Investment Planning Flashcards
Unsystematic Risk
Known as diversifiable risk, may also be referred to in some reference books as non-systematic risk.
- Business Risk
- Financial risk
Systematic Risk
Also known as 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.
FDIC Insured Amounts
Individual - 250k
Joint - 250k
Trust - 250k
IRA/Keogh - 250k
Types of Systematic Risk
PRIME
- Purchasing Power Risk
- Reinvestment Risk
- Interest Rate Risk
- Market Risk
- Exchange Rate Risk
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
EE Bonds
- Non- marketable, nontransferable, 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
- not subject to state or local taxes
I Bonds
- Non-marketable, nontransferable, cannot be used for collateral
- Sold at face value
- Interest rate is composed of two parts
1. a fixed base rate (remains the same for life of the bond)
2. an inflation adjustment every six months - Subject to federal taxation when redeemed
- Not subject to state or local taxes
General Obligation Bonds
backed by the full faith, credit and taxing power of the issuer. GO Bonds are generally considered the safe type of municipal credit
Revenue Bonds
Backed by specific source of revenue to which the full faith and credit is NOT pledged. Because revenue bonds are backed by a single source of funds (Like toll roads, hospitals, or nuclear power plants) , they have greater credit risk then 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 and MBIA
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 provisons
Risk for Corporate and Municipal Bonds
DRIP
Default Risk
Reinvestment Risk
Interest Rate Risk
Purchasing Power Risk
Default Risk
a creditor may seize the collateral and sell it to recoup the prinicple
What is the Risk associated with Government Bonds
RIP
Reinvestment risk
Interest rate risk
Purchasing power risk
Large Cap
exceeds 10 billion
Mid Cap
market value is b/w 2-10 Billion
Small Cap
market value less then 2 billion
Micro Cap
market value less then 300 million
American Depository Receipt (ADR)
- Prices of ADRs are 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 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)
Intrinsic Value
is 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)
if the price at which the stock can be purchased or sold on exercise of the option
Premium (options)
is 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 (options)
is the amount the market price of an option exceeds its intrinsic value
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 underlying security is held more then 12mo otherwise 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 9months or less.
Straddle
buying a put and 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 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 exam)
Warrants vs Call options
- Warrants are issued by corporations, whereas calls are created by individuals
- Warrants typically have maturities of servers years
- Warrant terms are not standardized, call options are standardized
Reg D Accredited vs Non-accredited
Accredited (unlimited)
- Net worth of 1mm +
- Annual Income over $ 200,000
- Couple with joint income of $300,000
Non- Accredited
- Sold to a maximum 35 investors
- Must use a purchaser representative if not “sophisticated”
Coefficient of determination R^2
The square of the correlation coefficient measuring the proportion of variation in one variable explained by the movement of the other
How is R^2 used on the exam?
it describes the % of a funds movement that are explained by the movements in the S&P 500. Index funds/ diversified funds based on the S&P 500 will have R^2 of very close to 100% while sector funds (not diversified) will have very low R^2 (typically 5%-25%)
Standard Deviation (risk level)
measures the variability of returns used in a non-diversified portfolio and is a measure of total risk
Beta (risk)
An index of volatility used in a diversified portfolio 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 the portfolio manager
IRR or dollar wighted return- compares absolute dollar amounts
Real rate if return
the inflation adjusted interest rate
Nominal Rate of Return
actual returns not adjusted for inflation
Holding period of 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 tax equivalent yield can be calculated.
TEY= tax exempt yield / 1 - marginal tax rate
or
tax exempt yield= TEY x (1 - marginal tax rate)
Duration
- 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 their maturities
- No coupon interest, yet produces “phantom” income
- no reinvestment risk
- sold at deep discount
- Fluctuate more than coupon bonds with same maturities
Using Duration to manage bond portfolios
if interest rates are expected to rise, shorten duration ( interest rates up shorten duration - UPS - UP for up and S for shorten) Buy high coupon bonds with short maturities. If interest rates are expected to fall legthen duration. Buy low coupon bonds with long maturities (interest rates fall - lengthen duration - FALLEN - FAL for fall and LEN for lengthen)
Conclusions for fluctuations in bond prices
- the smaller the coupon the greater the relative price fluctuation
- the longer the term to maturity, the greater the relative price fluctuation
- the lower the market interest rate the greater the relative price fluctuation
Convexity
- the degree to which duration changes as the yield to maturity changes
- largest for low coupon bonds, long maturity bonds and low yield to maturity bonds
- allows investor to improve the duration approximation for bond price changes
Return on Equity (ROE)
ROE = EPS/ Common Equity
EPS = earnings available for common
Common Equity = Net worth or book value
Dividend Payout Ratio
DPR = common dividends paid/ EPS
EPS: earnings available for common
Strong Form Market hypothesis
asserts that stock prices fully reflect ALL INFORMATION, public and private. Not even access to inside information can be expected to result in superior investment performance over time. Neither fundamental analysis not technical analysis can produce results over time on a risk adjusted basis.
Semi Strong Form Market Hypothesis
Asserts that all publicly known information is reflected in stock prices. Neither technical analysis or 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
Weak Form Market Hypothesis
suggests 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!
Tax Basis of Mutual Fund
- First in first out (shares acquired first sold first)
- specific ID (pick specific lots)
- Average cost method (divide total cost of all shares)
Risk Adjusted Measures of performance (Sharpe)
1st key:
Look for low R^2 (less than 60) or non-diversified portfolio
2nd Key: Look for highest sharpe number
Risk of adjusted measures of performance (Jensen (alpha)/ Treynor)
1st Key: Look for high R^2 (60+) or diversified portfolio
2nd Key: look for the highest positive alpha if not alpha given look for the highest trey nor number
Margin (Maintenance) Call
(1 - Initial megin % / 1 - maintenance margin %) x Purchase price of stock
Passive Investment Strategies
- Buy and hold
- DCA
- index investing
- strategic asset allocation ( revised every few years)
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
Futures Contracts
Long Commodity Position: if a farmer is long a commodity ( corn) he needs a short hedge and will sell a futures contract
Short Commodity Position: If Kellogg’s is a short commodity (corn) they need a long hedge and will buy futures contracts
