Characteristics, uses, and taxation of investment vehicles

Question 1

Cash and Cash Equivalents

Answer 1

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.

Question 2

Certificate of Deposit (CD)

Answer 2

• 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

Question 3

Money Market Funds

Answer 3

• invest in high quality short-term instruments, such as negotiable CD’s, commercial paper, and T-bills.
• Are not insured by FDIC.

Question 4

Treasury Bills

Answer 4

• 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

Question 5

Commercial Paper

Answer 5

• unsecured private sector promissory note
• maturities are 270 days or less
• slightly higher yield than T-bills

Question 6

Bankers Acceptances

Answer 6

• 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.

Question 7

Eurodollars

Answer 7

• 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.

Question 8

Registered and bearer bonds

Answer 8

• 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

Question 9

Yield to Maturity (YTM)

Answer 9

• 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

Question 10

Doctrine of reciprocity

Answer 10

-interest payable on US Treasury notes and bonds are free of income taxes at both the state and local levels.

Question 11

Treasury STRIPs

Answer 11

• 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

Question 12

Treasury Inflation-Protected Securities (TIPS)

Answer 12

• 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.

Question 13

Series EE bonds

Answer 13

• 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.

Question 14

Series HH Bonds

Answer 14

-Existing series HH bondholders pay taxes on the interest accrued semi-annually.

Question 15

Series I Bonds

Answer 15

• 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.

Question 16

Mortgage-Backed Securities

Answer 16

• 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.

Question 17

Zero-Coupon Bonds

Answer 17

• Eliminate reinvestment risk because no payments are made until the bond matures
• require taxes to be paid currently on the accrued interest each year.

Question 18

Term or Serial Payments

Answer 18

• 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.

Question 19

Debenture

Answer 19

• applies to any unsecured long-term corporate bond

- viewed as being more risky than a secured bond and therefore has a higher yield.

Question 20

Summary of Common Stock “BIG CID”

Answer 20

• Blue chip stocks
• Income stocks
• Growth stocks
• Cyclical stocks
• Interest-sensitive stocks
• Defensive sensitive stocks

Question 21

Cyclical Stocks

Answer 21

• automobiles
• cement
• paper
• airlines
• railroads
• machinery
• steel

Question 22

Defensive Stocks

Answer 22

• utilities
• soft drinks
• groceries
• candy
• drug/pharmaceuticals
• tobacco

Question 23

Street Name

Answer 23

-when brokers hold stock for investors (such as in a brokerage account)

Question 24

Date of declaration

Answer 24

-the date the board of directors approves and declares that a dividend will be paid.

Question 25

Ex-dividend Date

Answer 25

• the date that the market price adjusts for the dividend

- normally two business days before the date of record

Question 26

Date of record

Answer 26

• 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.

Question 27

Date of Payment

Answer 27

-the date that the company pays the dividend to the shareholders.

Question 28

American Depository Receipts

Answer 28

• 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

Question 29

Unit Investment Trusts (UITs)

Answer 29

• a fixed pool of securities, usually municipal bonds, with each unit representing a proportionate ownership in that pool.
• hold passive investments

Question 30

Closed-end Investment Companies

Answer 30

• 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

Question 31

Guaranteed Investment Contracts

Answer 31

• 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

Question 32

Put Bonds

Answer 32

• 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.

Question 33

Term Structure of Interest Rates

Answer 33

-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.

Question 34

Market Segmentation Theory

Answer 34

-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
-

Question 35

Unbiased (rational) expectations theory

Answer 35

• 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.

Question 36

Liquidity Preference Theory

Answer 36

-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.