Investment Planning Flashcards
What Are the Main differences between Futures and Options?
- Futures contracts obligate both investors to purchase/sale of an item, while options give one investor a choice to purchase or sell an item and the other an obligation
- Once equity drops below maintenance margin, investor must restore equity to initial margin (not maintenance margin).
Futures:
- Types of hedges
- Taxation
An agreement between two parties to make (Seller) or take delivery (long) of a specific commodity of a specified quality at a future time, place, and unit price.
- Futures contracts require daily settlement or mark-to-market.
Short hedge:
If a farmer grows and sells wheat, the farmer has a long position in wheat because the farmer will benefit when the price increases. If the price of wheat declines, the farmer loses money. Therefore, the farmer is subject to price changes in wheat.
Long Hedge:
long hedge involves a producer concerned about fluctuations in the prices of raw materials, such as a bread producer wanting to hedge against the possibility of high prices of wheat.
Taxation:
Net gains or losses are treated as 60% long term / 40% short term, regardless of the actual breakdown.
All open positions at the end of the tax year are treated as if they had been closed on the last day of the year for tax purposes.
Types of Options:
Call options—give the holder the right (not the obligation) to purchase the underlying security for a specified price within a specified period of time.
Put options—give the holder the right (not the obligation) to sell the underlying security for a specified price within a specified period of time.
ALWAYS REMEMBER:
Bulls by calls and sell puts
Bears But Puts and Sell Calls
Option Characteristics:
- Intrinsic Value
- Formulas derived from premium, TV, and IV.
- American vs. European
- In the money vs out of the money
- Breakeven
- Gains and Losses
Intrinsic value:
Is the difference between the market price of the stock and the exercise price (Can never be negative)
Call Option: Stock Price – Strike Price
Put Option: Strike Price – Stock Price
Note - Intrinsic value cannot be less than 0. If you get a negative number, select 0 as the answer on the exam.
- Premium= TV+ IV
American vs. European
- American options can be exercised at any time during the contract period.
- European options can only be exercised on the expiry date.
In the money vs out of the money:
In-the-money—the exercise price is below the market price for a call option (above the market price for a put option).
Out-of-the-money—the exercise price is above the market price for a call option (below the market price for a put option).
Breakeven:
Put- Strike + Call
Gains and Losses:
Black-Scholes Option Valuation Model
- Characteristics
- What factors affect it’s pricing
Determines the value of a European call option based on certain underlying factors.
What is a Zero Cost Collar?
- The investor purchases a put option to protect against downside risk and sells a call option to generate premium income to cover the cost of the premium paid for the put option.
Differences between Warrants and Rights:
Warrants:
Reason; Sweetener
TIme: LT
Pricing: Above Market
Rights:
Reason: Ownership
Time: ST
Pricing: Below Market
Correlation Coefficient:
Correlation ranges from +1 to -1 and provides the investor with insight as to the strength and direction two assets move relative to each other.
ρ= Cov
A correlation of +1 denotes that two assets are perfectly positively correlated.
A correlation of 0 denotes that assets are completely uncorrelated.
A correlation of -1 denotes a perfectly negative correlation.
Diversification benefits (risk is reduced) begin anytime correlation is less than 1.
Covariance
COVAB = (σA)(σB)(ρAB)
σ = Standard deviation ρ = Correlation coefficient
Measures the extent to which two variables (the returns on investment assets) move together (Direction Only), either positively (together) or negatively (opposite). P
Beta
A relative measure of systematic risk
The beta will be an effective measure of total risk within this perfectly diversified portfolio.
The market has a beta of 1. As a relative measure of risk, a security or portfolio with a beta of 1.25 would be considered 25% more volatile than the market
Portfolio Beta:
Studies show that betas for individual securities are not stable over time, but betas for portfolios are stable over time.
This is accomplished by weighting the beta for a security by its relative portion of the value of the portfolio.
Coefficient of Determination
Calculated by squaring the correlation coefficient.
The coefficient of determination is an important concept because unless it equals one, beta will not measure total risk (total risk = systematic + unsystematic risk). Beta does not capture the unsystematic risk within a portfolio.
You want to make sure that your R-squared is >.70 otherwise beta will not be a great measure of risk.
Semivariance
- Semivariance only considers the downside volatility (deviation) of an investment. Specifically, semivariance measures the variability of returns below the average or expected return.
- When used in the analysis, the lower the semivariance of a security, the less likely the security will incur a substantial loss in value.
Remember that you want this to be low
What risk measures do the following risk adjusted performance measures use:
Alpha
Treynor
Sharpe
Alpha and Treynor use Beta. Sharpe uses standard deviation.
What are some characteristics of the Treynor ratio?
Treynor is a relative risk adjusted measure, so you must compare one Treynor to another.
The higher the Treynor the better.
Treynor is appropriate to use when r-squared is equal to or greater than .70.
Tp = (rp - rf) ÷ (βp)
Where:
rp = The realized return on the portfolio. rf = The risk-free rate of return. βp = The beta of the portfolio.
What are some characteristics of the Sharpe ratio?
Sharpe is a relative risk adjusted measure, so you must compare one Sharpe to another.
The higher the Sharpe the better.
Because Sharpe does NOT use beta, it is alright to use Sharpe even when r-squared is less than .70.
Sp = (rp -rf) ÷ (σp)
Where:
rp = realized return on the portfolio. rf = risk-free rate of return. σp = standard deviation of the portfolio.
What are some characteristics of Jensen’s Alpha?
Alpha is an absolute measure of risk, therefore you can look at it and it tells you something.
A positive Alpha is good. A negative Alpha is bad.
Alpha also tells how much excess return was actually earned, based upon the amount of return expected for the risk under taken.
ap = rp - [rf + βp(rm - rf)]
Where:
rp = realized portfolio return. rf = risk-free rate of return. ap = alpha, an intercept that measures the manager’s contribution to portfolio return. βp = beta of the portfolio. rm = expected return on the market.
Coefficient of Variation.
- A relative measure of total risk (as measured by standard deviation) per unit of expected return (risk-adjusted return).
- Used to compare investments with varying rates of return and standard deviations.
- Serves as a cross-check on an investment decision.
- CV = standard deviation of asset ÷ expected return of asset.
- You want a low coefficient of variation.
Information ratio:
- The ratio of expected return to risk is measured by standard deviation.
- This ratio measures the consistency with which a manager beats a benchmark.
- Seeks to distill the combination of excess returns and the incremental risk undertaken to achieve those returns, both viewed as relative to a benchmark.
- Method to evaluate the return a fund manager achieves, given the level of risk of the underlying portfolio.
- Because the information ratio measures return and risk only relative to a benchmark, using the right benchmark is crucial to getting an accurate measure.
What is the formula for Margin Call?
Margin Call = Loan ÷ (1 – Maintenance Margin)
OR
MC= 1-initial margin X Share Price ÷ (1 – Maintenance Margin)
What does Value Line rank?
What are the rankings and are they a buy/sell signal?
Value Line ranks stocks, using a scale of 1 to 5.
Ranking 1 – Highest ranking – Signal to BUY!
Ranking 5 – Lowest ranking – Signal to SELL!
What does Morningstar rank?
What are the rankings and are they a buy/sell signal?
Morningstar ranks mutual funds, stocks, ETFs, and Bonds using 1 to 5 stars.
1 star – Lowest ranking – Low performing
5 stars – Highest ranking – High performing
What is the relationship (in number of days) between the “ex-dividend date” and “date of record”?
What is the relationship (in number of days) between the “ex-dividend date” and “date of record”?
An investor must purchase the stock before the ex-dividend date or 2 business days prior to the date of record.
The ex-dividend date is one business day prior to the date of record.
Remember: An investor must buy the stock prior to the ex-dividend date to receive the dividend
Characteristics of the Securities Act of 1933
Characteristics of the Securities Act of 1934
Securities Act of 1933:
Regulates the issuance of new securities (Primary Market).
Requires new issues are accompanied with a prospectus before being offered.
Securities Act of 1934:
Regulates the secondary market and trading of securities.
Created the SEC to enforce compliance with security regulations and laws.
Characteristics of the Investment Company Act of 1940
Characteristics of the Investment Advisers Act of 1940
Investment Company Act of 1940:
Authorized the SEC to regulate investment companies.
Three types of investment companies: Open, Closed and Unit Investment Trusts.
Investment Advisers Act of 1940:
This act required investment advisors to register with the SEC or state.
To register with the SEC, an advisor must file form ADV.
Less than $100 million in assets, register with the state.
Greater than $110 million, register with the SEC.
Between 100M and 110M AUM has the choice to register with the state or SEC.
Characteristics of the Securities Investors Protection Act of 1970
Characteristics of the Insider Trading and Securities Fraud Enforcement Act of 1988
Securities Investors Protection Act of 1970:
Established the SIPC to protect investors for losses resulting from brokerage firm failures.
This act does not protect investors from incompetence or bad investment decisions.
Insider Trading and Securities Fraud Enforcement Act of 1988:
Defines an insider as anyone with information that is not available to the public.
Insiders cannot trade on that information.
