achieve gains?
More willing to take risks to avoid losses. Would prefer a guaranteed gain.
183
What are the two primary categories of risks?
Systemic risks and non-systemic risks
184
What are systemic risks?
Those that impact the entire market. Difficult to eliminate through diversification, but can be mitigated through effective asset allocation.
185
What are non-systemic risks?
Risks that only affect one company or a portion of the market.
186
What is business risk and what is it associated with?
Business risk is associated with Beta. It is the risk that a particular company has a problem such as labour difficulties, supply chain issues, poor management etc.
187
Which type of risk do you face if you fail to diversify?
Concentration risk
188
What is credit risk?
The risk that a bond issuer will experience a rating decline or will default.
189
What is counterparty risk?
When entering into a derivatives contract, it's the risk that the counterparty to the contract fails to fulfill a certain promise. Counterparty risk was present during the 2008 credit crisis.
190
What is large investor risk?
The risk that a large investor (such as a hedge fund, private equity fund, pension fund) can impact the price of a stock so heavily that it causes smaller investors to suffer financial losses (such as mergers, purchases of large numbers of derivatives contracts, etc.)
191
What describes the risk of the market as a whole?
Alpha or systemic risk.
192
What is marketability risk?
Closely related to liquidity risk. Applies to assets where it may be difficult to find buyers under certain circumstances (such as real estate or shares in private companies).
193
What is regulatory risk?
The risk that government regulations could impact an investment.
194
What is reinvestment risk?
The risk that coupon payments are not able to reinvested at the same yield.
195
List all common types of risk...
```
Business risk
Call risk (timing risk)
Concentration risk
Credit risk
Counterparty risk
Default risk
Emerging markets risk
Event risk
Foreign exchange risk
Inflation rate risk
Interest rate risk
Large investor risk
Liquidity risk
Market risk
Marketability risk
Political risk
Regulatory risk
Reinvestment risk
Small companies risk
Sovereign risk (country risk)
Volatility risk
```
196
What is sovereign risk?
The risk that a country defaults on its sovereign debt.
