Characteristics, uses, and taxation of investment vehicles Flashcards
Cash and Cash Equivalents
the hallmark of cash and cash equivalents is their liquidity. Liquidity is the ability to sell or redeem an investment quickly at a known price, without incurring a significant loss of principal.
Certificate of Deposit (CD)
- deposits made with a bank or savings or loan for a specified period of time, usually no more than a year.
- negotiable CD’s are deposits of $100,000 or more placed with commercial banks. They may be bought and sold on the open market
Money Market Funds
- invest in high quality short-term instruments, such as negotiable CD’s, commercial paper, and T-bills.
- Are not insured by FDIC.
Treasury Bills
- maturities ranging from 4 to 26 weeks
- considered to be default risk free and is often used as a proxy for the risk free rate of return when determining an investors required rate of return.
- sold at a discount
Commercial Paper
- unsecured private sector promissory note
- maturities are 270 days or less
- slightly higher yield than T-bills
Bankers Acceptances
- securities that serve as a line of credit issued from a bank to finance imports and exports.
- companies too small to use commercial paper will use bankers acceptances to fund short-term debt needs.
- Trade at a discount from their face value on the secondary market.
Eurodollars
- U.S. dollar denominated deposits at banks located outside of the united states.
- has a maturity of less than 6 months.
- they are bank loans to very credit-worthy foreign companies that are taxed like a domestic CD.
Registered and bearer bonds
- registered bonds are registered with the corporation or organization and any payments will be paid to the individual of record.
- bearer bonds can be transferred like cash and the debtor will pay the person who holds the bearer bond
Yield to Maturity (YTM)
- the internal rate of return for cash flow associated with the bond, including the purchase price, coupon payments, and maturity value.
- market rate > YTM = discount bond
- market rate < YTM = premium bond
Doctrine of reciprocity
-interest payable on US Treasury notes and bonds are free of income taxes at both the state and local levels.
Treasury STRIPs
- the Federal Reserve assists in separating the interest and principle components of the bonds.
- Issued at a deep discount to par
- it is purchased through financial institutions and government securities brokers and dealers
- it may not be purchased directly from the U.S Treasury
Treasury Inflation-Protected Securities (TIPS)
- the principle value of the bond is adjusted for changes in the CPI, and the semi-annual interest payments received by the investor are determined by multiplying the inflation-adjusted principle value by one-half of the stated coupon payment.
- the coupon RATE remains the same for the life of the security, but the coupon PAYMENT changes based on the value of the inflation-adjusted principle of the securities.
Series EE bonds
- interest rate is fixed for the life of the bond.
- the value of the bond is guaranteed to double after 20 years
- may be purchased for an amount that is equal to 50% of its face value and for a minimum amount as lows as $25.
- Interest is not taxable until the bonds are redeemed or reach maturity
- interest may be completely excluded from gross income if the bond proceeds are used to pay for qualified higher education expenses.
Series HH Bonds
-Existing series HH bondholders pay taxes on the interest accrued semi-annually.
Series I Bonds
- Like EE bonds, interest accrues over time, with the feature of income tax deferral
- Unlike EE bonds, they are sold at face value.
- interest rate earned is a combination of two separate rates: 1) a fixed rate of return that remains the same and 2) a semi-annual inflation rate based on the changes in the CPI during the previous 6 month period.
- interest may be excluded from gross income if used for qualified higher education expenses.
Mortgage-Backed Securities
- GNMA ‘ginnie mae” is backed by the full faith and credit of the united states govt
- FNMA “fannie mae” and FHLMC “freddie mac” have only implied or indirect backing by the govt through federal subsidies.
- All agency issues are taxable at both the state and local levels.
Zero-Coupon Bonds
- Eliminate reinvestment risk because no payments are made until the bond matures
- require taxes to be paid currently on the accrued interest each year.
Term or Serial Payments
- principle on term bonds is repaid in full upon maturity
- serial bonds require the municipality retire a certain sum of the bonds issued each year.
- most municipals are issued with serial payment provisions.
Debenture
- applies to any unsecured long-term corporate bond
- viewed as being more risky than a secured bond and therefore has a higher yield.
Summary of Common Stock “BIG CID”
- Blue chip stocks
- Income stocks
- Growth stocks
- Cyclical stocks
- Interest-sensitive stocks
- Defensive sensitive stocks
Cyclical Stocks
- automobiles
- cement
- paper
- airlines
- railroads
- machinery
- steel
Defensive Stocks
- utilities
- soft drinks
- groceries
- candy
- drug/pharmaceuticals
- tobacco
Street Name
-when brokers hold stock for investors (such as in a brokerage account)
Date of declaration
-the date the board of directors approves and declares that a dividend will be paid.
Ex-dividend Date
- the date that the market price adjusts for the dividend
- normally two business days before the date of record
Date of record
- the date at which the company will determine who owns stock in the company and is therefore, entitled to the dividend.
- shareholders who purchase the stock between the date of record and the date of payment are not entitled to the dividend.
Date of Payment
-the date that the company pays the dividend to the shareholders.
American Depository Receipts
- represent ownership interest in foreign securities denominated in U.S. dollars and are issued by banks in foreign countries.
- eliminate the exchange risk that otherwise occurs when a direct purchase of foreign securities is made.
- dividends declared are first declared in the local currency
Unit Investment Trusts (UITs)
- a fixed pool of securities, usually municipal bonds, with each unit representing a proportionate ownership in that pool.
- hold passive investments
Closed-end Investment Companies
- only has a fixed number of shares available and trade between investors on the secondary market at whatever price supply and demand dictate.
- may trade at either a premium or discount to their NAV
Guaranteed Investment Contracts
- also called “stable value funds”
- securities sold by insurance companies primarily to pension plans.
- the rate of return is guaranteed for a fixed period of time.
- returns are relatively low because little risk is involved
Put Bonds
- the owner of the bond can choose to hold onto the bond if its coupon rate is higher than comparable market yields.
- the bond can be “put” or sold at an agreed time should the coupon be lower than market rates.
- the bond principal is then reinvested at current market yields.
Term Structure of Interest Rates
-refers to the relationship between the rates of interest on securities that have similar characteristics but different terms of maturities, as illustrated in a yield curve relating interest rates to maturities.
Market Segmentation Theory
-the more distant the maturities of two different securities are from each other, the lower the probability that the two securities will be substitutes for each other.
-the interest rates for short-term securities is determined by the supply of and the demand for short-term funds. Same holds true for long term funds
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Unbiased (rational) expectations theory
- the shape of the yield curve is a function of expectations concerning future interest rate movements.
- an upward sloping yield curve will prevail if short-term rates are expected to increase in the future.
- the yield curve will be downward sloping if short-term rates are expected to fall in the future.
Liquidity Preference Theory
-holds that there is more uncertainty over the long-term than the near term, so investors will demand a premium for giving up liquidity for a longer period. Therefore, the yield curve will usually be rising.
