Investment Planning Flashcards
Unsystematic Risk
Diversifiable risk, may also be referred to as non-systematic risk.
- Business risk: refers to the nature of the firm’s operation (i.e. possibility of loss due to new technology)
- Financial risk: refers to how the firm finances its assets (i.e. possibility of loss due to heavy debt financing)
Systematic Risk
Non-diversifiable risk. This part of the risk is inescapable because no matter how well an investor diversifies, the risk of the overall market cannot be avoided.
Types of Systematic Risk
“PRIME”
- Purchasing power risk: loss of purchasing power through inflation.
- Reinvestment rate 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: 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 changes in the value of currency.
FDIC Insured Amounts
per bank / per type of account
- Individual: $250K
- Joint: $250K
- Trust (per beneficiary): $250K
- IRA/Keogh: $250K
The Yield Ladder
"YMCA" Discounted bonds (yields higher than coupon) Y Yield to call M Yield to maturity C Current Yield A Nominal Yield (Annual Coupon Rate) C Current Yield M Yield to maturity Y Yield to call Premium bonds (yields lower than coupon)
EE Bonds
- Non-marketable, non-transferable, cannot be used for collateral
- Sold at face value
- Interest rate based on the 10-year 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
I Bonds
- Non-marketable, non-transferable, cannot 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 six months)
- Subject to federal taxation when redeemed (unless used as education bonds)
- Not subject to state or local taxes
Types of Municipal Securities
General obligation bonds: backed by the full faith, credit, and taxing power of the issuer. GO Bonds are generally considered the safest type of municipal credit.
Revenue bonds: Backed by a specific source 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 or nuclear power plants), they have a greater credit risk than GO bonds. As such, they trade at higher yields.
Insurer municipal bonds: The insurers pay timely interest and principal when the issuer is in default. Municipal bond insurers are AMBAC (American Municipal Bond Assurance Corp) and MBIA (Municipal Bond Insurance Association Corp)
Indenture Agreement Covers
- Form of bond
- Amount of issue
- Property pledged
- Protective covenant, including any provision for a sinking fund
- Working capital and current ratio
- Redemption rights, call, put or conversion provisions
Corporate and Municipal Bonds - Risks
“DRIP”
- Default risk: a creditor may seize the collateral and sell it to recoup the principal
- Reinvestment risk: as payments are received from an investment, interest rates fall. When the funds are reinvested, the investor receives a lower yield.
- Interest rate risk: rising interest rates may cause bond prices to fall.
- Purchasing power risk: inflation may lower the value of bond interest payments and principal repayment, thereby forcing prices to fall.
Government Bonds - Risks
“RIP”
No default or credit risk
Capitalization market categories of company
Large: market value exceeds $10 billion
Mid: market value is between $2-10 billion
Small: market value less than $2 billion
Micro: market value less than $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.
Real Estate (Land - improved) - NOI
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) computation.
Gross rental receipts \+ nonrental income (laundry, etc) --------------------------------- Potential gross income (PGI) - Vacancy and collection losses - Operating expenses (excludes interest and depreciation) --------------------------------- = Net operating income (NOI)
Options (general definitions)
Intrinsic value: the minimum price the option will command as an option. It is the difference between the market price and the exercise price of the stock.
Exercise price (strike price): the price at which the stock can be purchased or sold on exercise of the option.
Premium: the market price of an option. As the option approaches its expiration date, the market price of the option (the premium) approaches its intrinsic value.
Time premium: the amount the market price of an option exceeds its intrinsic value
IV + TV = Premium
Call Options - Taxability
At the time of purchase: non-deductible capital expenditure
- to the writer due to lapse: premium paid is short-term gain
- to the writer due to exercise: premium paid is added to sale price (can be long-term gain if the underlying security was held more than 12 months, otherwise is short-term gain). 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.
Hedging Strategies (straddles and combinations, collar, protective put)
Straddle: buying a put or buying a call; the buyer does NOT own the stock
Collar: sells a call (out-of-the-money) at one strike price and buys a put at a lower strike price; investor OWNS the stock.
Protective Put: buying a stock (or owning it already) and a put for the stock serving as insurance against the decline in the underlying stock (good answer for the exam).
