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CFP Exam Prep > Fundamentals of Investments _ Portfolio Theory > Flashcards

Fundamentals of Investments _ Portfolio Theory Flashcards

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1
Q

How do you determine an investor’s margin position and equity position relative to margin?

A

Margin Position = Equity / FMV

Equity = Stock Price - Loan

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2
Q

What formula is used to determine the price the investor will receive a margin call?

A

Margin Call = Loan / (1 - Maintenance Margin)

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3
Q

How do you determine the equity an investor must contribute with initial margin vs. maintenance margin?

A

Required Equity = Current Stock Price X Maintenance Margin

Actual Equity = Current Stock Price - Debt

Debt = Initial Stock Price X (1 - Margin Requirement)

Contribution = Required Equity - Actual Equity

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4
Q

For Research Reports, how does the Value Line and Morningstar rank securities?

A

Value Line
- ranks STOCKS on scale of 1 to 5 for timeliness and safety
- 1 is the highest ranking (BUY SIGNAL)
- 5 is the lowest ranking (SELL SIGNAL)

Morningstar
- primarily ranks MUTUAL FUNDS
- 1 star is lowest ranking
- 5 star is highest ranking

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5
Q

What is the difference between the ex-dividend date and the date of record?

A

Ex-Dividend Date = date the stock trades without the dividend
- one business day before the date of record
- sell stock on ex-dividend date, receive the dividend
- buy the stock on or after the ex-dividend date, NO DIVIDEND

Date of Record = date which you must be a registered shareholder to receive the dividend
- investor must purchase stock 2 business days prior to the date of record to receive dividend

** DIVIDEND RECEIPT investor must purchase prior to ex-dividend date or 2 business days before the date of record

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6
Q

What is the Securities Act of 1933?

A

Regulates new securities issues (Primary Market)

Requires new issues have prospectus before purchase

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7
Q

What is the Securities Act of 1934?

A

Regulates the secondary market and trading of securities

Created the SEC to enforce compliance w/ security regulations and laws

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8
Q

What is the Investment Company Act of 1940?

A

Authorized the SEC to regulate investment companies

3 types of investment companies:
1. Open
2. Closed
3. Unit Investment Trusts

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9
Q

What is the Investment Advisers Act of 1940?

A

Required investment advisors to register w/ the SEC or state

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10
Q

What is the Securities Investors Protection Act of 1970?

A

Established SIPC to protect investors for losses resulting from brokerage firm failures

Does not protect investors from incompetence or bad investment decisions

Protects accounts member firms open for clients regardless of the client’s citizenship

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11
Q

What is the Insider Trading and Securities Fraud Enforcement Act of 1988?

A

Defines an insider as anyone w/ information that is not available to the public

Insiders cannot trade on that information

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12
Q

What are the different money market securities?

A

Treasury Bills
Commercial Paper
Bankers Acceptance
Eurodollars

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13
Q

What are key characteristics of Treasury Bills?

A

Issued in varying maturities up to 52 weeks

Denominations in $100 increments thru Treasury Direct up to $5M per auction. Larger amounts available thru competitive bid.

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14
Q

What are key characteristics of Commercial Paper?

A

Short-term loans between corporations

Maturities of 270 days or less, does not require SEC registration

Has denominations of $100,000 and are sold at a discount

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15
Q

What are key characteristics of Bankers Acceptance?

A

Facilitates imports/exports

Maturities of 9 months or less

Can be held until maturity or traded

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16
Q

What are key characteristics of Eurodollars?

A

Deposits in foreign banks that are denominated in US dollars

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17
Q

What does the Investment Policy Statement (IPS) establish?

A

“RR TTLLU”

Risk
Return
Taxes
Time-line
Liquidity
Legal
Unique circumstances (to the client)

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18
Q

What are the key market averages and indices?

A

DJIA
- the only simple price-weighed average
- no market capitalization included

** all others are value-weighted indices

S&P 500
- uses market cap into the average

Russell 2000
- index of the SMALLEST market cap stocks in the Russell 3000

Wilshire 5000
- broadest index, measures performance of > 3,000 stocks
- has not had 5,000 stocks since DEC 2005

EAFE
- tracks stocks in Europe, Australia, Asia and the Far East

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19
Q

What are the four basic premises of Traditional Finance?

A
  1. Investors are Rational
    - logic, goal-based, free from emotion and irrationality, all info available
  2. Markets are Efficient
    - stock price reflects all relevant info
    - stocks trade at FMV at all times
  3. The Mean-Variance Portfolio Theory Governs
    - investors choose portfolios by viewing and evaluating mean returns and variance for their entire portfolios
  4. Returns are Determined by Risk
    - CAPM theory links return and risk for all assets by combining a risk-free asset with risky assets from an efficient market
20
Q

Define the following Behavioral Finance Biases:

  1. Affect Heuristic
  2. Availability Heuristic
A

Bias 1
- Deals with judging something, whether it is good or bad.
- Do they like or dislike some company based on non-financial issues.

Bias 2
- When a decision maker relies upon knowledge readily available by memory
- May cause overweighting due to recent events or patterns while ignoring longer term trends

21
Q

Define the following Behavioral Finance Biases:

  1. Anchoring
  2. Bounded Rationality
A

Bias 1
- attaching or anchoring one’s thoughts to a reference point even though there may be no logical relevance or pertinence to the issue in question
- known as conservatism or belief perseverance

Bias 2
- rationality limited by available information, the tractability of the decision problem, the cognitive limitations of their minds, and the time available to make the decision
- seek satisfactory solution instead of optimal solution

22
Q

Define the following Behavioral Finance Biases:

  1. Confirmation Bias
  2. Cognitive Dissonance
A

Bias 1
- “you don’t get a second chance at first impressions”
- people tend to filter info and focus on info supporting their opinions

Bias 2
- tendency to misinterpret info that is contrary to an existing opinion or only pay attention to info supporting an existing opinion

23
Q

Define the following Behavioral Finance Biases:

  1. Disposition Effect
  2. Familiarity Bias
A

Bias 1
- known as Regret Avoidance or “faulty framing”
- normal investors do not mark stocks to market prices
- investors create mental accounts when they buy stocks and continue to mark their value to purchase prices even after market prices have changed

Bias 2
- investors tend to overestimate / underestimate investment risk with which they are unfamiliar / familiar

24
Q

Define the following Behavioral Finance Biases:

  1. Gambler’s Fallacy
  2. Herding
A

Bias 1
- investors often have incorrect understanding of probabilities that can lead to faulty predictions
- investors may sell stock when it has been successful in consecutive trading sessions because they may not believe the stock will continue the upward trend

Bias 2
- cognitive bias
- people tend to follow the masses or the “herd”

25
Q

Define the following Behavioral Finance Biases:

  1. Hindsight Bias
  2. Illusion of Control Bias
A

Bias 1
- looking back after the fact is known and assuming they can predict the future as readily as they can explain the past

Bias 2
- tendency for people to overestimate their ability to control events

26
Q

Define the following Behavioral Finance Biases:

  1. Overconfidence Bias
  2. Overreaction
A

Bias 1
- usually concerns an investor that listens mostly to himself or herself
- mostly rely on their skills and capabilities to do their own homework or make their own decisions
- causes many investors to overstate their risk tolerance

Bias 2
- common emotion towards the receipt of news or information

27
Q

Define the following Behavioral Finance Biases:

  1. Prospect Theory
  2. Recency
A

Bias 1
- provides that people value gains and losses differently and will base their decisions on perceived gains rather than perceived losses
- investors get less utility from gains vs. losses
- explains why people over insure against risks thru low deductibles

Bias 2
- giving too much weight to recent observations or stimuli

28
Q

Define the following Behavioral Finance Biases:

  1. Affect Heuristic
  2. Similarity Heuristic
A

Bias 1
- Deals with judging something, whether it is good or bad.
- Do they like or dislike some company based on non-financial issues.

Bias 2
- used when a decision or judgment is made when an apparently similar situation occurs even though the situations may have very different outcomes

29
Q

What is standard deviation relative to an average?

A

1 std dev = 68% of average

2 std dev = 95% of average

3 std dev = 99% of average

30
Q

What does coefficient of variation (CV) measure?

A

useful in determining which investment has more relative risk when investments have different average returns

tells us the probability of actually experiencing a return close to the average return

the higher the CV the more risky the investment per unit of return

CV = standard deviation / average return

31
Q

What is kurtosis, what does it measure, and what are the two types?

A

kurtosis = variation of returns

little variation of returns, distribution will have a high peak or positive kurtosis (e.g., Treasuries)

widely dispersed returns, have a low peak or negative kurtosis

Leptokurtic = high peak and fat tails (higher chance of extreme events) THINK LEAP

Platykurtic = low peak and thin tails (lower chance of extreme events) THINK PLATEAU

32
Q

What does covariance (COV) measure?

A

the measure of two securities combined and their interactive risk

measure of RELATIVE risk

how price movements between two securities are related to each other

33
Q

What is correlation and correlation coefficient in relation to covariance?

A

Correlation and covariance measure movement of one security relative to another security

Covariance and correlation coefficient are both RELATIVE measures

Correlation ranges from +1 to -1, strength and direction of two assets relative to each other

+1 denotes perfectly positively correlated
-1 denotes perfectly negatively correlated

33
Q

Systematic Risk vs. Total Risk

A

Beta = market or systematic risk
* can be calculated by dividing the security risk premium by the market risk premium

Standard Deviation = total risk

34
Q

What Coefficient of Determination or R-Squared measure?

A

how much return is due to the market or what % of a security’s return is due to the market

calculate r-squared by squaring the correlation coefficient

provides insight into how well-diversified a portfolio is

the higher the r-squared the higher percentage of return from the market (systematic risk) and the less from unsystematic risk

r-squared > 0.70, beta is an appropriate measure of risk

less than 0.70 use standard deviation to measure risk

35
Q

What is PRIME?

A

Systematic risks

Purchasing power risk
Reinvestment rate risk (mostly impacts bonds)
Interest rate risk
Market risk (short-term for all securities)
Exchange rate risk

36
Q

What are Unsystematic Risks?

A

Remember ABCDEFG

Accounting
Business
Country
Default
Executive
Financial
Government/Regulation

37
Q

What do the Indifference Curves look like for Risk Averse vs. Risk-Seeking investors?

A
38
Q

What is the Capital Market Line (CML) formula?

A

uses standard deviation to measure risk

39
Q

What is the Capital Asset Pricing Model (CAPM)?

A

calculates the relationship of risk and return of an individual security

uses Beta as measure of risk

often referred to as the Security Market Line (SML)

return above SML = UNDERVALUED ==> BUY

return below SML = OVERVALUED ==> NO BUY

40
Q

What does Information Ratio measure and how?

A

RELATIVE risk-adjusted performance

the excess return and the consistency provided by a fund manager relative to a benchmark

the higher the excess return (or IR) the better

can be positive or negative depending on the fund’s performance relative to its benchmark

formula std dev is tracking error of active return (std dev of the difference between portfolio and index returns)

41
Q

What does Treynor Index measure and how?

A

risk-adjusted performance, “RELATIVE” indicator, one Treynor ratio needs to be compared to another

measure of how much return was achieved for each unit of risk

higher the ratio the better because that means more return was provided for each unit of risk

42
Q

What does Sharpe Index measure and how?

A

measure of portfolio performance using a risk-adjusted measure that standardizes returns for their variability

“RELATIVE” indicator, one Sharpe ratio needs to be compared to another one

higher is better

measures portfolio risk premiums relative to total portfolio risk

43
Q

How is the Jensen Model Index or Jensen’s Alpha differ from Sharpe and Treynor measurement?

A

Jensen’s Alpha is capable of distinguishing a manager’s performance relative to the market

Jensen’s model measures ABSOLUTE performance on a risk-adjusted basis

Positive alpha indicates fund manager provided more return vs. risk undertaken

Negative alpha is less return and zero alpha is equal return vs. risk undertaken.

44
Q

Which risk-adjusted performance measurement is appropriate to use and when (Sharpe, Treynor, Alpha)?

A

Both Treynor and Alpha use Beta as measure of risk. Use either when considering a diversified portfolio.
- Diversified when r-squared >= 0.70

When r-squared <= 0.70, standard deviation is appropriate measurement of risk == use Sharpe

45
Q

Summary of Portfolio Performance Measures

A

** If exam doesn’t give you R-squared, the select Sharpe **

CFP Exam Prep (21 decks)

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