Investment Flashcards
What is Unsystematic Risk?
Known as Diversifiable Risk, may also be referred to a Non-systematic Risk.
- Business Risk: Refers to the nature of the firm’s operations (i.e., possibility of loss due to new technology)
- Financial Risk: Refers to how the firm finances its assets (i.e., the possibility of loss due to heavy debt financing)
What is Systematic Risk?
Also known as Non-Diversifiable Risk.
- This part of risk is inescapable because no matter how well an investor diversifies, the risk of the overall market cannot be avoided.
What are the Types of Systematic Risk?
- Purchasing Power Risk: Loss of purchasing power through inflation.
- Reinvestment Risk: Risk that proceeds available for reinvestment must be reinvested at a lower interest rate than the instrument that generated the proceeds.
- Interest Rate Risk: The risk that a change in interest rates will cause the market value of the fixed income security to fall.
- Market Risk: Risk of the overall market
- Exchange Rate Risk: Risk associated with changed in the value of the currency.
Study Hint: Remember P.R.I.M.E.
FDIC Insured Amounts (per bank/per type of account)
- Individual: $250k
- Joint (per owner): $250K
- Trust (per beneficiary): $250k
- IRA/Keogh: $250k
The Yield Ladder
Discounted Bonds (Yields Higher than coupon)
Yield to Call
Yield to Maturity
Current Yield
Nominal Yield (Annual Coupon Rate)
Current Yield
Yield to Maturity
Yield to Call Premium Bonds (yields lower than coupon)
What are the provisions of EE Bonds?
- Non-marketable, Non-transferrable, can’t be used for collateral
- Sold at Face Value
- Interest Rate based on 10 yr Treasury Note Yields
- Fixed Interest Rate that is in effect at the time of purchase
- Subject to federal taxation when redeemed, unless used as education bonds
- Not subject to state or local taxes
What are the provisions of I bonds?
- Non-marketable, non-transferrable, can’t be used for collateral
- Sold at Face Value
- Interest Rate is composed of two parts:
- A Fixed Base Rate (remains the same for the life of the bond)
- An Inflation Adjustment (adjusted every 6 months)
- Subject to federal taxation when redeemed (unless used as education bonds)
- Not subject to state or local taxation
What are the Types of Municipal Securities?
- General Obligation Bonds (GO Bonds): Backed by the full faith, credit and taxing power of the issuer. GO Bonds are generally considered the safest types of municipal credit.
- Revenue Bonds: Backed by a specific sources of revenue to which the full faith and credit of the issuer is NOT pledged. Because revenue bonds are backed by a single source of funds (like toll roads, hospitals, power plants, etc.), they have a greater credit risk than GO Bonds. As such, they trade at higher yields.
- Insured Municipal Bonds: The insurers pay timely interest and principal when the issuer is in default. Municipal bond insurers are AMBAC and MBIA.
What do Indenture Agreements Cover?
- Form of Bond
- Amount of Issue
- Property Pledged
- Protective covenant, including any provision for a sinking fund
- Working Capital and Current Ratio
- Redemption Rights
What are the Risks of Corporate and Municipal Bonds?
- Default: A creditor may seize the collateral and sell it to recoup the principal
- Reinvestment: As payments are received from an investment, interest rates may fall. When the funds are reinvested the investor receives a lower yield.
- Interest Rate: Rising interest rates may cause bond prices to fall
- Purchasing Power: Inflation may lower the value of bond interest payments and principal repayment, thereby forcing bond prices to fall.
Study Hint: Remember: D.R.I.P.
What are the Risks of Government Bonds?
RIP only! No default or credit risk.
What are the market values to define
Market Capitalizations of Companies?
- Large: > $10 billion
- Mid: $2-10 billion
- Small: < $2 billion
- Micro: < $300 million
American Depository Receipt (ADR)
- Prices of ADRs quoted in US dollars
- Dividends paid in US dollars
- Dividends declared in foreign currency
- Attain diversification and risk reduction due to lower correlation of foreign securities with US securities.
What is the NOI calculation for Improved Land/Real Estate?
Improved land is normally income producing.
Income properties include residential rental, commercial and industrial properties. The intrinsic value of a real estate property can be computed using a Net Operating Income (NOI) calculation.
Gross Rental Receipts plus Non-rental Income (laundry, etc.) equals Potential Gross Income (PGI) minus Vacancy and collection losses minus Operating Expenses (excludes interest and depreciation) = Net Operating Income (NOI)
What are General Definitions for Options?
- Intrinsic Value is the minimum price the option will command as an option. It is the difference betwen the market price and exercise price of the stock.
- Exercise Price is the price at which the stock can be purchased or sold on exercise of the option.
- Premium is the market price of an option. As the option approaches its expiration date the market price of the option (Premium) approaches its Intrinsic Value Time. Premium is the amount the market prices of an option exceeds its intrinsic value.
Study Hint: IV + TV = Premium
What is the Taxability of Call Options?
At the Time of Purchase: Non-deductible Capital Expenditure
To the Writer Due to Lapse: Premium received is a short-term gain
To the Writer Due to Exercise: Premium received is added to sale price (can be long term gain if underlying security was held more than 12 months, otherwise short term). Covered Call.
To the Holder: If the option is NOT exercised, then the option is considered sold (it expires) and it is a short-term loss. The option period is 9 months or less.
Define: Hedging Strategies - Straddles, Collar, Protective Put
Straddle: Buying a Put and Buying a Call - The buyer does NOT own the stock.
Collar: Selling a Call (out-of-the-money) at one strike price and buying a Put at a lower strike price; investor OWNS the stock.
Protective Put: Buying a stock (or already owning it) and a Put for the stock serving as insurance against the decline in the underlying stock. (Hint: A good answer for the exam)
Compare: Warrants vs. Call Options
- Warrants are issued by corporations, whereas Calls are issued by individuals.
- Warrants typically have maturities of several years.
- Warrant terms are not standardized. Call options are standardized.
What are the Hedging Positions of Futures Contracts?
Long Commodity Position: If a farmer is long a commodity (for example, corn) he needs a short hedge and will sell a futures contract.
Short Commodity Position: If Kellogs is short a commodity (for example, corn), they need a long hedge and will buy a futures contract.
Compare: Reg D Accredited vs. Non-Accredited Investors
Accredited (Unlimited):
- Net worth of $1 million or,
- Individual with income of $200,000 or,
- Couple with income of $300,000
Non-Accredited
- Issue sold to a maximum of 35 investors
- Must use a purchaser representative if not “sophisticated”
Coefficient of Determination R2
The square of the correlation coefficient measuring the proportion of the variation in one variable explained by the movement of the other variable.
How is R2 used on the exam?
It describes the percentage of a fund’s movement that are explained by the movements in the S&P 500.
Index funds/diversified funds based on the S&P 500 will have R2 of very close to 100%, while sector funds (not diversified) will have very low R2 (typically 5% - 25%).
Risk Level Quantification
Compare: Standard Deviation vs. Beta
Standard Deviation: Measures variability of returns used in a non-diversified portfolio and is a measure of total risk.
Beta: An index of volatility used in a diversified portolio and is a measure of systematic risk.
Geometric Return vs. Internal Rate of Return (IRR)
Geometric Return or Time-Weighted Return: Evaluates the performance of a portfolio manager.
IRR or Dollar Weighted Return: Compares absolute dollar amounts.
“Real” vs. Nominal Rate of Returns
Real: The inflation adjusted interest rate
Nominal: Actual returns not adjusted for inflation.
The “Real” rate is defined as the Nominal Rate of return adjusted for inflation.
Holding Period Return (HPR)
The total return (income plus price appreciation and dividends less margin interest) over the entire period divided by the out of pocket cost of the investment.
Taxable Equivalent Yield (TEY)
To make the returns on municipal bonds comparable to those of taxable bonds, the TEY can be calculated.
- TEY = Tax Exempt Yield / (1-Marginal Tax Rate)
OR
- TEY x (1-Marginal Tax Rate) = Tax Exempt Yield
Duration (Principles to Remember)
Years to Maturity: Remember duration and maturity are positively related
Annual Coupon: Remember duration is inversely related to coupon rate
YTM: The current yield on comparative bonds (duration is inversely related)
Remember, Coupon and Yield are Interest Rates - Inversely Related.
Zero Coupon Bonds
- Duration equal to Maturity
- No coupon interest, yet produces “phantom” income
- No reinvestment rate risk
- Sold at deep discounts to PAR
- Fluctuate more than coupon bond with the same maturities
Rules for using Duration to Manage Bond Portfolios
If interest rates are expected to rise, shorten duration (Interest rates up, shorten Duration)
Remember: UPS: UP for “up” and S for “shorten”)
If interest rates are expected to fall, lengthen duration. Buy low coupon bonds with long maturities.
Interest rates fall → lengthen duration.
Remember: FALLEN - FAL for “fall” and LEN for “Lengthen.”
Conclusions to Fluctuations in Bond Prices
- The smaller the coupon, the greater the Relative Price Fluctuation
- The longer the term to maturity, the greater the Price Fluctuation
- The lower the market interest rate, the greater the Relative Price Fluctuation
Convexity
- The degree which duration changes as the yield-to-maturity (YTM) changes.
- Largest for low coupon bonds, long-maturity bonds and low-YTM bonds allows investor to improve the duration approximation for bond price changes.
What is Return on Equity (ROE)?
ROE = Earnings Available for Common (EPS)
Common Equity (net worth or book value)
How to Calculate Dividend Payout Ratio
Dividend Payout Ratio = Common Dividends Paid divided by Earnings Available for Common (EPS)
What are three types of Efficient Market Hypothesis (EMH)?
Strong Form: Asserts that stock prices fully reflect all information, public and private. Not even access to inside info can be expected to result in superior investment performance over time. Neither fundamental analysis nor technical analysis can produce superior results over time on a risk-adjusted basis.
Semi-Strong Form: Asserts that all publicly known information is reflected in stock prices. Neither technical analysis nor fundamental analysis can produce superior results over time on a risk-adjusted basis. Only an investor with access to inside information may consistently achieve superior results (but such access is illegal)
Weak Form: Suggests that historical price data is already reflected in current stock prices and is of no value in predicting future price changes.
Technical analysis will not produce superior results. Fundamental Analysis may produce superior results.
Types of Indexes / Benchmarks
- PRICE WEIGHTED:
- *Dow Jones:** 30 industrial stocks
FLOAT WEIGHTED:
- S&P 500 (large caps): Broader measure of NYSE activity
CAP WEIGHTED
- NASDAQ: Broadest measure of OTC trading
VALUE WEIGHTED
- Wilshire 5000: Broadest measure of the activity and movement of the overall stock market
- Europe, Australia and Far East (EAFE): Equity performance of the major foreign markets
- POPULAR CAP WEIGHTED
- *Russell 2000 (small caps):** Smallest 2000 stocks of the Russell 3000 index
- EQUALLY WEIGHTED
- *Value Line:** ±1700 stocks
Barclays Aggregate Bond: More than 5000 US Government, corporate and mortgage backed and asset backed bonds.
Tax Basis of a Mutual Fund
First-in, First-out method treats shares acquired first as being sold first.
Specific ID requires the seller to identify the shares of the fund that are sold. Specific ID allows the investor to create gain, neutralize gain or create a loss (most flexible).
Average Cost allows the investor to divide the total cost of all shares held by the number of shares sold.
Steps to Risk-Adjusted Measures of Performance (Sharpe)
- Step 1: Look for a low R2 (less than 60), or a non-diversified portfolio.
- Step 2: Look for the highest Sharpe number.
Steps to Risk Adjusted Measures of Performance
Jensen (Alpha) / Treynor
- Step 1: Look for high R2 (60+) or a diversified portfolio.
- Step 2: Look for the highest positive Alpha. If no Alpha is given, then look for the highest Treynor.
What is a Margin (Maintenance) Call?
The formula for calculating when an investor will receive a margin call is:
- (1 - Initial Margin % ÷ 1 - Maintenance Margin %) x Purchase Price of stock
Shortcut: 2/3 of the purchase price if the minimum maintenance is 25%. If it’s 30%, take 2/3 and then choose the next highest number.
Examples of Passive Investment Strategies
- Buy & Hold (EMH)
- Dollar Cost Averaging
- Index Investing
- Strategic Asset Allocation (revised every few years)
Examples of Active Investment Strategies
- Market Timing
- Tactical Asset Allocation
- Technical Analysis
Arbitrage Pricing Theory (APT) Keys
- Unexpected Inflation
- Unexpected changes in industrial production
- Unanticipated shifts in risk premium
- Unanticipated changes in structure of yields.
Negotiable CDs
Interest rate Risk
Lack Liquidity
Money Market Deposit Accounts
FDIC insured
6 preauthorized transfers / month
(3 by check)
Money Market Mutual Funds
- Default Risk
- NOT FDIC insured
(some open ended funds offer insurance) - Can be taxable OR tax exempt (municipal debt)
- Holdings:
- T Bills
- Neg. CDs
- Prime Commercial Paper
- Avg Maturity 90 Days
T Bills
- Maturity ≤ 1 yr
- NO Default Risk
- NO Credit Risk
- Issued at Discount OR Face Value
- $100 to $1mm (discount yield basis)
- Not callable
- Subject to Federal income Tax (exempt from local and state)
- Auctioned WEEKLY
Commercial Paper
100k denomination
270 day (9 mth) maturity
Bankers Accptance
- Finances imports and exports
- Bearer securities
- ≤ 9 mth maturity
- Trades at Discount to face value
Eurodollars
Deposit on NON-U.S. bank in US$
Yankee Bonds
- US$ denominated Bonds issued in the US by foreight banks and corps.
- Issued during favorable market conditions in the US
Original Issue Discount (OID) Bonds
- Bonds issued far below par
- Zero Coupon
- Payno interest until maturity
- Accreted interest
- Taxable – creates PHANTOM income
- (NO ACCRETION for Muni Bonds)
Treasury STRIPS
(Separate Trading of Registered Interest and Principle Securities)
U.S. Govt Issued Zero Coupon Bond
TIPS
(Treasury Inflation Protected Protected Securities)
- Marketable
- Face Value adjusted semiannually with inflation
- Measured by CPI over 6 mths
- Lower stated coupon than treasuries
- higher infrlation higher FACE value with Fixed %
- $1000 denominations
- Taxed ANNUALLY on the Apprciation of face value (Phantom Income)
- Not collectible until bond matures
- Holder has option to RAISE BASIS
- Income taxable in the year accrued
EE Bonds
- 30 yr life (20yr + 10yr extended maturity); $50 denom.; Issued May 1 and Nov 1
- New Rate every 6 mths
- Interest accrues monthly; Owner has option of interest taxed each year
- Owner must be ≥ 24 yo
- Cannot be in UTMA or UGMA
- Grandparent may claim exclusion for student
- If held < 5yrs THEN 3 mth interest penalty
- Treasury GUARANTEES DOUBLING in 20 yrs
HH Bonds
WERE available by xchange of EE bonds
Used to pay interest semiannually by check
I Bonds
Inflation Indexed Accrual Securities
- Monthly Interest, compounded semi annually
- Owner has option to DEFER taxation of interest
- If used for Education, Tax Exempt
- No guaranteed interest rate
- 2 parts to interest
- Fixed: same for life
- Inflation Adjusted: every six months for inflation
- $50 denominations
Mortgage Backed Securities
GNMA
FNMA
FreddieMac
G = Govertment Guarantee
F = Fah-Cocked
GNMA
- Buys : FHA, VA ( Farmers Home ASsociation) mortgages; All insured from banks
- Pass throug certs
- DIRECT guarantee of US govt; NOT ISSUED BY TREASURY
- TAXABLE at FED and SALT
- Min : $25,000
- Risk
- NO Default Risk
- Interest Rate Risk
- Reinvestment Rate Risk
- Intrst goes up NO GOOD; stuck with lower market rates
- value MBS goes down
- Intrst goes down reinvestment risk
- Intrst stays flat prices fall when rates rise
- YIELD = interest + principal
- Intrst goes up NO GOOD; stuck with lower market rates
GO (General Obligation) Bonds
- SAFEST of bonds
- Backed by muni taxes
- issuer makes promise to raise taxes to pay
- bond holders can FORCE issuers to tax levy
Revenue Bonds
- Backed by Specific Revenue (unpledged revenue stream)
- SINGLE SOURCE FUNDS = GREATER RISK
- Higher Risk = Higher Yields
Insured Muni Bonds
(S&P AAA rated when Issued)
- Insured by:
- AMBAC (American Municipal Bond Assurance Corp)
- MBIA/National (Muni Bond INsurance Ass)
- BAM (Build America Mutual Insurance)
Mortgage Bonds
Safest of the safest CORP bonds
Backed by Real Property owned by issuer
CMO
Collateralized Mortgage Debt Obligations
- High REINVESTMENT rate Risk
- Developed to prevent Repayment risk
- Multi Class Pass Through Securities
- Payments rec’d are CASH FLOW
- Payments over life of pool
- Tranches A to Z (Fast repayment to Slow Repayment)
- Risk Level Increases A to Z
Debenture
Corporate debt backed by issuer integrity
Indenture
- Agreement btwn issuer and trustee of bond
- Parts: Form of bond (zero or coupon)
- Amt of issue
- Propety pledged (if NOT debenture)
- Protective convenant (incldg sinking fund provision)
- Working capital and current ratio
- Call, Put, Conversion provisions
- Redemption rights
Investment Grade Bonds DRIP
Government Bonds RIP
Zero Coupons IP
- Default
- Reinvestment risk (when Interest rates go down)
- Interest rate risk (when interest rates go up)
- Purchasing Power Risk (Inflation lowers value, yeld, interest rates)
Rating Agencies and Grades
StAndArd And Poors: AAA, AA, A BBB
Moody’s: Aaa, Aa, A, Baa
Speculative below BBB (Better Band Bonds)
BB = Band Bonds
High Yield Corporate Bonds
≤ BB rating are JUNK
Pay higher yield
seldom the right answer
Convertible Bonds
- Have embedded call option
- Trades at Premium
- Hybrid debt securities
- Pays interest
- may convert to common stock
- Market Price of Convert driven by Value of Stock and Bond Interest
- Has a FLOOR VALUE
Bond Conversion Price Formula
CV = (Par/CP)*Ps
CV = Conversion Value CP = Conversion Price Ps = Per Share Price
Callable Bonds
- Called when interest rates drop (or bond prices go up)
- cost to issuer is call premium
Put Bond
- Buyer sacrifices some yield for the privelege
- HOLDER CAN SELL BACK TO ISSUER
- If interest rates rise and bonds go down
STRIPS
Do Not distribute interest during holding period
Yankee Bonds
Issued by Foreign Bank in the US
Capitalization
Market Vaue of a Company
Large Cap > 10bn
Mid Cap ≥ 2bn < 10bn
Small Cap ≤ 300mm < 2bn
Micro Cap < 300mm
ADR
American Depository Receipt
- Receipts for shares of NON-US/foreign based issues
- Held by a U.S. bank
- Entitled to Dividends
- Paid in US$
- Declared in currency of origin
- Mostly Qualified
- No Voting Rights
Net Operating Income Real Estate Valuation Formula
+ Gross Rental Receipts
+ Non rental income
= Potential Gross Income (PGI)
- Vacancy and collection losses
= Effective Gross Income
- Operating Expenses
= Net Operating Income (NOI) (Property Cash flow NOT YOUR cash flow)
- Debt Service
= Before Tax Income (Your Cash Flow)
Cap Rate Formula
Intrinsic Value FMV = (NOI / Cap Rate)
Cap Rate = (NOI / Intrinsic FMV)
Formula Cap Rate and Intrinsic Value of Real Estate
Intrinsic Value FMV = (NOI / Cap Rate)
Cap Rate = (NOI / Intrinsic FMV)
GIC
Guaranteed Investment Contracts)
Similar to CDs but issued by Insurance Companies
Guaranteed Interest Rates
Value depends on the Financial Strength of Issuer
POPULAR in DEFINED BENEFIT PLANS
Real Estate General
Hedge against inflation
Low Correlation with US Stocks typically
Types of Real Estate Investments
-
Unimproved land
- PASSIVE
- No income or depreciation
- Return based on potential appreciation
-
Improved land
- Rental Income
- Residential, commercial, industrial
REITS General tax info
- No taxes at the corporate level
- holder pays ordinary income on dividends
- If no income need, good for deferred accounts
- CONDUIT INCOME
REITs Holdings
- Holdings:
- Govt Securities
- Commercial Property
- Real estate
- Short Term Construction loans
- mortgages
REITS Income requirements
- ≥ 75% REIT cinom from Real Estate
- 15% MAY come from securities
- If REIT DISTRIBUTES ≥ 90% of income THEN
- Taxed ONLY on Non Distributed portion
- IF REIT Does NOT distribute 90% THEN
- ALL NET investment income is taxed
ETFs
- Basket of Stocks
- Open or Closed
- Traded on exchange
- Tax Efficient
- May be UIT or Investment company
Unit Investment Trusts
- Unmanaged, passive
- Collects income, pepays principal
- Self Liquidating, rarely sold
- Redeemed at NAV
- Has UNIT holders not share holders.
Mutual Funds
Marked to Market
Marked to Market = total market value / shares outstanding
Mutual Funds
Features
Continuously issued (if open ended)
Redeemable (not tradeable)
Nonnegotiable
MF
Open Ended Investments
Shares are continuously shold
Capitalizaton continually changes
MF Closed End Investment Companies
Capitalization Caps Out (no new issues)
Traded on an exhanges
valued like a security
May Hold ILLIQUID securities (Illiquid securitis held by CEF do not have to be sold)
Types of Funds Openend or Closed End
- *Aggressive growth**: Invests in securities offering maximum capital appreciation.
- *Balanced**: Invests in both stocks and bonds for both appreciation and income not necessarily at a 50%/50% allocation.
- *Growth** Invests in securities offering potentially rising share price. Dividends are less important.
- *Growth and income** Invests in equity securities and seeks dividend income value.
- *Global equity** Invests in securities traded worldwide, including U.S. issues.
- *International** Invests in securities of companies located only outside the U.S.
- *Corporate bond** Invests in bonds of U.S. based companies.
- *GNMA** Invests in mortgage-backed securities.
- *High yield** Invests in non-investment grade corporate bonds (BB or lower) for greater potential interest income.
- *Municipal bond** Invests in bonds issued by states and other municipalities.
- *Specialty Invests** in securities in particular sectors such as technology.
Hedge Funds
Aggressively managed investment portfolio using
Advanced Strategies
- Leverage
- Long/short derivatives
- Domestic
- International
Goal: HIGH returns in Bull OR Bear markets, bull or relative to ta benchmark
Hedge Funds: Private investment Partnerships
- Limited # of investors
- Large Up Front Investment
- Illiquid, generally ≥ 1 year.
- Unregulated under $100mm
- Requires Sophisticated and Accredited (1,2,3) Investors
Hedge Funds
Finance Reform Bill
Hedge funds register with SEC if
AUM ≥ $100mm
This bill requires trading transparency
Business that may operate as Limited Partnerships
- Real Estate
- Oil and Gas Drilling
- Blind Pools
- Objective is known, but actual properties are not when LP is formed
Performance of GP is major consideration
Equity Reit Income =
Net Rental Income - Interest paid on loans
Mortgage Reit Income =
Spread between lending and borrowing rate
Reits cannot invest in…
Limited Partnerships
RELP
Real Estate Limited Partnership
- NOT publicly traded
- Illiquid
- Thin secondary market
- Last about 10-20 years or until all properties are liquidated
REMIC
Real Estate Mortgage Investment Conduit
- Limited Life
- Self Liquidating entity
- ONLY real estate morgates OR securities BACKED by real mortgages
- More flexible than CMOs
- Issuers can separate mortage pools by risk or maturitie
- CMOs have AAA bond ratings and REMICs have a range of risks
- REMICs may eventually replace CMOs
Option Forumulas
- Call ME Option Intrinsic Value = Market Price - Exercise Price
- Put EM Option Intrinsic Value = Exercise Price - Market Price
- Option Time Premium = Intrinsic Value - Market Price
Options: Key elements
Key elements of options include the following:
•Intrinsic value is the minimum price an option will command. It is the difference between the market price of the underlying asset and the exercise price of the option.
•Time premium is the amount the market price of an option exceeds its intrinsic value.
•Exercise price (strike price) is the price at which the stock can be purchased or sold on exercise of the option.
•Premium is the market price (cost) of an option. As the option approaches its expiration date, the market price of the option (the premium) approaches its intrinsic value.
Option Navigator
Call Option Taxation
≤ 9 mth Timeline of options
- If Lapsed
- Writer is taxed on prmium at STCG
- If Exercised
- Writer taxed on premium + sale price = LTCG
- If stock held ≥ 12 mths ELSE
- If Stock held < 12 mths THEN = STCG
- Writer taxed on premium + sale price = LTCG
LEAPS
Long Term Equity Anticipation Securities
Maturities > 2 years
Anticipated for LT market moves
e.g. S&P 500 Index is a useful hedge if funds mimic the S&P 500.
Futures Contract elements
Agreement btwn buyer and seller through a commodity exchange
- *Spot price**: The current market price of a commodity in the cash market.
- *Open interest**: The number of futures contracts trading for a particular commodity on any given day.
- *Daily limit**: The maximum permissible price increase or decrease relative to the settlement price on the previous day.
Types and elements of Futures
- Commodity
- Financial
- foreign currency
- Contracts require margin accounts. Subject to markgin calls to restore initial margin.
- Delivery means settlement
- Offset means buyers sell their position and sellersy by prior to delivery
- Speculating is very risky.
- Businesses use to hedge against business risk
- Long position held by the party who whats to buy (bullish)
- Short position held by the party who wants to sell (bearish)
Warrants – like an option BUT …
Issued by Coprations
Maturity in YEARS
Not standardized
NO INTRINSIC VALUE
Collectibles
Rare Objects (stamps, coins, rugs, antiques…)
- Typically risk in value during invlation
- Limited buy/sell market
- negatively correlated with financial assets
- can be used to diversify risk
- Taxed at 28% (LTCG rate for collectibles is 28%)
Natural Resources
Negatively correlated with the Stock market
If the supply of or demand for a commodity or other product is elastic, it is highly responsive to price changes.
Precious metals
Inflationhedge
The gold mutual fund = gold without the risks and some expenses associated with purchasing gold bullion
Precious metals are treated as collectibles for tax purposes. 28%
Reg D
Private Placement Memorandum
PPM
- Can be sold to a MAXIMUM OF
- 35 “non-accredited” investors (Must be Sophisticated) and
- an UNLIMITED # of accredite investors
- Exempt from registration
- Disclosures given to investors through “offering memorandum”
Accredited Investor
1-2-3
Net Worth ≥ $1,000,000 (not with residence)
Annual Income ≥ $200,000 (single); $300,000 (MFJ)
Sophisticated Investor
Investors must sign and investment letter OR
hire a personal purchaser representative (lawyer or accountant)
Dividend Growth Model
Do (1+g)
V = ——————
r - g
Systematic Risk
Measured by Beta
NonDiversifiable types of risk:
PRIME
Purchasing power: Inflation
Reinvestment Rate: investing at lower interest rates
Interest rate risk: Change in interest rates will cause security to fall (fixed income)
Market risk: OVERALL market – cannot be avoided
Exchange Rate risk: changes in value of currencies
UNsystematic Risk
Diversifiable
Can be reduced or elimiated
Business Risk: related to a firms operation
Financial risk (credit/default risk): how a firm finances its assets and operations
TOTAL Risk measure by Standard Deviation
Beta is systematic only
- Also called Portfolio Risk
- Combiation of Systematic and Unsystematic Risk
- Reduce through diversification
Use adiversified portfolio to eliminate the unsystematic (diversifiable) risk.
After the unsystematic risk is eliminated, what remains is the systematic risk.
Political Risk
aka sovereignty risk
risk that a foreign government will default on its loan or fail to honor business commitments because of a change in national policy.
Devaluation and Revaluation of Currencies relative to the other
Devalue: currency decreases
Revalue Increases
International currencys
investors achieve risk reduction because of lower correlation of foreign securities with U.S. securities
Foreign/NonDomestic Stocks
Exchange rate risk is constant with a foreign stock, bond, or mutual fund.
foreign stocks are first taxed in the country of origin, then again in the United States.
U.S. taxpayers generally receive a foreign tax credit
Foreign markets are usually less efficient than U.S. markets because fewer analysts follow the stocks.
Liquidity and Marketability
Liquidity is both transaction speed and stability of price.
Marketability refers to speed of transaction.
The CFP Board may look beyond the definition above by addressing whether or not the investment has a “market” on which it may be bought or sold.
Distributions: Normal and Lognormal
Normal: Mean is the most likely return, and it’s bell shaped
Lognormal: positively or negatively skewed (depending on where the tail is)
Covariance and Correlation Coefficient
Correlation coefficient and covariance express the extent to which the movements of stocks in the same portfolio are similar or not.
Covariance considers an infinite possibility of outcomes.
Correlation coefficient falls within a specific range
Correlation Coefficient formula
To determine the correlation coefficient of the returns in a portfolio on the exam, standard deviation of each security’s return and the covariance between the eturns on the securities are needed.
Correlation of Investments 1 and 0
Perfectly positively correlated securities have a relationship of +1.0. They move exaclty the same
IF the correl coeff of ij = 1, THEN
SD of the Portfolio = weighted avg of SDs of the two assets.
A correlation coefficient of 0.0 means there is no relationship between the price changes among these securities.
Perfectly negatively correlated securities have a value of -1.0 and risk is completely eliminated. It moves exactly opposite.
Coefficient of Variation
CV = Standard Deviation / Averge Return
Coefficient of Variation (CV) is a measure of relative variability used to compare investments with widely varying rates of return and standard deviations
Standard Deviation vs Beta
Standard deviation measures variability of returns used in a nondiversified portfolio and is a measure of total risk.
Beta measures volatility of returns used in a diversified portfolio and is a measure of systematic risk.
Standard Deviation above and below the mean
In a normal (bell-shaped) distribution,
68% of all results will fall within + one standard deviation of the average or mean
95% of all results will fall within two standard deviations, and
99% withing three standard deviations
Example of Calcuating range of results by standard deviation
EASY
Formula for BETA
Using Beta for Risk Adjusted returns
Beta coefficients can be used to standardize mutual funds for risk.
To standardize for risk, divide an individual fund’s realized return by its beta coefficient
Risk Adj Rate of Return (Standardized risk) = Fund Return / Beta
Simple Return = Arithmetic mean
Which is the average
Not a good measure of numbers that are %, such as returns
Compound Returns = Geometric Mean
AKA Time Weighted Return
measure of the change of wealth over multiple periods and How to calculate
- Add 1 to the returns expressed as a decimal, (for example, 25% becomes 1.25, 15% becomes 1.15,-12% becomes .88)
- Multiply the returns results of step 1
- The result of step 1 becomes the future value (FV)
- -1 is always the present value (PV)
- N is the number of years of the investment
- Use financial calculator to solve for i.
Why Use Geometric Mean
The main use of the geometric mean (time-weighted return) is to evaluate the performance of the portfolio manager
Time-weighted return
eliminates the effects of additions and withdrawals and their timing that distort dollar-weighted return
Dollar-weighted return
same as IRR/NPV
measures changes in total dollar value
additions and withdrawals of capital as part of the return along with income and capital gains and losses
Real rate of return aka inflation-adjusted interest rate
Real Rate of Return = [(1 + after-tax return / 1 + inflation) -1] x 100
1.infl [input] then 1.return then [shift %chg]
Nominal Return
given period computed without accounting for the purchasing power of the dollar inflation.
Total Return
annual return on an investment including appreciation or loss and dividends or interest.
Risk Adjust return
The return has been altered to account for the differences in risk among variables of the same type.
Holding period return (HPR)
HPR = total return / cost of investment
Weakness: If the time period of the investment is greater than one year, the HPR overstates the true annualized return. If it is less than one year, then it understates.
HPR = Selling price+div&Inc-purchase price
———————————————–
purchase price
Internal Rate of Return (IRR)
When is it good?
When the IRR is greater than the required return, the investment is acceptable.
Use Cfj – remember +/-
If comparing to known return … use i/yr after ALL cash flows entered
THEN NPV
Caluclate Current Yield of a Bond
Current Yield of a bond = Annual Interest $ / Bond’s Current Price
TEY
Taxable Equivalent Yield
Taxable Equivalent Yield = Tax Exempt Yield / 1 - tax rate
Bond Duration Relationships
of years goes Up=> Duration goes UP
Yield to Maturity goes Up => Duration goes DOWN
Coupon goes UP => Duration goes DOWN
Convexity goes up => Duration goes UP
Duration of a Zero Coupon = maturity
Shorter Duration Less Risk
Interest rate risk and reinvestment rate risk
Reinvestment risk is uncertainty about the rate at which future income can be reinvested.
Immunization
This passive investment strategy
to safeguard a bond portfolio against interest rate volatility.
Ifthe duration of the overall portfolio is equal to a preselected time horizon. This time horizon typically matches a financial planning goal
Change in Bond Prices and Formula
On sheet
Good for SMALL changes
△P = Change in Bond Price
△y = Change in Interest Rates
y = YTM
Bond price volatility guidelines
- When the coupon is smaller, the relative price fluctuation is greater
- When the term to maturity is longer, the relative price fluctuation is greater
- When the market interest rate is lower, the relative price fluctuation is greater
If interest rates rise buy high coupons with short maturities
UpS Shorten Maturities
DowN LeNgthen, loNger maturities
Zero Growth Model
Good for Preverred Stock
Price = Dividend / Required Rate of Return
Constant Growth Model
Price = Dividend * (1 + Growth rate of dividend)
- *_________________________________**
- *Required RoR** - Growth rate of dividend
formula won’t work if NO dividend use free cash flow FCF
Dividend Discount Model
- If the market lowers the required rate of return for a stock, the value of the common stock will rise
- The opposite (higher required rate of return or lower dividends) lowers the value of the common stock
- If investors expect that growth in dividends will be higher as a result of favorable development for the firm, the value of the common stock will rise
Dividend discount model shortcuts
Shortcut #1
If the 1st growth rate is lower than the second growth rate, choose the next lowest number in the answer.
calculate the value using the DDM with the 2nd return only
Shortcut #2
If the first growth rate is higher than the second growth rate, choose the next highest number in the
answer.
Yield Curve refesher
Yield curves show the market rates of interest for bonds of different maturities with similar credit ratings.
Required Rate of Return Formula
R = rf + (rm - rf) * beta
Price/earnings P/E Ratio
How to use to value staocks
Current market price = Earnings × P/E ratio
Price/free cash flow
DDM but without dividend
How to value a company without a dividend
V = FCF0(1+g) / r-g
Book Value =
Book Value = Assets - (Liabilities + Preferred equity common)
It is the sum of common stock outstanding, capital in excess of par, and retained earnings.
Return on Equity (ROE)
ROE = Earnings available for common (EPS) / Common equity (net worth or book value)
Dividend Payout ratio and EPS formula
Dividend Payout Ratio=Dividends Paid/EPS common stock
EPS = ROE (per share) × Book Value or Net Worth (per share)
Modern Portfolio Theory (MPT)
seeks to quantify the relationship
between risk and return.
- Security valuation: Describing a universe of assets in terms of expected return and expected risk
- Asset allocation decision: Determining how assets are to be distributed among classes of investment
- Portfolio optimization: Reconciling risk and return ie. portfolio with best return for a given level of expected risk
- Performance measurement: Dividing each stock’s performance (risk) into market-related (systematic) and industry/security-related (residual) classifications
CML expresses the macro aspect of modern portfolio theory
The CML shows the relationship between risk and returns for ALL possible portfolios
The CML reveals the following:
•The expected return on a fully diversified portfolio
•That a diversified portfolio should fall somewhere along the CML
•That individual securities or inefficient portfolios fall below the CML
•That it cannot be used to evaluate the performance of a single security or a portfolio that lacks
full diversification
•That Rf is the risk-free return (100% T-bills)
Security Market Line and Market Risk Premium
ri = rf + (rm - rf) *Bi = SML
Erm - Rf = Market risk premium
(Erm - rf )*B = stock risk premium
Efficient Market Hypotheses
Strong form=stock prices fully reflect all information, both public and private. Neither fundamental analysis nor technical analysis produces superior results
Semi-strong form=all publicly known information is fully reflected in stock prices. Neither technical analysis nor fundamental analysis can produce superior results
Weak form=historical price data is already reflected in current stock prices and is of no value in predicting future price changes. Fundamental analysis may produce superior results
Anomalies
- P/E effect: Stocks with low P/E ratios perform better than stocks with high P/E ratios
- Small-firm effect: Stocks of small firms outperforms stocks of large firms. A “small” firm is one with total market value in the lowest 20% of all stocks
- January effect: Stocks decline at the end of the year and rebound in January, especially in the first five trading days
- Neglected-firm effect: Stocks of firms not commonly studied by analysts outperform stocks of firms that receive considerable attention from analysts
- Value Line phenomenon: Stocks rated “1” (the top ranking) by the Value Line Investment Survey outperform those ranked “5” by the survey
Fundamental Analysis Methods
Top-down method investor first looks at trends in the general economy
Bottom-up method =individual stock with outstanding performance before considering the impact of economic trends
Technical Analysis defined
Technical analysts generally use charts or computer programs to identify and project price trends
technical analysis is not concerned with the specific financial position
examines the short or intermediate term outlook
Technical Approaches
- Dow theory
- Advance/decline line
- Barron’s Confidence Index
- Moving average (200-day)
- Odd lot theory
- Mutual fund cash position
- Investment advisor opinions
Resistance Levels
Breaking through a ceiling is bullish
breaking through a floor is bearish
Benchmarkes and index
- Dow: 30 industrial, 20 transportation, 15 utility: Price Weighted
- S&P 500: Brad measure of NYSE; Float Weighted
- Russell 2000: smallest 3000 stocks; Popular Cap Weight
- Wilshire 5000: Measure of activity and movement 7000 issues Broadest Measure; Value Weighted
- Value Line: 1700 issues Equally weighted
- NASDAQ: Broadest measure of OTC Cap Weighted
- EAFE (Europe Australasia, Fare East: market Cap Weighted
Exdividend Date
The date of record for the corporation is the first business day after the ex-dividend date. On that record date, settled trades are reflected on the corporation’s books. To be on the corporation’s books as holder of record and thus receive the current dividend, the investor must purchase stock before the ex-dividend date.
Performance measures
(if R squared is below 60 you are not sharpe
above you need an alpha Treynor)
- Sharpe: This measure is expressed as the ratio of the excess return of the portfolio to its standard deviation
- Treynor ratio expressed as the ratio of the excess return of the portfolio to its beta.
- Apha aka Jensen ratio: This measure calculates the portfolio return actually attained and subtracts from it what the return should have been based on the risk assumed in the portfolio. Measure of portfolio manager.
What R2 Reveals
R2 is the percentage of a fund’s movements that is explained by movements in the S&P 500.
Information ratio (IR)
The information ratio (IR) measures the portfolio manager’s ability to generate excess returns relative to a benchmark, but also attempts to identify the consistency to the investor.
IR = Rp - Rb / SD of the asset
Investing on Margin
Margin requirement =
(1-Initial Margin %)
—————————————– × Purch price of stock
(1-Mainenance margin %)
Stock Option Collar Hedge Construction
A long position in the stock (owns it)
•
A short position in the call (wrote [sold] the call and received premium)
•
A long position in the put (owns it and paid premium)
Dividend reinvestment plans (DRIPs)
DRIPs are plans whereby stockholders automatically reinvest dividend payments in additional shares of the issuing company’s stock.
Instead of receiving the normal dividend check, participating stockholders will receive quarterly notification of the new shares purchased in their accounts. Although no cash is received, these dividends are fully taxable.
This creates phantom income.
Control of volatility
Volatility could be controlled by buying stocks with low Betas
Arbitrage pricing theory (APT)
take advantage of perceived differences
- Unexpected inflation
- Unexpected changes in the level of industrial production
- Unanticipated shifts in risk premium
- Unanticipated changes in the structure of yields
The Black-Scholes model uses five variables to value the option of a non-dividend paying stock.
- The price of the underlying stock
- The exercise price (strike price) of the option
- The time remaining to the expiration of the option
- The interest rate
- The volatility of the underlying stock
Note: An increase in the exercise price of a call decreases the call’s value (an indirect relationship). In contrast, an increase in the exercise price of a put increases the put’s value (a direct relationship). All the other variables have a direct relationship for calls or puts.
