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Equity Investments & FI Flashcards

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1
Q

Infinite period dividend discount model

A
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2
Q

Dividend discount model assumptions

A
  • Dividends are correct metric for valuation purposes
  • Dividend growth rate is perpetual and never changes
  • Required rate of return is constant over time
  • Dividend growth rate < required rate of return
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3
Q

Gordon model alternatives

A
  • Use a more robust DDM that allows for varying growth patterns
  • Use a cash flow measure instead of dividends
  • Use another approach, such as a multiplier method
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4
Q

Two stage DDM

A
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5
Q

PE ratio link to Gordon Growth

A
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6
Q

EV/EBITDA

A
  • EBITDA used as proxy for operating cash flow (excludes depreciation and amortisation)
  • EBITDA is a source of funds to pay interest, dividends and taxes
  • EBITDA is calculated prior to payment to any of the company’s financial stakeholders; using it to estimate enterprise value is therefore appropriate
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7
Q

Leverage factor

A
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8
Q

Margin call price

A
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9
Q

Global depositary receipts

A

Issued outside a company’s home country and outside the US.

Not subject to foreign ownership and capital flow restriction

Traded in London and mostly in the USD

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10
Q

American depository receipts (ADRs)

A

US dollar denominated security

Enables foreign companies to raise capital from US investors

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11
Q

Level I/II Non-Domestic

A
  • Unlisted
    • Develop and broaden US investor base with existing shares
    • Not raising capital on US market
    • Form F6
  • Listed
    • Same as above but has listing fees
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12
Q

Level III non-domestic securities

A
  • Develop and broaden US investor base with existing shares/new shares
  • Forms F-1/ F-6
  • Actually raising capital
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13
Q

Rule 144A

A

Access qualified instituional investors. Raise capitals through private placements to QIBs. No SEC registration. Low listing fees, no reporting. Can be done through private placements

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14
Q

Porter’s 5 forces

A
  1. Threat of substitute products
  2. Bargaining power of customers
  3. Bargaining power of suppliers
  4. Threat of new entrants
  5. Intensity of rivalry
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15
Q

Excess/deficiency bonds

A
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16
Q

Inverse effect

A

Bond price is inversely related to the market discount rate

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17
Q

Convexity effect

A

% price change is greater when market discount rates go down, than when they go up

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18
Q

Coupon effect

A

Lower coupons more volatile than higher coupons

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19
Q

Maturity effect

A

Longer dated more volatile than shorter dated bonds

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20
Q

Discount rate basis

A
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21
Q

Add-on rate basis

A
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22
Q

Forward rate on bonds

A

1y1y = “the 1 year into 1 year rate” = one year rate starting in one year time

Spot rates are geometric averages of forward rates. YTM’s are a weighted average of spot rates

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23
Q

G-spread

A

YT bond - YTM government benchmark (interpolated)

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24
Q

I-Spread

A

YTM bond - interest swap rate benchmark (interpolated)

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25
Q

Z-Spread

A

Zero volatility spread for measuring spreads off the spot rate curve, spread over each of the spot rates in a given benchmark term structure

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26
Q

Option Adjusted Spread (OAS)

A
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27
Q

Measuring spreads summary

A
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28
Q

Macaulay Duration

A
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29
Q

Modified Duration

A

Approximate percentage change in full price

Provides a linear estimate of the percentage price change

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30
Q

Duration Gap

A

Duration Gap = Macaulay duration - investment horizon

If duration gap is negative reinvestment risk dominates price risk

If duration gap is positive price risk dominates coupon reinvestment risk

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31
Q

Duration gap (first order)

A
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32
Q

Approximate mdofied Duration

A
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33
Q

Price-yield relationship straight bonds

A

Longer maturity, lower coupon means higher duration and convexity

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34
Q

Effective duration

A
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35
Q

Point value of a basis point

A
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36
Q

Aproximate Modified Convexity

A
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37
Q

Convexity price adjustment

A
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38
Q

Price-yield relationship for callable bonds

A
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39
Q

Price-yield relationship for putable bonds

A
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40
Q

Effective convexity

A
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41
Q

Bond indenture/Trust deeds

A

Legal contract that describes the form of the bond, the obligations of the issuer and the rights of the bond holders.

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42
Q

Credit enhancements

A
  • Internal enhancements - over collateralization, excess spread(held in reserve accounts), subordination
  • External enhancements - Bank guarantee or a surety bond issued by an insurance company reimburse investors for losses incurred & letter of credit from a financial institution
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43
Q

Foreign bonds

A

Bonds issued by entities that are incorporated in another country in the national bond market of another country in that country’s currency

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44
Q

Eurobond

A

Issued outside the jurisdiction of any one country and trade in a currency different from the countries in which they trade

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45
Q

Bond tax considerations

A

Capital gain treated differently than income. Original issue discount bond may have a portion of the the discount subject to income tax. Some jurisdictions have a tax provision for bonds bought at a premium where the premium can be used to offset taxable income.

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46
Q

Amortizing bond

A

Fully amortised bond entire principle paid over life of bond.

Partially amortized bond – pays interest and principal over the life of the bond but principal is still outstanding on maturity

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47
Q

Sinking fund provisions

A

Issuer sets aside funds over course of maturity

Could be set aside in a segregated cash reserve or a specific provision to retire a specific portion (e.g. 4%) of principal ever year

Lowers credit risk

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48
Q

Conversion value (parity value)

A

Current share price x Conversion ratio

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49
Q

Conversion Premium

A

Convertible bond price - Conversion value

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50
Q

Phases of bond issuance

A
  1. Funding determination
  2. Select the underwriter commonly handled by a syndicator
  3. Underwriter prepares prospectus (offering circular) and issuer chooses trustees to oversee master agreement
  4. Gauging demand with roadshow, grew market represents a forward market for bonds about to be issued to help determine the final offer price
  5. The offering day follows the pricing day, when the underwriting agreement is signed, and added to the final terms of the bond
  6. On closing day, the bonds are delivered to investors, represented by a global note usually held by the paying agent
51
Q

Shelf registration

A

Issuer prepares a single offering circular (master prospectus) that describes a range of future bond issuances

Subject to less scrutiny than standard offerings. Available for issuers, with sufficient clout.

Each document proceded by announcement document.

52
Q

Public offerings auctions (FI)

A
  • Competitive bids require the bidder to specify an acceptable yield, and if the auction determines a lower yield, the bidder is not offfered anything
  • Non-competitive bids require bidder t accept the yield determined by the auction, and thus they will always receive the securities
53
Q

Bond settlement (secondary market)

A
  • Government bonds typically settle T+1
  • Corporate bonds typically settle T+3
  • Money market trades can settle T+0 (cash)
54
Q

T bill

A

Less than 1 year = T-blll (money market)

55
Q

T note

A

At least 1 year, up to 10 years (capital market)

56
Q

T bond

A

More than 10 years (capital market)

57
Q

On-the-run

A

Sovereign debt which is usually recently issued

58
Q

Commercial paper ratings

A
59
Q

Commercial paper

A
  • Short term unsecured promissory note, can fund working capital requirements, largest issuers are financial institutions
  • Can be used to pay the holders of maturing commercial paper (rolling over the paper), can create rollover risk, can obtain back up lines of credit to protect against risk
  • Investors are regularly able to assess issuer’s financial condition and so default rates are very low
  • Yields are higher than sovereign bonds of the same maturity
60
Q

US Commercial paper vs Eurocommercial paper

A
61
Q

Corporate short-term notes

A

Up to five years

62
Q

Corporate medium term notes

A

More than five years, up to 12 years

63
Q

Corporate longer-term bonds

A

Longer than 12 years

64
Q

Settlement of corporate notes

A

Primary market settlement takes several days, but secondary market settlement is generally T+3

65
Q

Retail deposits

A

Primary source of funding, demand deposits provide highest level of liquidity, typically zero interest.

Savings accounts, pay interest, but less liquid than demand deposits.

Money market accounts

66
Q

Central bank funds

A

Reserve funds provide a liquidity buffer for depositors. Central bank may act as lender of last resort. Reserve funds may earn interest, and banks may be required to hold a minimum level of funds. Rate on central bank funds are determined by the market but influenced by central bank open market operations.

67
Q

Interbank funds

A

Unsecured loan and deposit market between banks, with terms ranging from overnight to one year. The rate on funds can be quoted fixed or relative to a reference rate. Banks require line of credit with each other to obtain unsecured funds (confidence can dry up)

68
Q

Large-denomination negotiable Certificates of Deposit

A

Specific amount on deposit for a fixed term and fixed rate payable on maturity. May represent a deposit that can be traded or not traded. NEgotiable come in two forms’ large or small). Only large denomination CDs are relevant as a wholesale funding source. CD market available domestically and internationally (Eurobond)

69
Q

Repo

A

Sale of a security with a simultaneous agreement to buy back the same security from the original buyer at a set price on an agreed date, difference between the prices represents the interest on a collateralized loan. Can theoretically be used for infinite leverage (buy security with funds, use this security as a collateral for more funds etc.)

Reverse repos conversely can be used to borrow securities to cover a short position

70
Q

Repo detail

A

Terms can be one day (overnight repor) or more (term repo). High demand collateral is referred to as ‘on special’.

Both parties are exposed to counterparty default risk, credit risk is bilateral, but is usually structured to acknowledge the greater credit risk of the cash borrower, amount of funds borrowed is less than the market value of the collateral and the difference is called the repo margin.

71
Q

Trustee or trustee agent (ABS)

A
  • Entity with trust powers that safeguard the securitized assets
  • Hold funds fue to the bondholders until they are paid
  • Provide periodic remittance reports to bondholders
72
Q

Maturity of mortgages

A
  • US typically 15-30 years
  • Europe typically 20-40 years
73
Q

Payment compositon mortgages

A
74
Q

Prepayments

A
  • Allowing prepayments creates uncertainty in the timing and amount of cash flows - known as prepayment risk
75
Q

Rights of the lender in a foreclosure

A
  • Recourse loan: lender has a claim against the borrower for the shortfall from the loan amount and proceeds from the property sale
  • Non-recourse loan - lender has no such claim and can only look to the sale of the property to recover the outstanding balance
76
Q

Mortgage Pass - Through Security

A
  • Cash flow = Interest + Scheduled principal + Prepayments
  • Reduced by servicing fees
77
Q

Confirming and non-conforming loans

A
  • Conforming loan - meets specified criterion to be included in the loan pool of an agency
    • Size of loan
    • Loan documentation required
    • Maximum loan-to-value ratio
    • Requirement for insurance
  • Non-conforming loans used as collateral for mortgage pass-through securities are privately issued
78
Q

Single monthly mortality rate

A
79
Q

Extension risk

A

Interest rates increase, prepayments will decrease. RMBS price declines as interest rates are higher. Income received is typically limited to the interest payment and scheduled principal payment

80
Q

Contraction risk

A

If interest rates decrease, prepayments will increase. Risks to the RMBS investor include: reinvestment rate risk, negative convexity puts ceiling on price

81
Q

Collateralised Mortgage Obligations (CMO)

A
  • Securities whee the cash flow of mortgage-related products are redistributed to various tranches
  • Prepayment risk (extension and contraction) is redistributed among tranches through structuring, they have different levels of prepayment risk. Broadens the appea of mortgage backed securities to institutional investors
  • In contrast mortgage pass-through secutiries the collateral for a CMO is a pool of mortgage pass-through securities not a pool of mortgages.
82
Q

Planned amortization class (PAC) tranches

A
  • Amortization based on a sinking fund schedule within a range of prepayment speeds hence creating greater predictability of cash flows for the pac holder
  • The greater predictability of cash flows comes at the expense of support tranches or companion
  • Most CMO PAC structures have more than one PAC tranche
83
Q

Support tranches

A
  • If prepayments are slow support tranches do not receive principal until the PAC tranches receive their scheduled principal
  • If prepayments are fast support tranches absorb the principal in excess of scheduled principal
84
Q

Floating rate tranches

A
  • Fixed-rate tranches can be split into floating and inverse-floating tranches
  • Floaters pay more when rates go up, converse for inverse-floaters
85
Q

Commercial mortgage-backed securities

A

Backed by a pool of commercial loans on income-producing property such as multifamily properties, hotels

Common for loans to be non-recourse. Lender must therefore review each property individually using measures commonly used in credit risk

Loan-to-value

Debt-to-service coverage ratio = Annual net operating income / Debt service

86
Q

CDO

A

Generic term to describe a security backed by a diversified pool of one or more debt obligations

  • CBO: backed by corporate and emerging market bonds
  • CLO: backed by leveraged bank loans
  • Synthetic CDO: backed by a portfolio of credit default swaps
87
Q

CDO transaction

A
88
Q

CDO cash flows

A

Cash flows = interest from collateral assets + maturing of collateral assets + sale of collateral assets

Loss to equity tranches will occur if the returs from the collateral does not exceed the cost of paying off the senor and mezzanine tranches. The maximum loss will represent their entire investment

89
Q

Credit Engancement in securitisation

A

Allows for loss absortion

  1. First to excess spread (excess revenue generated by difference between coupon and underlying collateral)
  2. Then to overcollaterilisation (FaceV of loans > ParV)
  3. Then from the bottom tranch upwards
90
Q

RMBS WAL vs WAM

A

Weighted average maturity ignores amortisation of the principle. Weighted average life is the weighted average time taken to make a principle repayment

91
Q

Sequential Pay CMO (High Tranch)

A

High Contraction risk

Low Extension risk

92
Q

Sequential CMO (low tranche)

A

Low contraction risk

High extension risk

93
Q

Redemption regimes (Covered Bond)

A

Exist to align covered bond’s cash flows as closely as possible to original maturity schedule should bond’s financial sponsor default

94
Q

Hard-bullet covered bonds

A

If payments are not made as schedules a bond default is triggered and bond payments are accelerated

95
Q

Soft-bullet covered bonds

A

Delay the default and accelerated payments until a new final maturity date which is usually up to a year after the original maturity date

96
Q

Conditional pass-through covered bonds

A

Convert to pass-through securities after the original maturity date if all bond payments not made

97
Q

Covered bond definition

A

Similar to ABS but offer bondholders dual recourse to both issuing financial institution and underlying pool of assets

Underlying assets kept on financial institutions balance sheet not transferred to remote SPE

Normally only one bond class

Covered sponsors must replace any prepaid or non-performing assets

98
Q

Value of security market index made of

A

Actual or estimated value of constituent securities

99
Q

Fundamental Weighting

A

Weighting of each security = Fundamental size measure / Sum of fundamental size measure

Leads to value tilt

100
Q

Challenges with Fixed Income Indices

A

Number of different types more than with equities

Much greater index turnover due to maturing FI securities

Primary dealer (market makers) - index providers have to obtain prices from dealers or estimate from similar securities

More difficult to replicate

101
Q

Commodity indexes

A

Use futures contracts on one or more commodities

Each index has different weighting mechanism

Changes reflect: risk-free interest rate, change in futures prices, roll yield

102
Q

REIT

A
  • Indexes Represent market for real estate securities and real estate market in general
  • REIT Highly illiquid market, infrequent transactions and pricing information
  • Types: Appraisal, repeaat sales, and REIT indexes
  • Can be based on public or private unds which invest in real estate
  • REIT indexes based on publicaly traded REITS with continuous market prices
103
Q

Who sells CDS

A

Insurance companies, IBs, hedge funds

104
Q

Brokers

A

Agents who fill orders for their clients

Help clients by reducing cost of finding couterparty

105
Q

Exchanges

A

Provide places where traders can meet to arrange trades, becoming more similar to dealers

106
Q

Alternative Trading Systems vs Exchanges

A

Function like exchanges but do not exercise regulatory authority over subscribers

Dark pools do not display client orders so help protect traders from market moving against them (pre-trade untransparent)

107
Q

Dealers

A

Fill client orders by trading with them

Provide liquidity

May include hedge funds, IBs, prop trading assets

Primary dealers buy/sell government debt

108
Q

Replication

A

Buying risk in one form and selling it in another e.g. equity positions and call options

109
Q

Initial margin requirement

A

Portion of security price that must be paid to broker by trader (equity potion)

Trader’s equity = margin requirement x initial value of short position

110
Q

Execution Instruction

A

How to fill order

111
Q

Validity Instruction

A

When the order may be filled

112
Q

Clearing Instruction

A

How to arrange final settlement trade

113
Q

Market Order

A

Instructs broker or exchange to obtain best price immediately

No price criteria given

Can be expensive to execute as execution price uncertain, but allocation risk low

114
Q

Limit order

A

Specifies highest buying price or lowest selling price acceptable

Price risk lowered, but execution risk higher

115
Q

Examples of validity instructions

A
  • Day order: order expires if unfilled at close
  • Good-till-canelled: cancellaiton date specified by trader
  • Immediate or cancel: canelled if cannot be filled in whole or in part (fill or kill)
  • Good-on-close: Often market orders. Can only be filled at close of trading
  • Stop order, may not be filled until stop condition satisfied. Contribute to momentum
  • Buy stop execution delayed until trade occers at or above stop price
  • Sel stop order: execution delayed until trade occurs at or below stop price
116
Q

Continuous trading market

A

Trades can be arranged and executed whenever market is open

Generally used when market is liquid

May start/end trading session with a call market

117
Q

Call market

A

Trades can only be arranged when market is called

Highly illiquid between trading sessions

Use single price auctions to match buyers to sellers (single trade price to maximize total volume of trades)

118
Q

Quote driven market

A

Electronic exchange which prices are determined from bid and ask quotations made by market makers

Also known as a price-driven market. Dealers fill orders from their own inventory or by matchning them with other orders

119
Q

Order driven markets

A

Use rules to match, buy and sell orders

Submitted by customers or dealers

Rank orders based on price (price priority)

Secondary precedence rules include unhidden vs hidden, time enetered

120
Q

Uniform pricing rules

A

Commonly used by call markets

All trades executed at same price

121
Q

Discriminatory pricing rule

A

Used by continuous markets

Standing order (order that arrives first) determines trade price

122
Q

Derivative pricing rule

A

Used by crossing networks

Crossing networks matches buyers and sellers who are willing to trade at prices obtained from other markets

123
Q

Market Information

A
  • Pre-trade transparent market publishes trade prices and sezes soon after trades occur
  • Buy-side traders prefer transparency
  • Dealers prefer opaque market - information advantage
  • Opaque markets - wider bid/ask spread, higher transaction costs
124
Q

Positive convexity

A

Prices go up faster as yields fall, for a given interest rate change % price increase would be greater than % price decrease

1 CFA (26 decks)

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