Investment Planning Flashcards
Coefficient of Variation
CV = std dev /avg return
The higher the coefficient of variation the more risky an investment per unit of return.
Kurtosis
Leptokurtic= high peak and fat tails (higher chances of extreme events)
Platykurtic=low peak and thin tails (lower chance of extreme events)
Covariance
Measure of relative risk
Cov=std dev asset A times std dev asset B times correlation coefficient of Assets A and B
Correlation coefficient
Correlation ranges -1 to +1
Cor coefficient = covariance of Assets A and B/(std dev A* std dev B)
- correlation of +1, positively correlated
- correlation of 0, uncorrelated
- correlation of -1, negative correlation
Beta coefficient
-Is a measure of individual security’s volatility relative to mkt
-The greater the Beta, the greater the systemic risk of that security.
- equals security risk premium/market risk premium
Standard deviation
- measure of total risk
Coefficient of determination or r2
= is a measure of how much return is due to market
-If r 2 is >70% use beta
-If r 2 is <70% use std dev
Market risk premium
Return of the market rm minus Risk free rate of return Rx
Security Market Line vs Capital Market Line
-SML uses beta as it’s measure of risk
-CML uses std dev as its measure of risk
-If port provides a return above the SML, security is undervalued and should be purchased
-If port provides a return below the SML, security is overvalued and should NOT be purchased
Optimal Portfolio
Is the point at which an investor’s indifference curve is tangent to the efficient frontier
Holding Period Return
= (Selling price - purchase price)+/- cash flows divided by purchase price or equity invested
Internal Rate of Return
-NPV = PV of cash flows - Initial Cost
-If NPV is positive, then IRR>Discount rate
-If NPV is zero, then IRR = Discount rate
-If NPV is negative, then IRR<Discount rate
Mutual funds report returns
-on a time weighted basis. Investors are concerned about dollar weighted returns.
Expected Rate of return
r = D1/P +g
Where:
r = The required rate of return.
g = The dividend growth rate.
D1 = Next period’s dividend.
P = is market price
If D1 is not provided, you can use D0, which is this year’s dividend multiplied by the growth rate provided. D(1+g).
-If the required rate of return decreases, the stock price will increase
-If the dividend is expected to increase, the stock price will increase
-If the required rate of return increases, the stock price will decrease
-If the dividend is expected to decrease, the stock price will decrease
Dividend Payout Ratio
DPR = common stock dividend/Earnings per share
Determines percentage of earnings paid out in dividends to shareholders.
-the higher the dividend payout ratio, the more mature the company
-a high dividend payout ratio may also indicate the possibility of a dividend being reduced
-a low dividend payout ratio may indicate that the dividend may increase, thereby increasing the stock price
Return on Equity Formula
ROE = Earnings per share/ Stockholders equity per share
Dividend Yield Formula
Div Yield = Dividend/Stock Price
-formula states annual dividend as a percentage off the stock price
GNMA Bonds
are backed by the full faith and credit of the US government
Corporate bond risk vs US Government bond risk
US government bonds are not subject to default risk. Municipal bonds can be considered to have default risk unless they are insured.
Coupon rate of bond formula
Coupon rate = coupon payment /par value
Current Yield of bond formula
Current yield = coupon payment/mkt price of bond
Bond compounding
On CFP exam, always assume semiannual compounding UNLESS told otherwise in the question.
Bond Yield Ladder Summary
When shopping, if you see a Discount, Call Mom’s Cell Now - Discounts from highest to lowest is YTC, YTM, CY and Nominal Yield
- for a Premium it would be opposite
Bond Duration
- The bigger the duration, the more price sensitive or volatile the bond is to interest rate changes
-Duration is the moment in time the investor is immunized from interest rate risk and reinvestment rate risk
-Modified duration is a bond’s price sensitivity to changes in interest rates
-A bond portfolio should have a duration equal to the investor’s time horizon to be effectively immunized.
Convertible bond conversion formula
CV = Par Value/Conversion Price * Price of Common Stock
Unit Investment Trust
- can be equity or fixed income, typically fixed income trust
- are self liquidating and passively managed
- issues “units” not shares
Net Asset Value
= (Assets - Liabilities)/Shares Outstanding
3 Types of Investment Companies
- Closed End (fixed capitalization that may trade at a premium or discount on an organized exchange)
- Open End (unlimited number of shares and trade at NAV)
- Unit Investment Trust (UIT)
Index Finds
- Passive investment strategy that is tax efficient
- Tracks performance of various market indices
- Low turnover rates minimizing cap gain distributions
Sector Funds
- not well diversified and have a low r2 (0.50 - 0.60)
International vs Global Funds
- Global invests in both international and US securities
- International EXCLUDED US securities
Exchange Traded Funds
- low cost of ownership
- typically a passive investment
- tracks an index
American Depository Receipts (ADRs)
- Foreign stock held in domestic branch banks’ foreign branch
- Trade on US exchange denominated in US dollars
- Do NOT eliminate exchange risk
Taxability of Options
- If contract lapses (or expires) premium paid is a short term loss and premium received is short term gain
- If contract is exercised, the premium is added to the stock price to increase the basis in the underlying stock. If stock held >12 mos, long term gain or loss. If held < 12 mos, short term gain or loss
Futures Contract
- primary players are hedgers and speculators
- futures contract are “marked to market”, gains/losses are credited/debited to your account daily
Education and Retirement Funding Questions
- Two step process
- 1st, determine the NPV of the cash flow stream at time period zero (always use inflation adjusted interest rate)
-2nd, determine the savings required (determine if the savings will occur at the beginning or ending of the time period). Use BEGIN or END on calc
