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CFA Exam Level 1 > Equity Investments > Flashcards

Equity Investments Flashcards

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1
Q

What are the three main functions of the financial system?

A
  1. Allow individuals and companies to save and borrow, raise equity and debt and trade assets
  2. Determine the returns equate the supply / savings to demand / borrowing
  3. Allocate capital
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2
Q

Under what conditions is the financial system best at operating efficiently?

A

Liquid markets
Transactions costs are low
Readily available information

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3
Q

The rate at which borrowers want to borrow is equal to the rate at which lenders want to lend, is defined as the …?

A

Equilibrium interest rate

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4
Q

What is the difference between financial and real assets?

A

Financial assets: Non- physical securities (stocks and bonds), derivative contracts, and currencies.
Real assets: Physical assets including real estate, equipment, commodities

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5
Q

What is the name of the tax on the profit when you sell an asset that’s increased in value?

A

Capital gains tax

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6
Q

What is the difference between public and private securities?

A

Publicly traded securities are traded on exchanges or through securities dealers and are subject to greater regulation and scrutiny.
Private securities are not available to the public and are often illiquid and not subject to regulation.

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7
Q

Securities that have values that depend on (are derived from) the values of other assets are better known as…?

A

Derivatives

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8
Q

What is the difference between a financial and a physical derivative?

A

Financial derivative contracts are based on equities, equity indexes, debt, debt indexes, or other financial contracts.

Physical derivative contracts derive their values from the values of physical assets such as gold, oil, and wheat.

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9
Q

Markets for immediate delivery of an underlying asset are referred to as…?

A

Spot markets

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10
Q

Markets for the future delivery of physical and financial assets are more commonly known as…?

A

Forward markets

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11
Q

Contracts that provide the buyer the right, but not the obligation, to purchase (or sell) assets over some period or at some future date at predetermined prices, are better known as…?

A

Options

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12
Q

What is the difference between the primary and secondary market?

A

The primary market is the market for newly issued securities.
Subsequent sales of securities are said to occur in the secondary market.

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13
Q

What is the difference between issuing in the money market or on the capital market?

A

Money markets refer to markets for debt securities with maturities of one year or less.
Capital markets refer to markets for debt securities with maturities of one year or more.

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14
Q

What does it mean if you are to issue a security?

A

The initial sale of a security

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15
Q

What class of share is an equity security with scheduled dividends that typically do not change over the security’s life and must be paid before any dividends on common stock may be paid?

A

Preference shares

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16
Q

How does an investor get access to real assets without buying a property directly?

A

By buying publicly traded REITS

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17
Q

What are block brokers?

A

Block brokers help with the placement of large trades

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18
Q

An organisation that looks after a clients financial assets is also known as a…?

A

Custodian

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19
Q

When an insured person purposely causes damage or claims fictitious losses so he can collect on his insurance policy, they are committing…?

A

Fraud

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20
Q

Dealers that trade with central banks when the banks buy or sell government securities are known as…?

A

Primary dealers

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21
Q

What is payment in lieu when shorting a stock?

A

The short seller must pay all dividends or interest that the lender would have received from the security over the loan period to the owner

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22
Q

What is a leveraged position?

A

The use of borrowed funds to purchase an asset

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23
Q

In a short sale does the short seller need to deposit an initial margin?

A

Yes the short seller needs to deposit margin in order to buy back the stock and return it to the lender

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24
Q

What is the margin call price formula?

A

( Margin\ call\ price = P_0(\frac{1- initial\ margin}{1- maintainance\ margin}) )

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25
Q

What is the bid price?

A

Bid Price: The price at which the bank / the market maker / the dealer is willing to buy

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26
Q

What is the ask price?

A

Ask Price: The price at which the bank / the market maker / the dealer is willing to sell

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27
Q

What is the bid ask spread?

A

The difference between the bid and ask price. The source of a dealer’s compensation

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28
Q

What is a market order?

A

Instruction to execute the trade immediately at the best possible price.

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29
Q

What is a limit order?

A

Buy below or sell above a given price.

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30
Q

What is a stop order?

A

Used to prevent losses or to protect profits.

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31
Q

What is an all-or-nothing order?

A

Concerns the volume of the trade, execute only if the whole order can be filled

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32
Q

What is a hidden order?

A

Orders where only the broker or exchange knows the trade size

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33
Q

Securities sold directly to qualified investors, typically with the assistance of an investment bank is also known as a…?

A

Private placement

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34
Q

A firm makes its public disclosures as in a regular offering but then issues the registered securities over time when it needs capital and when the markets are favorable, is also known as a…?

A

Shelf registration

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35
Q

What is a dividend reinvestment plan?

A

Existing shareholders to use their dividends to buy new shares from the firm at a slight discount

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36
Q

Existing shareholders are given the right to buy new shares at a discount to the current market price, is better known as a…?

A

Rights issue

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37
Q

What is the purpose of an investment banks in an IPO?

A

IBs serve as a sort of intermediary between corporations looking to IPO and investors through equity issues.
IBs provide underwriting services for new stock issues when a company decides to go public.

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38
Q

What is the difference between call markets and continuous markets?

A

Call Market: A market is called at a certain time and place and all the traders trade at that time.
Continuous Market: traders can trade continuously at any time when the market is open (typical type of market)

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39
Q

What are the three different types of market structures?

A
  1. Quote driven markets: where dealers provide liquidity
  2. Order-driven markets where traders provide liquidity
  3. Brokered markets where brokers provide liquidity
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40
Q

What are the four characteristics of a well functioning financial system?

A

Complete markets
Operational efficiency
Informational efficiency
Allocational efficiency

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41
Q

Describe a security market index?

A

security market index is used to represent the performance of an asset class or segment of a market made up of multiple securities to mimic a portfolio.

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42
Q

What is more difficult to build and maintain an equity index or a bond index?

A

A bond index as many mature so need to be replaced, and don’t trade as frequently so there is not as much continuous trade data

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43
Q

What is the difference between a price return and a total return?

A

Total return includes dividends

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44
Q

An index that contains an equal number of shares in each stock, is called a…?

A

Price weighted index

45
Q

What is the formula for calculating a price weighted index?

A

( Price\ weighted\ index = \frac{Sum\ of\ stock\ prices}{Number\ of\ stocks\ in\ index} )

46
Q

What are the issues of using a price weighted index?

A

A given percentage change in the price of a higher priced stock has a greater impact on the index’s value than does an equal percentage change in the price of a lower priced stock

47
Q

What is an equal-weighted index?

A

An index with an equal dollar amount of each stock in the index

48
Q

What are the issues with using equal-weighted index?

A

They require constant rebalancing

49
Q

What is a market cap weighted index?

A

Stocks in the index are weighted according to their total market capitalisation.

50
Q

Shares that are actually available to the investing public and excludes the value of shares held by controlling stockholders because they are unlikely to sell their shares, is known as…?

A

Market float

51
Q

The value of shares that excludes shares that are not available to foreign buyers, are known as…?

A

Free float

52
Q

What is the difference between rebalancing and reconstructing an index?

A

Rebalancing an index: adjusting the weights of securities in a portfolio to their target weights after price changes have affected the weights

Index reconstruction: periodically adding and deleting securities that make up an index.

53
Q

What are broad market equity indicies?

A

Indicies that represent the majority of stocks in a market

54
Q

Indicies that measure the returns for a sector (e.g., technology), are better known as…?

A

Sector indexes

55
Q

Indicies that measure the returns of large cap, small cap, mid cap, value, growth are better known as…?

A

Style indicies

56
Q

What is the difference between value and growth stocks?

A

Value stocks: Low P/E ratio stocks

Growth stocks: High P/E ratio stocks

57
Q

When is a capital market informationally efficient?

A

When the current price of a security fully reflects all available information about that security

58
Q

In a perfectly efficient capital market, should an investor utilise a passive or active investment strategy?

A

A passive strategy

59
Q

Does new regulation promote or restrict market efficiency?

A

It restricts it

60
Q

Why is information efficiency of importance to a portfolio manager?

A

When markets are efficient, active management will not lead to positive returns on average

61
Q

What is the difference between market value or fundamental value?

A

Market value of an asset is its current price.

Intrinsic value or fundamental value: The value that a rational investor with full knowledge about the asset’s characteristics would willingly pay.

62
Q

What are the factors that impact market efficiency?

A

Number of market participants
Availability of information
Impediments to trading – e.g. arbitrage
Transaction and information costs

63
Q

If current security prices fully reflect all currently available security market data, what form of efficiency is the market?

A

Weak form efficient

64
Q

What level of efficiency is a market if technical analysis is useless?

A

Weak form efficient

65
Q

What level of efficiency is a market if fundamental analysis has value?

A

Weak form efficient

66
Q

What is the level of market efficiency if security prices fully reflect all publicly available information?

A

Semi-strong form efficiency

67
Q

What is the level of efficiency if security prices fully reflect all information both public and private?

A

Strong form efficiency

68
Q

Describe behavioural finance?

A

Investors behave in ways that are often irrational
Investors often have inherent biases
Investors suffer loss aversion
Investors often suffer from overconfidence

69
Q

What are the rights and obligations of a common stockholder?

A

Vote for the board of directors, on merger decisions, and on the selection of auditors.

70
Q

Are firms required to pay dividends on common equity?

A

There is no legal obligation to pay dividends

71
Q

What form of shares allow the firm the right to repurchase the shares at a pre-specified price?

A

Callable common shares

72
Q

What form of shares give the shareholder the right to sell the shares back to the firm at a pre-specified price?

A

Putable common shares

73
Q

What is the difference between cumulative and non-cumulative prefs?

A

Cumulative preference shares: are usually promised fixed dividends, and any dividends that are not paid must be made up before common shareholders can receive dividends.

The dividends of non-cumulative preference shares do not accumulate over time when they are not paid, but dividends for any period must be paid before common shareholders can receive dividends.

74
Q

What are participating preference shares?

A

Participating preference shares: receive extra dividends if firm profits exceed a predetermined level and may receive a value greater than par if the firm is liquidated

75
Q

What are debt like shares which has a maturity date on which date the company will repay the capital amount to the holder called?

A

Redeemable preference shares

76
Q

What is direct investing?

A

Direct investing in the securities of foreign companies simply refers to buying a foreign firm’s securities in foreign markets

77
Q

What are DRs?

A

Depository receipts (DRs) represent ownership in a foreign firm and are traded in the markets of other countries in local market currencies

78
Q

What are GDRs?

A

Global depository receipts (GDRs) are issued outside the United States and the issuer’s home country in USD

79
Q

What are ADRs?

A

American depository receipts (ADRs) are denominated in U.S. dollars and trade in the United States.

80
Q

Overweighting or underweighting industries in your portfolio based on the current phase of the business cycle, is a practice known as…?

A

Industry rotation

81
Q

What is a highly concentrated industry?

A

An industry with a low number of small companies in it

82
Q

What are three methods by which firms can be classified into industry groups?

A

products and services they offer
Sensitivity to business cycles
Statistical methods

83
Q

What are the three limitations of using statistical methods to group companies into industry groups?

A

Future correlations are not representative of past correlations
Geographical groupings may differ over time
Risk of statistical error

84
Q

What is a cyclical firm?

A

One whose earnings are highly dependent on the stage of the business cycle

85
Q

What is a defensive industry?

A

Industries least affected by the stage of the business cycle

86
Q

What are the steps used to identify a peer group?

A

Use trade documents and materials
Read peer financial reports
Use commercial classification providers

87
Q

What are the porters five forces?

A

Suppliers, substitutes, competitors, customers, new entrants

88
Q

What are the 5 stages of the industry life cycle model?

A
  1. Embryonic
  2. Growth
  3. Shakeout
  4. Maturity
  5. Decline
89
Q

What is the difference between cost leadership and differentiation?

A

Cost leadership: the lowest costs of production in its industry therefore passing on the lowest prices to consumers

Differentiation: Products should be distinctive in terms of type, quality, or delivery.

90
Q

The deliberate undercutting of price level to eliminate new entrants to an industry, only to raise these prices back to the normal level upon that elimination, is known as what type of pricing?

A

Predatory pricing

91
Q

What is the difference between regular and special dividends?

A

Regular dividends occur when a company pays out a portion of profits on a regular schedule

Special dividends are paid when circumstances allow the firm to make a one-time cash payment to shareholders

92
Q

What are stock dividends?

A

Dividends paid out in new shares rather than cash

93
Q

What are cash dividends?

A

Payments made to shareholders in cash.

94
Q

The date an upcoming dividend payment is announced is known as …?

A

Declaration date

95
Q

The last date you can buy a share on and receive the dividend is known as…?

A

The day before the ex-dividend date

96
Q

The date a dividend is paid out is known as the…?

A

Payment date

97
Q

What is the value for the one year DDM?

A

( Value = \frac{D_1}{1+K_e} + \frac{P_1}{1+K_e} )

98
Q

What is the formula for the two year DDM?

A

( Value = \frac{D_1}{(1+K_e)} + \frac{D_2}{(1+K_e)^2} + \frac{P_2}{(1+K_e)^2} )

99
Q

What is the formula for the n-year DDM?

A

( Value = \frac{D_1}{(1+K_e)} + \frac{D_2}{(1+K_e)^2} +…+ \frac{D_n}{(1+K_e)^n} + \frac{P_n}{(1+K_e)^n} )

100
Q

Why do we assume that dividends are infinite in a DDM?

A

As we assume businesses have an indefinite life

101
Q

When do we use a FCFF model over the DDM?

A

When the business is not currently paying dividends, but has dividend paying capacity

102
Q

What is the formula for the cost of preference shares?

A

( K_p = \frac{D_p}{P_0} )

103
Q

What is the formula for the gordon growth model?

A

( P_0 = \frac{D_0(1+g)}{K_e - g} )

104
Q

How do you estimate g for the gordon growth model?

A

g = ROE x Retention rate

105
Q

Would you use the FCFE model or the DDM if you were calculating the PV on the basis on dividend paying capacity rather than expected dividends?

A

FCFE

106
Q

When would we use a constant dividend model vs when would we use a multi year dividend model?

A

Use a constant model for stable, mature businesses paying constant dividends
Use a multi year model for young, unstable businesses with erratic dividend policies

107
Q

What is the rationale for using price multiples over the DDM?

A

Easier to calculate

The DDM is very sensitive to inputs

108
Q

What are the 11 Broad Grouping Sectors

A
  1. Consumer Discretionary
  2. Consumer Staples
  3. Energy
  4. Financial Services
  5. Health Care
  6. Basic Materials & Processing
  7. Industrial Producer Durables
  8. Real Estate
  9. Technology
  10. Telecommunications
  11. Utilities

CFA Exam Level 1 (10 decks)

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