Chapter 9/10/11 Flashcards
Exchange-traded-funds (ETFs)
ETFs issue shares that represent an interest in an underlying basket of securities which typically mirrors a specific index. Purchasers of ETFs do not pay sale charges but instead pay commission fees.
Difference between ETFs and mutual funds
ETFs trade on exchanges and are close-ended funds unlike mutual funds. Additionally, ETFs often have lower expenses than mutual funds and their shares may both be sold short and purchased on margin.
Inverse ETF
Designed to perform in a manner that’s the inverse of the index being tracked by short selling the investments within the fund. W/ an inverse ETF, for example, if the S&P falls 1.5% the inverse ETF should rise 1.5%.
Exchange-traded notes (ETNs)
A type of unsecured debt security that pays a return which is linked to an underlying market index or other benchmark. ETNs trade on exchanges and are available in both inverse and leveraged varieties. ETNs DO NOT MAKE INTEREST PAYMENTS. Instead, ETNs pay the holder an amount which is based on the performance of an underlying index or benchmark. The maturities of ETNs can range from 10 to 30 years. ETNs are issued by a financial intermediary and backed by their full faith and credit. The costs associated w/ ETNs are reocurring costs, including daily investor fees, and brokerage commissions involved w/ buying or selling ETNs.
Indicative value
The reference value of the benchmark minus the daily investor fee of an ETN.
Hedge funds
Not an investment company. Private investment pools not required to register w/ the SEC. Buyers of the fund are typically institutional or high net worth. Since hedge funds only deal w/ these types of investors, there relatively unregulated. Due to these exemptions, hedge funds may use strategies that are prohibited for more heavily regulated investment entities. Hedge funds are not required to disclose specific information regarding their holdings. Hedge funds often restrict their investors from redeeming for certain periods of time meaning there is little liquidity.
PE funds
PE and VC funds raise capital by offering investors limited partnership units that are sold as private placement.
REITs
Not an investment company. REITs are securities and require that prospectuses are sent to any investors who purchase shares that are offered to the public in the primary market. REITs create a portfolio of real estate investments from which investors may earn profits.
3 types of REITs:
- Mortgage REITs: borrow funds from investors and then invest the funds in mortgages and typically earn income based on the difference between these two rates of interest
- Equity REITs: own and operate income-producing real estate, such as apartment buildings, commercial property, shopping malls, vacation resorts, and other retail properties. Income is generated from rent.
- Hybrid REITs
3 varieties of REITs
- Sold as private placement and not registered w/ SEC.
- Registered w/ SEC and exchange-listed.
- Registered w/ SEC and not exchange-listed.
True or false: Dividends from REITs are taxed as ordinary income?
True, to avoid double taxation of dividends that are distributed to investors, a REIT must distribute a minimum of 90% of the income it generates from its portfolio
Direct participation programs (DPPs)
A type of investment in which the results of the business venture (cash flow, profits, and losses) directly flow through to the investors. Most DPPs are limited partnerships.
Limited partnerships
A type of DPP. A limited partnership requires a minimum of two partners—one general partner and at least one limited partner. The general partner (GP) is responsible for managing the program and must contribute at least 1% of the program’s capital. The limited partner (LP) is a passive investor who has no control over managerial decisions.
Advantages of limited partnerships
- No double taxation. All income is taxed on a personal level as ordinary income.
- Limited partners are only liable for their investment.
- Typically diversification of assets.
Disadvantages of limited partnerships
- Lack of control for limited partners.
- Iliquidity.
- Tax issues: can complicate individual tax filings.
- Positive capital call: investors in limited partnerships may be asked to contribute additional funds after their initial investment. Failure to make the additional contribution could result in the investors forfeiting their interest in a project.
DPP offering practices
To raise money, the general partner (also referred to as the program’s sponsor) may conduct either a public or private securities offering. In a public offering, the general partner will hire an underwriter to market the program to the public and will register the DPP’s interests with the SEC. An offering prospectus is provided to potential investors.
Tax treatment of individual partners in a DPP
Losses that are generated by passive activities may only be deducted against income from passive activities. If passive losses exceed passive income, the excess passive losses may be carried forward indefinitely to offset passive income in future years.
As an added benefit, when the ownership interest in a passive activity is sold, the investor can deduct all passive losses that are carried forward against any form of income—passive or non-passive.
How do limited partnerships invest in oil & gas?
Exploratory drilling, a.k.a. wildcatting, involves searching for oil and gas in unproven areas. Due to the uncertainty of success, these programs are considered high-risk ventures.
Development program: leases are acquired for the right to drill in proven areas. Lower risk. The lower risk is based on the belief that a productive exploratory well could be surrounded by equally productive drilling locations.
Balanced program: A combo of exploratory drilling and development programs.
Income program: Acquires interests in already producing wells.
What is an option?
A derivative security that gets its value from the value of underlying securities such as stocks, indexes, and ETFs.
An option is a contract between a buyer/owner/holder who is also considered the long. The buyer pays the option’s premium and gains the right to exercise the option. On the other hand, there’s the writer/seller of the option, who is considered the short. The seller receives the option’s premium and assumes an obligation if the contract is exercised in the future.
Call options
The buyer pays a premium and gains the right to call the underlying instrument at a set strike price. If the buyer doesn’t exercise, the premium paid represents the maximum loss. The seller receives the premium but must sell the instrument at the strike price if it’s called.
Ex: If there’s a cal option on a stock, the buyer of the call option is bullish and wants the stock to go up because they could still buy it at the strike price but the value would be greater. The seller would want to see it go down.
Put options
The buyer pays a premium and gains the right to sell an instrument at the strike price.
Ex: If you enter into a put option on a stock as the buyer, you are bearish and expecting the stock to go down so you can sell it for more than its worth in the future.
True or false: All options have expiration dates?
True, if an option has not been exercised or liquidated prior to its expiration, it expires.
What makes up the option premium?
The intrinsic value and time value. Intrinsic value is the amount by which an option is in-the-money, while time value is the portion of an option’s premium that exceeds its intrinsic value.
* An option will only have intrinsic value if it’s in the money.
How to determine intrinsic value of an option (if an option is in-the-money or out-the-money)
The relationship between the strike price of an option and the current market price of the underlying security determines whether an option is in-the-money or out-the-money. Calls are in-the-money if the market price > strike price. Puts are in-the-money if market price < strike price.
How to determine time value?
How to determine time value for an option that is in-the-money: Take current market price - strike price and the difference between this value and the premium is the time value.
How to determine time value for an option that is out-the-money: There is no intrinsic value for an option that is out-the-money, so any premium is comprised solely of time value.
Breakeven point of an option
For buyers of options, breakeven represents the amount they need the underlying stock to move in their favor to recapture the premium paid. For sellers of options, breakeven represents the amount they can afford the underlying stock to move against them because they received the premium.
Remember the phrase: Call UP and Put DOWN - for calls its strike price up (plus) the premium. for puts its stike price down (minus) the premium.
Liquidating an option
An alternative to exercising an option. To liquidate an option, an investor (either the buyer or seller) executes an opposite transaction on the same option contract. The buyer of an option creates the position with an opening purchase and could subsequently liquidate the position through a closing sale. The seller of an option creates the position with an opening sale and could subsequently liquidate the position through a closing purchase.
Two styles of exercising an option:
- American style exercise: Options may be exercised at any time up to the day on which they expire.
- European style exercise: Options may only be exercised at a specified point in time, usually on the day of expiration.
- All equity options use American style.
What is the process of exercising an option?
- Notify the broker-dealer
- The broker-dealer will notify the options clearing corporation (OCC)
- The OCC will randomly issue the exercise notice to a broker-dealer whose account shows a short option position that’s identical to the long option position being exercised.
- The broker-dealer that receives the exercise notice, must select a client to whom the notice will be assigned. There are three methods by which this assignment may be accomplished—(1) using random selection, (2) using first-in, first-out (FIFO), or (3) using any other method that’s deemed to be fair and equitable.
True or false: W/ options, the third friday of the expiration month is the final day to exercise and a brokerage must be notified by 5:30pmEST?
True, additionally, at 4pmEST on that Friday options stop trading.
Options disclosure document/Characteristics and Risks of Standardized Options
A brochure created by the OCC that offers investors with a description of the options market and info about options.
Index options
a financial derivative that gives the holder the right (but not the obligation) to buy or sell the value of an underlying index. When settled, the buyer recieves cash.
W/ an equity option, the buyer would receive the underlying stock.
Long hedge
If an investor is long stock and fears that the stock will decline, buying a put on the stock creates a long hedge
Short hedge
If an investor is short stock and fears that the stock will rise, buying a call on the stock creates a short hedge.
Covered vs uncovered options
Covered options: Essentially just means that the seller owns the stock and is obligated to sell if the buyer exercises. The seller anticipates that the stock will drop so that the seller will receive the premium on the option and the dividend from the stock.
Uncovered options: If an invester writes an option and doesn’t own the stock. An uncovered call writer has an unlimited maximum potential loss since there’s no limit as to how high the price of the security may rise.
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Covered put
The seller of a put is obligated to buy the underlying stock if the buyer of the put exercised the contract. Therefore, for the put to be covered, the seller must either be short the underlying stock or deposit cash equal to the strike price. If an investor sells an XYZ put and doesn’t deposit sufficient cash, the position is considered an uncovered put.
Which option position has the potential for an unlimited gain?
Long call
