FINAL Flashcards
Weeks 11-15
Bond Price Relationship
interest rates and bond price have an inverse relationship
Bond Price Movements
- Maturity (longer maturity = greater price sensitivity)
- Coupon (lower coupon = greater price sensitivity)
- Initial YTM (lower YTM has greater price sensitivity, greater PV of cash flows, higher duration)
Bond with a Warrant
warrant = give holder the right to buy a fixed number of stocks at a predetermined price by a certain expiration date.
Pricing = straight value of bond + market value of warrant
Convertible Bond
Convertible bond gives holder the right to convert the par value of the bond to common stock at a pre-determined price (conversion) by a certain date.
conversion ratio = par value of bond/ per-share conversion price
Macaulay’s Duration
weighted average time before the owner of the bond receives half of the present value of the bond’s cash flows
- based on maturity date, timing of intermediate and ending cash flows and YTM
Portfolio Duration
weighted duration of each bond in the portfolio
Duration vs Modified Duration
duration is a measure of how sensitive a bond is to changes in interest rates. modified duration quantified the bond’s price sensitivity to a change in interest rates
modified duration = duration (1+y)
Expected $ Change in Bond Price
$ change = -modified duration * change in y * bond price
% change = -modified duration * change in y
Limitations of Modified Duration
only considers changes in interest rates, assumes a linear relationship; therefore, only accurate for small interest rate changes
Convexity of the Price Change
duration is a good measure of price change for small interest rate changes but less accurate for larger moves. prices appreciate more than calculated with duration alone, when yield decreases
Convexity and Callable Bonds
price appreciation is capped with callable bonds because the company can call at a premium and refinance. price appreciation is capped with mortgages because holders can refinance.
Bond Characteristics
bond portfolios can provide the investor with a range of risk and return characteristics.
returns: coupon payments, accrued interest with zero coupon bonds, capital appreciation/loss
risks: changes in interest rates, credit-rating changes, default risk, liquidity risk, call risk, pre-payment risk
Bond Index Investing
create portfolio that replicates a bond market index, portfolio does not necessarily have to match the exact index but rather closely match characteristics
Cash Flow Matching
matching the bond’s maturity to when the liability is due. minimizes risk that interest rate moves would reduce the future value of the bond
Portfolio Immunization
matching the duration of bond portfolio with the investment horizon of the future liability or duration of liabilities. balances the overall effect of interest rate moves.
Active Bond Management
open account with firm offering individual bonds, research (type of bond, coupon rate, etc), interest rate anticipation, yield curve strategy, sector rotation (over or under weighting sectors), credit analysis (front-running a credit upgrade or downgrade)
Bond Swaps (active management)
- maturity swap (sell bond and buy another to alter overall maturity of portfolio)
- quality swap (sell bond and buy another to alter the overall quality rating of the portfolio)
- yield swap (swap bond to improve yield)
- tax swap (sell one bond and buy another similar yet different bond to harvest capital loss and offset capital gain up to $3,000 of ordinary income)
Formula Bond Investing
Bond Ladders: staggered maturity dates
Bond Barbells: average maturity based on portfolio of short and long term bonds
Bond Bullet: staggered purchase date with same maturity
Riding the yield curve: duration of bond portfolio exceeds duration of liability
Capitalized Earnings
normalized earnings divided by an appropriate capitalization rate
Preferred stock valuation
price of preferred stock = dividend/k (rate)
Dividend Discount Model
D1 = D0 (1+g)
Constant growth DDM = D0(1+g)/(k-g)
Reversion to the Mean
stock prices tend to trade above and below intrinsic value because of market sentiment
Bottom-up vs Top-down
bottom-up: individual securities to sectors/industries to economy
top-down: reverse order
Fundamental Analysis
- Economic and Industry Prospects (macroeconomic analysis, seasonality and cycles, industry prospects and trend projections)
- Company Operational Analysis (financial statements, ratio/trend, company prospects)
- Valuation (TVM, market multiples)
Intangible Assets
People, relationships, infrastructure, knowledge
Ratio Analysis
Provides for meaningful comparisons based on SEC industry code and company size
Liquidity Ratios
Current ratio: current assets/current liabilities
Quick ratio: (current assets - inventory)/ current liabilities
Working capital: current assets- current liabilities
Coverage Ratios
times interest earned: operating profit (EBIT)/ interest payment
Leverage Ratios
Debt to equity: debt/equity
Debt to assets: debt/assets
Asset Utilization Ratios
Account Receivable Turnover: sales/((begin receivables+end receivables)/2)
Average Sales Credit Period: days in year/turnover ratio
Management Performance Ratios
Return on Assets: net income/assets
Return on equity: net income/ equity
Profitability
Gross Profit Margin: GP/Revenue
Operating Profit Margin: EBIT. Revenue
Net Income Profit Margin: Net income/ revenue
Dupont Analysis
expanded return on equity equation
2-lever model: ROE=ROA (NI/assets)/Financial Leverage (total assets/equity)
3-lever model: ROE = profitability (NI/sales)asset turnover (sales/assets) financial leverage
Dividend Policy
Board of Directors Establish dividend policy
payout ratio = total dividends paid/ total earnings
Retention (plowback ratio) = 1-payout ratio
Dividend Growth
contingent on company’s return on equity and plowback ratio
dividend growth = ROE * (1-payout ratio)
Valuation
- replacement value
- TVM
- market multiples
value isn’t a number, it’s a range
Technical Security Analysis
everything the market knowns is already contained in price action of the stock
1. Price (trend lines, moving averages, price oscillators)
2. Volume
3. Patterns
4. Time (cycles)
5. Sentiment
Contrarian Thinking: percentage of bullish advisors, mutual fund cash positions, market reaction to news, overbought or oversold indicators
Gross Domestic Product
total production within the U.S., indicator of economic health
GDP = C (household consumption) + I (business investment) + G (government spending) + NE (net exports)
Business Cycle
cyclical pattern of general level of economic activity (GDP): expansion, peak, contraction, trough
Yield Curve Changes
graphical representation showing the relationship between YTM and term to maturity. Changes in yield curve reflect change in expectations
Market Cycles
Business Cycle: recurring patterns of boom and bust economic activity measured by GDP growth or contraction
Financial Cycle: recurring pattern of expansion/recession in financial markets. tends to precede business cycle by 6-12 months
Sector Rotation
active strategy of over and under weighting sectors based on economic and market cycle analysis
Cyclical vs Defensive Industries
cyclical: tend to outperform during times of macro-economic expansion and peak
- ex: basic material and consumer cyclicals (lodging, auto, retail, airlines, real estate)
defensive industry: do well during recession
- ex: consumer non-cyclicals (food, lodging, healthcare, utilities)
Pooled versus Individual Investments
advantages with pooled investing (fund or ETF)
- broad diversification on low-dollar investment, professional management, high liquidity, automatic reinvestment of interest and dividends
advantages with individual investments
- total control of buy and sell decisions, ability to sell short, no management fees, liquidity varies, speculation with options and futures
Passive Equity Strategy
purchase a diversified portfolio of securities with intent of long-term investing, believe markets are efficient, low fees/time spent
- ex: buy and hold, indexes (basket of securities, low costs), smart beta indexing (non-market capitalization weighting), low portfolio turnover, passively-managed funds
Active Equity Strategy
market is inefficient, out-perform, high fees/trading costs
- ex: individual security selection, sector rotation, value or growth investing, factor investing, ESG investing
Combination of Passive/Active
Satellite approach (key passive index and many smaller active investments)
Dollar-cost-averaging
fixed dollar investment at specified intervals, automatic investment plan, more shares purchased when share price is low, fewer purchased when price is high
Dividend Reinvestment Plan
dividends are automatically reinvested in the company’s stock, no additional costs, application of dollar-cost-averaging, reinvested dollars are taxed in year they could have been taken out
Margin Accounts
offers trading leverage, pays interest on margin loan, security is pledges as collateral, margin account agreements
maximum leverage depends on initial margin % set by federal law, broker-dealer
- minimum account balance ($2,000 or 100% purchase price)
- initial margin %
- maintenance margin (set by broker-dealer), if account fails, margin call
maintenance call = (1-50%)/*1-maintenance margin) * initial stock price
Short Sales
margin rules apply, broker retains proceeds from the short sale and marked to market each day
Qualified Stock Dividends
a qualified dividend is income treated as a long-term capital gain: qualifying companies (dividends from domestic and certain foreign companies that meet IRS definition) and minimum holding period for common stock dividends (more than 60 days out of 121-day period. 91 days out of 181 for preferred stock)
Worthless Security Rule
treated as a capital loss, assumes sale was made on last day of the year
Wash Sale Rule
Stock or other investment security is sold at a loss and repurchased a substantially identical security within 30 days before or after the sale.
- losses are not recognized for tax purposes
- adjusted basis reflects repurchase price plus loss realized on date of sale
- holding period for replacement stock includes holding period of original sales
Taxable vs Tax-advantaged Accounts
Taxable: municipal bonds, US T-bills, note and bonds, growth stocks with long-term capital gains
Tax-advantaged: high-income producing assets, short-term stocks, zero coupon bonds, TIPS
Call Option
Buyer: right to buy (believe market will increase)
Seller (write): obligation to sell (believe market will decrease)
Put Option
Buyer: right to sell an asset (believe market will increase)
Seller (write): obligation to buy
Buyer pays a premium to writer to secure right
Option Clearing
listed options - standardized contracts traded on exchanges. clear through options clearing corp (OCC). options are standardized.
over-the-counter options: not listed on exchanges, lack the standardization and clearing house intermediary
Option Contracts
strike price: (price which the call buyer can buy, price at which the put buyer can sell)
premium cost: (price per share buyer must pay writer)
expiration date: (date that the right no longer exists)
type of contract: (call or put)
Traditional Options vs LEAPS
traditional options: expires within 6 months, liquid, available on many underlying securities
LEAPS: long-term equity anticipation securities have expiration dates out to 3 years, limited in respect to number of underlying securities, often illiquid
Cost of the Option Premium
value of an option is dependent on five factors:
1. current price of asset
2. strike price
3. time to expiration
4. volatility
5. risk-free interest rate
European vs American Options
European option: grants option holder right to exercise only at a specific time
American option: grants the option holder the right to exercise anytime up to expiration date, flexibility will result in higher premium
Option Settlement
Stock & ETF option: security delivered, settlement is made by delivering appropriate number of shares
Index option: cash settlement, index-based options are settled in cash
Premium’s Intrinsic and Time Value
Intrinsic value: current value of the option
Time value: amount investor will pay for the likelihood that the option will be in-the-money before expiration
Writing Call and Put Option
writer benefits from receipt of the premium; however, if the option is exercised then there can be a loss
- maximum gain is the premium received
- maximum loss depends on the type of position
- covered call/put: max loss is limited since security already owned
-uncovered (naked) put/call: max loss for uncovered call if infinity. max loss for naked put is the difference between strike price and zero.
Characteristics and Risks of Standardized Options
broker-dealer offering the options account is required to send investor the ODD
- Options disclosure document explains characteristics and risk of standardized options
- options account must be approved by the registered options principal at the firm
Forward versus Futures Contract
Forward: agreement between two parties, one party agrees to buy and second party agrees to deliver
Future: standardized forward contract that gives buyer right to buy/sell, clearing house, contract can be sold on secondary market before delivery date, settled in cash
Long Option vs Future
Long the Option
Pro: buyer has right, max loss is premium, variety of premiums, unique combos to create payoff pattern
Con: time decay, bid-ask premium spread, lower liquidity, options not available on all securities
Long the Future
Pro: direct move with price of commodity, no time decay, highly liquid contracts, contract multiplier much higher than stock option
Con: rapid price changes, must maintain margin, futures must be settled at expiration or position closed prior
Payoff Strategy
Protective put: long the stock, long the put
Collar: long the put, long the stock, short the call
Buy Straddle: long the call, long the put
Sell Straddle: short the call, short the put
Strangle: long the call, long the put
Covered Call: payoff pattern for the covered call writer
Factors impacting premiums
- strike price
- time to expiration
- implied volatility
option selection: your outlook on the market, risk tolerance
Potential Benefits of Alternative Investments
enhanced risk-return relationship: possibility of alpha, reduce portfolio risk, improved portfolio diversification
introduction leverage into portfolio
Characteristics of Commodities
volatility of return
- supply and demand, storage and delivery, scarcity
ways to invest in commodities
- purchase commodity, purchases shares in commodity company, futures indexes, mutual funds, ETFs, hedge funds
Collectibles
items held for appreciation
categories: artwork, sculptures, antiques, memorabilia, wine, automobiles, tangible property, stamps, coins
characteristics: illiquid market, asynchronous information, subjectivity with valuations
ST = ordinary tax rate
LT = 28% capital gain rate
Managed Futures
pooled investments managed by professional commodity trading advisers, trade future contracts, active management, high fees plus performance incentives, high volatility of return, uncertain correlation with traditional assets
Real Estate Investment Trust (REITs)
publicly-traded, closed-end investment companies listed on stock exchanges or over the counter, liquid
- equity REITs, income REIT, hybrid REIT
highly predictable cash flows
Real Estate Mortgage Investment Conduits (REMICs)
pooling and securitization of commercial and residential mortgages, offers flow-through treatment, form of collateralized mortgage, distribution tranches, illiquid
Real Estate Limited Partnerships (RELPs)
pass-through entities that pool money to invest in residential and commercial properties, income is considered passive to LPs
- general partners: day-to-day operational decisions
- limited partners: passive investors, share in income and capital appreciation
generally high commissions and management fees, lack of liquidity, due diligence
Master Limited Partnerships
publicly-traded limited partnership, liquidity as traded on stock exchanges, invest in natural resources and energy, general and limited partners, required to receive pass-through tax treatment
Hedge Fund Strategies
alternative classes, arbitrage, sectors, country, fixed income, contra funds, market timing, special situations
Hedge Fund Characteristics
incentive fee, illiquid, lockup period, minimal regulatory oversight, business entity, exempt from SEC, limited to accredited investors
Hedge Fund Due Diligence
understand investment, fund governance, investment strategy and risk controls, use of leverage, fee structure and performance incentives, investment minimums, withdrawal options, research management team, historical performance, references
Venture Capital
non-publicly-traded investment companies, pool investor capital to invest in a portfolio of start-ups, realizing only a small number will succeed, venture capital investors have an exit strategy
angel investors: seed funding for early-stage development
venture equity firms: start-up through emerging operations and expansion
venture debt firms: provide bridge loans until next stage of equity funding
Private Placement Debt
non-public debt security, no SEC registration, qualified institutional buyers (>$100M)
- speed to market, avoid underwriting costs, negotiated terms and schedules, higher interest rates, lack of liquidity
Private Placement Equity
non-public placement of equity, pooled investments, venture capital and buyout groups, investors offer limited partnership, LT investment with cash-out plan, fees and expenses
Private Equity “Evergreen Funds”
open to accredited investors, actively managed funds, no fixed end date, diversification, general/limited partners, no lock-up, minimum investment low, need due diligence
Investment Policy Statements
describes investment course of action, aligned with client’s values and goals. formalized during times of calm decision-making. written document, promotes clarity, written agreement.
1. communicate your core investment tenants
2. allowable asset classes/target allocations & investment assumptions
3. permitted vs excluded security types
4. trading discipline/execution
5. selection criteria (due diligence)
5. distributions, reinvestment and contributions
6. benchmarks: identical in asset class, representative of style and region, passively managed, open to new investors
7. maintain asset allocation, rebalancing rules
8. communicate: format of report and frequency of communication
