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Investment Analysis > Investment Analysis Mid-term > Flashcards

Investment Analysis Mid-term Flashcards

1
Q

Relative vs Absolute return

A

Absolute: Returns directly equal to stock price change

Relative: Returns equal to relative performance to a base benchmark (S&P 500)

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2
Q

What is an Efficient Market?

A

Market where information is immediately, fully, quickly, and correctly discounted in the share price. Capital is efficiently allocated to most productive and Intrinsic value = share price

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3
Q

What is an Inefficient Market?

A

Market where information is NOT immediately, fully, quickly, and correctly discounted in the share price. Intrinsic value not equal to share price

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4
Q

How do you derive asset’s IV?

A

FTV model
1. Fundamentals -> short vs long term outlook, company + macroeconomic data to assess growth outlook
2. Valuations -> Valuation Models (Gordon Growth Model)
3. Technical -> Overall Market position, flows, sentiment

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5
Q

How do markets become efficient over time?

A
  1. Technological
    -> Information spreads faster
    advancement
  2. Regulatory requirement -> Fair & equal access to information + sound financial accounting practises
  3. Professional investing industry -> More + Better active investors
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6
Q

Why is a more efficient market good?

A
  1. Efficient allocation of limited resources to higher value projects -> Prevent mis allocation or over allocation of capital
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7
Q

What is behavioural biases? What are some examples

A

Subconscious bias that negatively impacts judgement/decisions
1. Loss Aversion -> Dissatisfaction from a loss GREATER than satisfaction from gain of same magnitude

  1. Herding -> Investors ignore their own information/analysis and trade in same direction as others
  2. Investors over confident in their ability to gather/process information
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8
Q

What is a nudge?

A

Reminder to overcome behavioural biases

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9
Q

How do interest rate affect stock prices?

A

Higher interest rates = higher opp cost of buying stock higher than holding cash.
Hence, Dividends in the future discounted more in the future -> Lower net present valuation of stocks

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10
Q

Why are certain stocks riskier?

A
  1. Company debt (floating rate debt or not)
  2. Uncertainty of market size/product availability/regulations
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11
Q

How would you describe the efficient frontier?

A
  • Represents a range of portfolio allocations that delivers the lowest volatility between the lowest and highest expected return
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12
Q

What is the Optimal Portfolio?

A
  • Allocation that gives the Highest Sharpe ratio
    Where the Sharpe Ratio is the Excess return of the portfolio over the risk free rate
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13
Q

Personally Preferred Optimal Portfolio

A

Point where the Capital Allocation line is tangent to the efficient frontier and meets the Indifference curve of individual - The allocation that maximises returns for individuals desired level of risk

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14
Q

What is the Capital Allocation line?

A
  • Refers to Expected return of your portfolio based on Capital allocation into Risk-Free assets and Portfolio
  • To improve returns -> Can borrow or reallocate from risk-free assets into portfolio
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15
Q

Shortcomings of Mean-variance optimization?

A
  1. MVO assumes that returns are normally distributed -> However real equity distributions are left skewed
  2. Diversification Doesn’t work during periods of market stress
    - Irrational behaviours tend to spike during “left-tail” events (GFC, Covid-19)
    - Increasing correlation in equities
  3. Permanent Capital Impairment
    - Credit Suisse Company -> Bankruptcy
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16
Q

Why do companies issue debt/equity?

A
  • Companies require working capital for various initiatives -> therefore they turn to either equity or debt financing
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17
Q

Advantage of Debt?

A
  • All else equal debt is a cheaper way than equities to achieve financing
    1. Interest on debt is tax-deductible
    2. Lenders expected returns are lower than those of shareholders -> reduced risk
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18
Q

Disadvantage of Debt

A
  1. Unlike Stocks: legally compels you to make future interest payments
    - Constraining on growth for company
  2. Unlike equity holders
    - Creditors can force a company’s liquidation
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19
Q

Principal Agent Problem?

A

Exists when asymmetric information exists between management and investors
- Although Management works for investors, they know the company better + may have other incentives (personal projects etc.)
- Investors simply want Higher payout ratio (dividend payout) which lead to Higher justified valuation
- Misaligned incentives may exists

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20
Q

What are the components of a stock’s delivered return?

A

Growth
o Capital Gains on Stock Price
Valuation
o
Dividends
o Payouts to shareholders
FX Gains/Losses
o Changes in ER

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21
Q

What are some defensive equity sectors?

A
  • Consumer Staples
    Nestle, P&G etc.
  • Utilities
    Energy companies
  • Telecommunications
    Singtel
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22
Q

What is WACC?

A

Weighted Average cost of Capital -> Benchmark rate CFO uses for capital expenditure.
Discount rate used to discount future value of cashflows to present value. Compare WACC with cost of investment to determine ROI

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23
Q

How to estimate equity returns (valuation models)?

A
    1. Gordon Growth Model
      o Calculates a companies intrinsic value by discounting future dividend cashflow back to present value (PV)
  2. CAPM Model
    - Determining expected rate of return for an asset/investment vs risk free rate
  3. Multiples vs mean
    - Ratio calculated by dividing market value of an asset by specific item from financial statement
    - P/E ratio
  4. Asset-Based Valuation
    - Obtain IV from assets and liabilities of company
24
Q

How to estimate risk-free rate?

A
  • Backward looking view: Comparing individual stock’s historical performance to overall market to determine risk-free rate
25
Q

What is disadvantage of Market Cap weighted indices?

A
  1. Risk of overweight in index towards companies with higher market value
  2. Over-weighting/over-representing stocks that have rallied meaningfully in the market/
26
Q
A
27
Q

How do lower interest rates affect equity evaluation of stocks under DCF

A
  • DCF
  • Lead to higher net present value in Gordon growth Model
  • Lower opportunity cost for investing in stocks.
    -> Lower discount rate on equities
    Hence Lower IR boost long-term valuation for stocks.
28
Q

How do lower interest rates affect equity evaluation of stocks under PE

A
  • Lower interest rates leads investors to shift to equities (higher opp cost)
  • Since P/E is a function of cost of capital -> Lower IR result in higher P/E
  • Mistaken investors can believe P/E is too high which leads them to miss out on returns
29
Q

Disadvantage of Gordon Growth Model?

A
  • Difficult to analyse for Growth Companies
    Inconsistent long-run growth rate of dividends
    Harder to estimate -> Tech companies may prefer to re-invest into company
  • Difficult to predict Permanent Capital Impairment
    (Unforeseen Shocks to company)
30
Q

How do currency fluctuations affect stock valuations

A

Depreciation in home currency:
1. Home Currency Importers face higher import costs + eroding purchasing power of consumers
2. Foreign Currency Exporters
Windfall gains when converted into home currency

31
Q

What metrics can you use to assess fund?

A
  1. Information Ratio -> Indication of deviation of return between actively managed fund vs benchmark (divide actual returns by tracking error)
  2. Active Share
    - Measured by Number + Weight of positions vs benchmark
    - Indication of greater conviction of manager
32
Q

How would you know which benchmark to choose?

A
  1. Choose a benchmark that reflects the investment style of the manager
  2. Select a benchmark that strips away systematic biases or exposures that could cause the manager to underperform or outperform
  3. Large Enough Benchmark to asses manager breadth

Leaves behind true alpha of manager

33
Q

What is the fundamental law of Active Management

A
  1. Managers forecasting skill
    - Accuracy of forecasting active returns
  2. Managers portfolio structuring skills
    - Ability to match forecasted returns to active weights (Active Share + Portfolio Concentration)
  3. Breadth
    - How many “independent decisions” can manager make
  4. Aggressiveness
    - Tracking Error
34
Q

How to reduce cost of Buying Put

A

Bearish Risk Reversal
- Directional conviction that price will drop
- Investor should purchase a Put option (bet the stock will drop) and sell an upside call (agree to sell if the stock goes up).
- Investors offsets risk premium from downside Put, but using premium from selling upside call. If stock price goes down, but not below Put strike price, losses would be zero
- If price rises however, investor can make potentially unlimited losses

35
Q

What is a futures contract?

A
  • Contract agreement to buy or sell a specific asset at future date for set price
  • 1:1 movement between futures and underlying
  • Obligation for buyer of future to execute on contract which is enforced by trading house
  • Buyer must put up initial and maintenance margin (% of agreed price) if trade goes against them
  • Multiplier exists, since 1 future can equal basket of indices
36
Q

What is the worst case scenario of holding Call?

A

Loss of Call premium

37
Q

How does Level of Interest Rates affect options?

A
  1. Rise in Interest rates benefits call price
    - Delays right to buy stock -> Value of delaying purchase increases since returns from risk-free asset greater.
  2. Rise in IR negatively impacts put price
    - Delays the point in time when underlying asset is sold
    - Higher rates -> higher opp. cost of delaying sale
38
Q

What does in the money mean?

A
  • Call: When share price is higher than strike price (profit making)
  • Put: When share price is lower than strike price (profit making
39
Q

What are Bonds (fixed income securities)

A

Form of debt issued by debtor who is obliged to pay specified amounts of money at specified future date.
Debtor must pay a interest (a coupon) semi-annually or quarterly

40
Q

What are the types of coupons

A

Fixed Rate coupons (fixed IR)
OR
Floating coupons (fluctuate in line with inflation)

41
Q

What is assessed in Credit Rating?

A

Credit rating agencies assess the default risk and loss given default for debtors. Scored on willingness + ability for issuers to pay

42
Q

What determines Bond Yield Rate (YTM)?

A
  1. Prevailing risk free real rate
    - Real rate -> Inflation adjusted risk-free rate across all bonds/treasuries
    - Must be on par/higher than real rate
  2. Credit Risk (Higher Risk)
    - Risk of default by investors
    - Loss given default
  3. Expected Inflation risk (Higher Inflation Risk)
    - Expect Inflation premium for bonds rises
    - Especially for fixed rate bonds
  4. Technical
    - Demand/Supply for bond + liquidity of bond
43
Q

What is the duration of a bond

A

Duration = Sensitivity of bond prices to yield.
Expressed in years as it is roughly also number of years it take to hold a bond until half of discounted cashflow is received

44
Q

Higher duration of bonds is caused by?

A
  1. Longer maturity (principal payment later)
  2. Smaller coupons (greater relative weight in final principal payment
  3. Smaller Yield to Maturity (YTM) -> Principal payment discounted by less
45
Q

What does True Alpha of Manager mean?

A

Managers ability to innately pick outperforming/underperforming stocks

46
Q

Q: What drives the slope of the Yield Curve?

A
  • Pure Expectation Theory
    o Yield curve is a sequence of future short-end spot interest rates ->
    o Upward sloping Yield curve -> Confidence in strength of economy -> Expect FED will hold/raise interest rates straight
    o Inverted Yield Curve -> Expectations of recession -> Expect FED will decrease interest rates
  • Liquidity Preference theory
    Expect higher yields for longer maturity -> Due to long-term uncertainty-> Known as Term Premium
  • Segmented Markets & Preferred Habits
    o Technical -> Market Participants (Pension funds strong demand for long-term assets)
47
Q

Q: Give example of Bond Covenants?

A
  • Different types of Protections for Creditors
    Max dividend payout: Cap to ensure company services debt
    Max leverage Ratio: Cap on debt-to-equity ratio
48
Q

What is a Call Spread?`

A
  • Investor has directional view that price will rise -> But expects rise to be limited
  • Investor can buy a call and then sell an upside call further out of the money of the same expiry
  • Therefore if price rises above strike price 1 but not above strike 2 -> Investor can make full profit by funding buy premium with sell premium
  • If price falls can use sell premium to fund buy premium.
  • If price rises above strike price 2 -> Investor would still profit from spread of strike price 1 and 2
49
Q

What is a Put spread?

A
  • Investor has directional view that price will drop -> But expect drop to be limited
  • Investor can buy a put and then sell a downside put further out of the money of the same expiry
  • Therefore if price above strike price 1 but not below strike 2 -> Investor would make full profit by funding buy premium with sell premium
  • If price rises can use put 2 premium to fund put 1 premium.
  • If price falls below strike price 2 -> Investor will still profit from spread of strike price 1 and 2
50
Q

What is Mean Variance optimisation?

A
  • Process to optimise portfolio allocation such that the portfolio’s risk/return ratio is maximised -> Maximise returns for the individuals desire level of risk.
51
Q

What are Callable bonds?

A

Bonds that insure issuer.
Allows the issuer to redeem bond before the maturity ends (price is capped)
Allows issuer to re-issue at a lower coupon rate

52
Q

What are puttable bonds?

A

Bonds that insure buyers. Buyer has right to sell bond back to issuer at pre-determined price. Protects the bondholder by guaranteeing pre-specified selling price at specified date

53
Q

What are convertible bonds?

A

Hybrid debt + equity features
Allows bondholder to convert bond for specified number of shares of issuer
Upside exposure + Downside protection

54
Q

What are credit defaul swaps?

A

Allows investors to trade credit spread of issuer. Insurance contract against issuers risk of default - Do not need to hold underlying debt.
- Buy credit swap: when you expect credit risk to rise OR you expect insurance price to rise.
- Sell when you expect risk to fall

55
Q

What is a Call option?

A

An insurance contract against a share rally. It gives you the right to buy the stock at a specified price and specified future date.
- Must pay premium for the call option
- No obligation to execute (will lose premium)
- Investor profits when the stock price rallies beyond strike price

56
Q

What is a Put option?

A

An insurance contract against a share drop. It gives you the right to sell the stock at a specified price and specified future date.
- Must pay premium for the call option
- No obligation to execute (will lose premium)
- Investor profits when the stock price drops beyond strike price

57
Q

What are Derivatives

A

Financial Instruments that derive performance from underlying asset performance

Investment Analysis (1 decks)

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