Exam 1 Flashcards
1
Q
A commitment of cash into a business, bank account, real estate, stocks, bonds, or other asset, usually for the purpose of obtaining income and/or a profit.
A
Investment
2
Q
Lending money to an individual, bank, credit union, corporation, or government.
A
Lending Investments
3
Q
What is a lender promised from a lending investment? (2):
A
- Contractual interest payments
- Return of principal either on demand or a maturity date
4
Q
When do lending investments have low and high default?
A
Government issued bonds are promised the payments and have low risk. Personal loans, company bonds, etc. have a risk of default because they are not promised an amount of money/return
5
Q
T/F
The promised return is the most that you can earn per year if you hold the investment until the maturity date
A
True
6
Q
Including stocks, stock mutual funds and ETFs, precious metals, and real estate involving legal ownership of a business or real property
A
Ownership Investment
7
Q
Which has more risk and return, ownership investment or lending investment?
A
Ownership investment entails more risk but higher potential returns
8
Q
How are lending investments interest and principal determined?
A
Interest and principal payments are set by contract and are generally fixed
9
Q
Where do returns come from? (3):
A
- Income received from holding the asset
- Like a dividend on a stock or a coupon on a bond
- Gains and losses in the market price of the asset, called capital gains and losses
10
Q
How is risk measured?
A
The standard deviation of the total return on the asset over the next year
11
Q
For an investor that holds a reasonably diversified portfolio, the most important measure of the risk of an asset is the ______ between the returns on that asset and the returns on the entire portfolio
A
Covariation
12
Q
The ability to convert an asset to cash on short notice at a fair price.
A
Liquidity
13
Q
An investment that the fund reasonably expects cannot be sold in current market conditions in seven calendar days without significantly changing the market value of the investment
A
SEC definition of an illiquid investment
14
Q
When are capital gains and losses taxable?
A
Only when realized, and the tax rate is reduced if the asset is held for more than one year
(As a result, active traders often bear higher tax burden than do buy-and-hold investors)
15
Q
What is exempt from federal income taxation?
A
Interest on most municipal bonds and bonds issued by state and local governments
16
Q
What is and is not taxed at the state level?
A
Common stock dividend income is, treasury bond interest is not
17
Q
What is taxed at a lower federal tax rate than coupon income on treasury and corporate bonds?
A
Dividends on common stocks and many preferred stocks
18
Q
When are returns in accounts (like 401k, IRA, etc.) taxed?
A
They are not taxed while in the account but then taxed at ordinary rates upon withdrawal
19
Q
If you want a high expected after-tax return, you must…
A
Bear relatively high risk or low liquidity
20
Q
The percentage of the portfolio invested in each of multiple broad asset categories
A
Asset allocation
21
Q
First forecasting future macroeconomic conditions, then industry conditions, and then identifying the best stocks or bonds within the best industries
A
Top-Down Approach
22
Q
Starts at the individual stock (or bond) level, looking for attractive characteristics, and then building the portfolio as a collection of those stocks
A
Bottom-Up Approach
23
Q
The strategy of changing asset allocation between stocks, bonds, real estate, and money market securities in response to changes in perceived risks and expected returns
A
Market Timing
24
Q
The strategy of shifting stock investments among industries, such as financials, utilities, and technology, in response to industry trends and stock valuations
A
Sector Rotation
25
Within a particular industry, the investor buys those stocks with the best expected return-to-risk tradeoffs, and avoids the others
Security Selection
26
Assumes stock and bond markets are efficient, or are not so inefficient to make it worth spending the resources required to exploit the inefficiencies, try to do as well as the overall market
Passive Investment Strategy
27
Annual percentage increase in the prices of a market basket of goods and services
Inflation Rate
28
Real Rate of Interest Equation:
(1 + Nominal Interest Rate)/(1 + Inflation Rate) - 1
29
The actual interest rate paid on the investment
Nominal Interest Rate
30
The annual rate at which a saver builds up purchasing power, or the annual rate at which a borrower surrenders purchasing power
Real rate of interest
31
What is income tax levied on -
nominal interest income or real interest income?
Nominal Interest Income
32
Short-term lending investments
Money market securities
33
A comparable alternative to a savings account at a bank or credit union
Money market fund
34
Zero-coupon, default-free obligations of the U.S. government
Treasury Bills
35
The implied rate of interest based on the highest price that the dealer is willing to pay to buy the T-Bill from someone
Bid Rate
36
The implied rate of interest based on the lowest price that the dealer is willing to accept to sell the T-Bill to someone
Ask Rate
37
With bid and ask prices, the ___ is always higher than the ___
Ask is always higher than the bid
38
By law, banks and credit unions must publish the ___ on all deposit accounts, which allows for a fair comparison across accounts that use different compounding intervals, like daily versus quarterly
APY
39
The APY will always be greater than or equal to the ____ for t-bills
bond equivalent yield
40
What is the safest/most liquid security available?
Treasury Bills
41
Interest earned on t-bills is taxable at the ___ level, but is exempt from income taxation at the __ and __ level
Federal
State and Local
42
Interest earned on Fannie and Freddie paper is taxable at ___ level(s)
federal level, and also taxable at the state and local level for states and localities with income taxes
43
Municipal bonds interest is exempt from...
federal income tax
44
When are municipal bonds exempt from state income tax?
If the investor and issuer are both from the same state
45
A municipal security that generally has a long maturity of 10 years or more, but the interest rate resets frequently, and holders are able to liquidate their security through a "put" or "tender" feature, at par.
Variable Rate Demand Obligation (VRDO)
46
Essentially, at each interest rate reset date, the municipality must pay a competitive interest rate to investors based on current market conditions, or the investors will..
Demand their money back
47
An unconditional commitment by a bank to pay investors the principal and interest on the VRDOs, if the municipality is short of cash
Bank's letter of credit
48
Short-term, promissory notes issued primarily by corporations, including many foreign corporations.
Commercial Paper (CP)
49
Commercial Paper maturity max and average
Up to 270 days but the average is 30-60 days
50
Primary buyers of commercial paper (4):
Mutual funds, banks, insurance companies, and pension funds
51
Where repayment is based on the cash flows of an underlying pool of financial assets
Asset-backed commercial paper
52
Houses the assets and issue the commercial paper, a sponsor (typically a bank)
Special Purpose Entity (SPE)
53
Pool of loans, such as consumer credit card receivables, auto and equipment loans, manufactured housing loans, or auto dealer floor plan loans
Asset pool
54
To protect asset-backed CP buyers, often the amount of the CP issues is less than the total amount of principal in the loan pool, known as ____.
Overcollateralization
55
Short term credit ratings from best to worst (7):
```
A+
A
AA
AAA
B
C
D
```
56
Interest earned on commercial paper is taxable at the ___ level and also the ____ level for states and localities with income taxes
Federal
| State and local
57
Time deposits issued by banks in denominations of multi-millions or even billions of dollars
Large-denomination CDs (Jumbo CDs)
58
Where are jumbo CDs tradable?
In the secondary market and are generally negotiable
59
Unlike retail CDs, negotiable CDs (jumbo) cannot generally be...
Withdrawn before maturity
60
FDIC insures up to..
$250,000
61
The typical difference between the bid and ask rates for CDs is around ____
5 basis points
62
A CD issued by a U.S. branch of a foreign bank
Yankee CD
63
A CD denominated in U.S. dollars issued by a bank in a different country
Eurodollar CD (unsecured)
64
The sale of a security with an agreement to buy the security back at a set price in the future
Repurchase Agreement (repo or RP)
65
The purchase of a security with an agreement to sell the security back at a set price in the future
Reverse Purchase Agreement
66
Short-term (mostly overnight) unsecured loans between banks
Federal Fund Transactions
67
Average interest rate on fed funds
Fed funds rate
68
When the fed wants to increase market interest rates to reduce inflation, it will...
Sell treasury securities to banks
69
Average cost to large banks of borrowing U.S. dollars in London on an unsecured basis
LIBOR (London Interbank Offered Rate)
70
An interest rate benchmark used as a reference rate to set interest rates on financial products such as mortgages and private student loans
LIBOR
71
The difference between the 3-month LIBOR rate and the yield on a 3-month treasury bill. It measures the default risk perceptions of investors, specifically the default risk of lending money without collateral to large banks.
TED (Treasury EuroDollar)
72
Pool and invest individuals' money into financial assets
Mutual Funds
73
An annual fee, as a percentage of assets under management
Expense Ratio
74
Sales charges, which are levied when either buying or redeeming shares from the fund sponsor
Loads
75
Net Asset Value per share (NAV) formula:
NAV = [Fund Assets - Fund Liabilities]/(# of Shares Outstanding)
76
The true value per share of the underlying investments held by the fund, less any liabilities
NAV
77
Investors earn a profit or a loss from mutual fund investments from a combination of (2):
1. Capital gain or loss between the time of purchase and sale, when depends on the movement in the NAV of the fund
2. Distributions to shareholders of income earned by the fund, including interest, dividends, and capital gain
78
A money market mutual fund (MMF) is required by law to..
Invest in money market securities
79
Money market funds are not ___ and never have ___
FDIC-insured
| sales loads
80
All money market funds invest in money market securities, but typically specialize based on..
The type of security (corporate, treasury, U.S. government, municipal) purchased
81
Prime funds usually pay ______ than other types of MMFs
higher before-tax yields
82
Safest investment around
Treasury Bills
| federally taxed but exempt from state and local
83
MMFs are not allowed to buy securities with maturities of ___ or more
397 days or more
84
MMFs are required by law to maintain a weighted average maturity (WAM) of less than ___ days
60 days
85
Weighted average life (actual maturity) must be kept below ___ days
120 days
86
T/F
There has never been a default on a U.S. government agency debt security
True
87
MMFs cannot invest more than ___ of their assets with any issuer (except the U.S. government and government agencies)
5%
88
In an extreme situation, it is possible that the MMF share price could fall below $1 if (2):
1. The value of the investments held by the MMF fell drastically
2. There was a rush to redeem shares
This is called "breaking the buck"
89
Choosing a money market fund:
Historical returns what do you look at?
Look for a fund that earns returns above the average for its peer group over the past 5 years.
Compare apples to apples -
U.S. treasury fund to other U.S. treasury funds and a national municipal fund to other national municipal funds
90
What funds have the highest credit quality?
U.S. treasury funds
91
Lending investments that have longer original maturities than money market securities
Bonds
92
T/F
All bonds promise the return of principal at the maturity date
True
93
The principal on a bond is also called the face value or ___
Par value
94
Each interest payment is called a ___
Coupon
95
The percentage of the par value paid each year in interest
Coupon Rate
96
Suppose a bond has a $1000 principal or par value and pays a 5% coupon. How much is the coupon?
(.05/2)$1000 = $25 in coupon payments each 6 months
$50 per year
97
Bonds that pay variable coupons, with the amount of the coupon tied to a short-term interest rate in the market
Floating-Rate Bonds
98
If a promised interest or principal payment is not made to the bondholder as scheduled, the bond is in ___
Default
99
How many years are...
Short-term bonds?
Intermediate-term bonds?
Long-term bonds?
Short-term bonds are 2-3 years or less
Intermediate-bonds are 3-10 years
Long-term bonds are greater than 10 years
100
Coupon Bond Example
Suppose the current date is May 15, 2018 and the treasury sells me a new, 8% coupon, $1000 par treasury bonds that matures on May 15, 2021. What are the coupon payments?
.08(1000)/2 = $40 each 6 months
| and also the $1000 principal on May 15, 2021
101
The return now offered by already-issued bonds of the same type, similar maturity, and similar risk
Prevailing market interest rate
102
The annualized return from buying a bong and holding it until maturity, assuming no default.
Yield to Maturity (YTM)
103
YTM is mathematically equivalent to the..
Internal rate of return (IRR)
104
The higher the price of the bond in the market, the ____
Lower the YTM
105
The invoice or actual price of the bond is calculated as:
Invoice (actual) price = Flat (quoted) price + Accrued Interest
106
Accrued Interest Formula:
Accrued Interest = Semiannual Coupons x (days Since last coupon/days separating coupons)
107
Bonds that do not pay coupons
Zero-coupon bonds
108
The difference between the price originally paid and the par value of the bond at maturity represents...
The implicit interest earned by the investor
109
For investors with long horizons, any coupon payments will be reinvested rather than spent, creating a ____
Reinvestment risk
110
When sold to the public, treasury bonds have maturities of ___ years
30
111
Treasury notes are otherwise identical to treasury bonds, but have original maturities of ______ years
2, 3, 5, 7, or 10
112
U.S. treasury floating rate notes (FRNs) have a ____ maturity
2 year
113
The interest rate earned (accrued) every week on FRNs is variable, and is equal to..
The auction rate on new 13-week T-bills, plus a fixed spread
114
Who is the clientele for FRNs?
Investors that want to receive a variable interest rate that adjusts every week, but want to avoid the costly effort of quarterly participation in 13-week Treasury Bill auctions
115
FRN investors are willing to give up some ___ to obtain a slightly higher ____ and reduce the time and expense of participating in quarterly auctions
Liquidity
| Yield
116
Zero-coupon, default-free obligations of the U.S. government with maturities of up to 30 years
Treasury Strips
117
Strips are not auctioned by the Treasury, but are constructed by...
Dividing or "stripping" apart the coupon and principal payments from already-issued Treasury Bonds and Notes
118
Strips must be purchased by using a ___ or indirectly through a ____.
Stockbroker
| Mutual Fund
119
Since there is only one future cash flow, a treasury strip YTM is a ______ for that maturity date
"Pure" risk-free interest rate
120
Zero-coupon bonds are suitable investments when there is no need for _____, and the investor wants to lock in a ______, eliminating the reinvestment risk inherent in coupon bonds
Annual Income
| Multiyear return
121
Measures the annual increase in the prices of a market basket of goods and services purchased by the typical consumer
Inflation Rate
122
If the coupon on a bond is 5% and inflation is 3%, the real return on the bond is only about ___
2%
123
Designed to protect bond investors from the effects of inflation
Treasury Inflation Protected Securities (TIPS)
124
The inflation-adjusted principal is called the ____
Accrued principal
125
The ___ the inflation rate, the faster the ___ increases, and the more you receive back as principal at maturity
Higher
| Principal
126
TIPS prices are quoted as a percentage of the ___ principal
Accrued
127
Suppose you buy a 10-year, 3% coupon (1.5% per six months) inflation-indexed bond when issued for $1000 in January 2018. What are the accrued principal and semi-annual coupon payments over the upcoming year for the following inflation rates?
7/18 - 1% CPI increase
1/19 - 3% CPI increase
Accrued Principal:
7/18 - 1010
1/19 - 1040.3
Coupon:
7/18 - 15.15
1/19 - 15.60
128
For TIPS, the higher the realized inflation rate, the more ______ on the inflation portion of your return, and the lower will be your after-tax real return
Taxes you will pay
129
The inflation rate that equates the realized annual returns from the two alternative investments
Breakeven inflation rate
130
The breakeven rate may not perfectly reflect the market consensus inflation expectation, because TIPS clearly have ____ than regular treasuries, so TIPS yields should be ____ as a result
Less inflation risk
| Lower
131
Debts of corporations
Corporate Bonds
132
Most corporate bonds promise coupons _____ with principal repayment at the ___
Semiannually
| Maturity date
133
The most important difference between Treasury and corporate bonds is that the latter carry a ___ in their yields to compensate investors for the risk of default
Premium
134
In bankruptcy, the interest and principal payments might be _____ on ____ favorable terms to the bondholder, or the assets of the company might be ___, with bondholders receiving ___ than promised
Renegotiated on less
Liquidated (sold)
Less
135
If you buy a corporate bond and hold it all the way until maturity, the most you can earn is..
The YTM on the bond when you buy it
136
If the bond defaults, the actual return will be ___ than the ___ YTM when purchased
Less
| Promised
137
All else equal, bonds of ____ are usually safer investments than bonds of ____, due to more diversified operations
Larger companies
| Smaller companies
138
Profitability is typically measured by ___ by bond rating agencies
EBIT/Sales
139
Companies with low levels of _____ have more stable profits, for a given volatility in their sales
Fixed costs versus variable costs
140
Interest-bearing debt divided by stockholder's equity
Debt/Equity ratio
141
Measures interest-bearing debt relative to pre-tax cash flow available to pay interest on the debt
Debt/EBITDA ratio
142
Measures interest expense in relation to the profits of the business
Interest Coverage
143
Interest Coverage formula:
EBIT/Interest Expense
144
___ and ___ history are reassuring to bondholders
Conservatism (using little debt) and rapidly paying back debts
145
Some bonds, generally called mortgage bonds, have specific assets pledged as ___ for the debt
Collateral
146
If the company defaults on a mortgage bond, bondholders can seize the collateral, and repay themselves from..
The proceeds of the sale
(Any excess proceeds go back to the issuer, or alternatively, the bondholders become general creditors for the amount of any deficiency)
147
Bonds that do not have any specific pledged collateral are called ___
Debentures
148
Generally has the first claim on any unplugged assets of the company in a default
Senior bond
149
Receive nothing until the senior lenders have been repaid in full
Junior or subordinated bonds
150
Qualitative measure of default risk
Rating
151
Highest S&P bond rating is..
Next highest..
Lowest ratings are..
Highest: AAA
Next highest: AA, then A, then BBB, BB, and B
Lowest: C and D (bonds in default)
152
Corporate bonds that have ratings of at least __ or __ are called investment-grade bonds
Baa
| BBB
153
Bonds with ratings of __ or __ or lower, or bonds with no ratings at all, are called high-yield or speculative-grade or junk bonds
Ba
| BB
154
The ___ the bond rating, the ___ the risk of default, and thus the higher the ___ required by investors
Lower
Higher
YTM
155
Investors should purchase junk bonds or junk bond mutual funds only when their yields are significantly ______ on Treasury Bonds
Above the yields
156
Debts of states and municipalities (cities, counties, school districts, etc.), used to provide funding for roads, sewer plants, schools, or other public projects
Municipal Bonds (munis)
157
Munis are often issued in the form of ____
Serial bonds
158
____ bonds "are said to entail the full faith and credit (and in many cases the taxing power) of the issuer, depending on the applicable state or local law"
General Obligation (GO) Bonds
159
____ bond "is a bond that is payable from a specific source of revenue. Pledge revenues may be derived from operation of the financed project, grants, or excise or other specific non-property tax"
Revenue bond
160
An example of a revenue bond is a water and sewer bond, where revenue from water and sewer bills is used to..
Pay interest and repay principal
161
In general, the default risk of ___ is lower than the default risk of ___, since states and municipalities have the power to levy taxes
General Obligation municipal bonds
| Corporate bonds
162
One major attraction of municipal bonds for the investors is a..
Tax break
163
Investors are usually willing to accept lower ____ yields on high-quality municipal bonds than on other types of bonds
Pre-tax
164
Debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property
Mortgage-backed securities (MBS)
165
Entitle the holder to a pro-rata share of all principal and interest payments made on the pool of loan assets
Pass-through participation certificates
166
Designed to protect investors from or expose investors to various types of risk
Collateralized Mortgage Obligations (CMO)
167
In the United States, bonds trade in a _____ market
Decentralized dealer
168
Two advantages to having a bank, broker, or dealer sell your bond:
Two disadvantages:
1. You receive an interest rate just as high as large, sophisticated investors receive
2. You pay no commissions on bond purchases
1. Investment flexibility (you can only buy when there is a Treasury auction)
2. Complication of a transfer to a broker if you want to sell bonds before maturity
169
What is the T+2 rule?
The broker must receive investor's cash for a bond purchase within two business days of trade execution
170
Bond investors are taxed on ____ and also on ____
Interest earned
| Capital gains or losses
171
The tax rate you pay on your last dollar of income
Marginal tax rate
172
Corporate bonds offer no ____ to investors
Tax breaks
173
After-tax yield formula:
After-tax rate of return = Before-tax return(1- tax rate)
174
Suppose the Treasury Bond yield is 7% and the municipal bond yield for bonds in your state of residence is 5%. If you are in the 15% tax bracket, what is your after-tax yield on the T-bond?
7%(1 - .15) = 5.95%
175
Suppose you have a 36% federal tax rate and a 6% state income tax rate, and you can get a 7.5% yield on a corporate bond. What is the after-tax yield on the corporate bond if you do not itemize your deductions on your federal tax return?
What if you itemize and are under $10,000 limit on state and local taxes?
After tax yield:
7.5%(1 - .06 - .36) = 4.35%
Itemize:
7.5%(1 - .06 - (1 - 0.6).36) = 4.512%
176
Don't consider buying a municipal bond, or muni mutual fund, unless your Federal tax bracket is __ or higher
25%
177
Real Rate after Taxes formula:
[1 + Nominal Interest Rate(1 - tax rate)]/(1 + Inflation Rate) - 1
178
Interest earnings from coupons, plus any capital gain or loss are added together to give the ____ return on a bond investment
Total holding-period
179
The price or value of a bond is just the present value of the _______ to be received through the maturity date, using the current ___ interest rate for bonds that have approximately the same risk and maturity as the bond being priced
Coupons and principal
| Market
180
Zero-coupon bond pricing formula:
Bond Price = PV(Principal)
181
Regular coupon-bearing bonds pricing formula:
Bond Price = PV(Coupons) + PV(Principal)
182
Suppose you have a Treasury Bond with $1000 principal that pays a 6% annual coupon and has 10 years to maturity. If the annual interest rate in the market is 6% for other bonds of similar risk and maturity, what is the present value or price of the bond? Assume coupons are paid annually.
Bond Price = PV(Coupons) + PV(Principal)
Bond Price = 60[1-(1.06)^-10] / .06 + 1000/(1.06)^10
Bond Price = $442 + $558 = $1000
183
The longer the maturity of a bond, the _____
Greater the interest rate risk
184
Safer investment
Short-term or long-term bond?
Short-term
185
The weighted average of the times to receipt of each cash flow on the bond, with weights equal to the proportion of the total value attributable to that individual payment
Duration (Macaulay Duration)
186
Duration is higher when coupon rate on the bond is ___
Lower
187
A lower coupon rate means that the bond's cash flows are more _____, and hence the PV-weighted average cash flow receipt is longer
"back loaded"
188
Duration decreases as ___ increases
YTM
189
Measures wholesale rather than retail prices, and the GDP price deflator
Producer Price Index (PPI)
190
When inflation increases or is expected to increase, what else increases?
Interest rates
191
If interest rates do not keep up with inflation, people will spend their savings or buy..
Other "hard" assets such as real estate or gold
192
Higher expected inflation generally leads to ___ bond prices
Lower
193
Measures the total output of the U.S. economy
GDP
194
If real GDP declines for two quarters in a row, the economy is said to..
Be in a recession
195
With higher interest rates in the market, the prices of existing bonds..
Go down
196
Treasury bond investors typically ___ when the economy worsens, and ___ when the economy improves
Book a profit
| Book a loss
197
Treasury bond investors earn capital gains when..
Treasury yields fall
198
Lower bond price = higher ___
YTM
