Investment Planning Flashcards
1
Q
What is Unsystematic (non-systematic) Risk?
A
Not System-wide
Diversifiable risk.
Business risk- nature of operation
Financial risk- how a firm finances its assets
2
Q
What is Systematic Risk?
A
System-wide
Non-Diversifiable risk.
The risk of the overall market. This cannot be avoided.
Expressed by Beta.
3
Q
What are the types of Systematic Risk?
A
PRIME
Purchasing Power Risk: Loss of purchasing power through inflation.
Reinvestment Risk: Risk that one would need to reinvest available proceeds at a lower interest rate that the instrument that generated the proceeds.
Interest Rate Risk: Risk that a change in interest rates will cause the market value of a fixed income security to fall.
Market Risk: Risk of the overall market
Exchange Rate Risk: Risk of changes in the value of currency.
4
Q
FDIC Insured Amounts
Per Bank/Per TYPE of account
A
Individual: $250k
Joint (per OWNER): $250k
Trust (per beneficiary): $250k
IRA/Keogh: $250k
5
Q
Yield Ladder
A
Discount Bonds:
Y (YTC)
M (YTM)
C (CY)
A (Annual Coupon)
C
M
Y
Premium Bonds:
6
Q
EE Bonds:
- Issue price?
- How is interest rate derived?
- How does the interest accrue?
- How long must they be held?
- Is there any Treasury guarantees?
- Who can own one?
- How are they taxed?
A
- Non-marketable, non-transferable, cannot be used as collateral.
- Issued at face value.
- Interest rate is based on the 10-year Treasury note yields, and is fixed at the time of purchase. The fixed rate applies for the 30-year life of each bond, which is 20-years, but also adds a 10-year extended maturity period.
- Denominations are as low as $50.
- Interest Accrues monthly, and is compounded semi-annually.
- Savings bonds must be held one year, and there is a three-month interest penalty applied to bonds held less than 5 years.
-Treasury GUARANTEES the value will double after 20 years. - Subject to federal taxation when redeemed UNLESS USED FOR EDUCATION
- Not subject to state or local taxes.
- Must be owned by an adult at least 24 years old, typically a parent, and cannot be held in an UTMA/UGMA and still qualify for the interest exclusion.
- A Grandparent may claim the interest exclusion if the grandchild/student is a dependent of the grandparent.
The interest earned is not subject to Federal income tax until the bonds are redeemed or reach full maturity. The owner has the option of having the interest taxed each year.
7
Q
HH Bonds
A
HH bonds were available only by exchanging at least $500 in Series EE bonds.
Pay interest semi-annually.
Non-marketable.
Interest is taxed yearly.
After 2004, no longer exchangable.
8
Q
I Bonds:
- Issue price?
- How is interest rate derived?
- Who can own one?
- How are they taxed?
A
- Non-marketable, non-transferable, cannot be used as collateral.
- Sold at face value.
- INTEREST RATE is composed of two parts: A fixed base rate, and an inflation adjustment (adjusted very 6 months). Different from TIPS.
- Subject to federal taxation when redeemed UNLESS USED FOR EDUCATION.
- Not subject to state or local taxes.
- Taxed like EEs. The owner will generally choose whether to be taxed each year.
- Must be owned by an adult at least 24 years old, typically a parent, and cannot be held in an UTMA/UGMA and still qualify for the interest exclusion.
- A Grandparent may claim the interest exclusion if the grandchild/student is a dependent of the grandparent.
9
Q
Types of Municipal Securities
A
GO Bonds: Backed by the full faith, credit, and taxing power of the issuer. Considered the safest type of muni credit.
Revenue Bonds: Backed by specific sources of revenue. Full faith and credit of the issuer are NOT pledged. Have a greater credit risk than GO bonds, but have higher yields.
Insured Muni Bonds are insured by AMBAC and MBIA
10
Q
What do Indenture Agreements Cover? (6)
A
Form of Bond
Amount of Issue
Property Pledged
Protective covenant, including provisions for a sinking fund
Working Capital and Current Ratio
Redemption Rights (call or put)
11
Q
What are the Risks of Corporate and Municipal Bonds?
A
DRIP
Default
Reinvestment
Interest Rate
Purchasing Power
12
Q
What are the Risks of Government Bonds?
A
RIP
Reinvestment
Interest Rate
Purchasing Power
No Default
13
Q
Market Caps of Companies
A
Large: > $10 billion
Mid: $2-10 billion
Small: < $2 billion
Micro: < $300 million
14
Q
American Depository Receipt (ADR)
A
Receipt for buying shares of a foreign based corporation.
Instead of buying shares of a foreign-based company in overseas markets, Americans can buy foreign shares in the US in the form of an ADR.
Prices for ADRs are quoted in US dollars.
Dividends are declared in foreign currency, but are paid in USD.
15
Q
Bankers Acceptance:
- Length of maturity?
- How does it trade?
A
Finances imports and exports.
Bearer securities that can be held till maturity.
9 month or less maturity, and trades at a discount to face value.
Before a foreign exporter will ship goods to the US, the exporter wants assurance of payment when the goods arrive.
16
Q
Eurodollars
A
US dollar denominated deposit in ANY FOREIGN BANK.
17
Q
Eurodollar Bond
A
A Eurodollar bond is a U.S.-dollar denominated bond issued by an overseas company and held in a foreign institution outside both the U.S. and the issuer’s home country.
Mercedes issues a usd bond in Canada.
18
Q
Yankee Bond
A
US dollar denominated bonds issued in the US, BY FOREIGN BANKS AND CORPS.
These bonds are issued in the US when market conditions are more favorable than on the Euro markets.
19
Q
What is the NOI calculation for improved land/real estate?
A
Improved land/real estate is normally income producing. The intrinsic value of a real estate property can be computed using the NOI computation:
Gross rental receipts
+ Nonrental income
= Potential Gross Income
- Vacancy and collection losses
- Operating expenses (cash expenses only. Excludes interest amortization, depreciation, or debt service)
= NOI
NOI / Cap rate = Intrinsic value
The focus of operating expenses is the properties cash flow, not the investors cash flow.
20
Q
What are the general definitions of Options?
A
IV is the minimum price the option will command as an option. Market Price - Ex Price.
Ex Price is the price that the stock can be purchased or sold on the exercise of an option.
Premium is the market price of an option. As the option approaches its expiration date the market price of the option (premium) approaches its IV.
Time Premium is the amount the market price of an option exceeds its IV.
IV + TV = Premium
21
Q
What is the Taxability of Call Options?
A
At the time of purchase: Non-deductible capital expenditure
To the writer due to lapse: Premium received is a short-term gain
To the writer due to exercise: Premium received is added to sale price (can be long term gain if underlying security was held more than 12 months, otherwise short term).
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.
22
Q
Hedging Strategies - Straddles, Collar, Protective Put
A
Straddle: Buy a Put AND buy a Call. The buyer DOES NOT own the stock.
Collar: Sell a Call (out-of-the-money) at one strike price, and buy a Put at a lower strike price. Investor OWNS the stock.
Protective Put: Buy/Own a stock, and then buy a Put for the stock. This serves as insurance against a decline in the underlying stock and is a good answer on the exam.
23
Q
Warrants vs. Call Options
A
Warrants are issued by corporations. Calls are issued by individuals.
Warrants typically have maturities of several years.
Warrant terms are not standardized. Call options are standardized.
24
Q
What are the Hedging Positions of Futures Contracts?
A
Long (owner) commodity position: If a farmer is long a commodity, they need a SHORT hedge, and will SELL a futures contract. This will protect the farmer from the price of that commodity from falling and having to sell the commodity at a lower price. By selling the future short, the farmer locks in a higher price is the commodity was to devalue.
Short (buyer) commodity position: If a manufacturer is short a commodity (doesn’t own/needs), they need a LONG hedge, and will BUY a futures contract. This will protect the manufacturer from the price of the commodity from rising, and having to buy at a higher price. By buying a future long, the manufacturer locks in a lower price if the commodity was to revalue.
25
Reg D Accredited vs. Non-Accredited Investors
1, 2, 3, 35
Accredited (unlimited):
Net worth of $1 million
Ind. with income of $200,000
Couple with income of $300,000
Non-Accredited:
Issue sold to a max of 35 investors
Must use a purchaser representative if not "sophisticated"
26
Coefficient of Determination R²
The square of the correlation coefficient measures the proportion of the variation in one variable explained by the movement of the other variable.
How is R² used on the exam?
It describes the percentage of a fund's movement thats explained by the movements in the S&P 500.
Diversified funds (Index Funds) based on the S&P 500 will have an R² of very close to 100%. Alpha (Jenson), Treynor.
Non-Diversified funds (Sector Funds) will have a very low R² (typically 5%-25%). Sharpe.
27
Standard Deviation Vs. Beta
Both Standard Deviation and Beta are used to express the risk of a security.
- Standard Deviation measures VARIABILITY of returns used in a NON-DIVERSIFIED portfolio and is a measure of TOTAL RISK.
- STD, Variability, Non-diversified, Total Risk, Low R², Sharpe.
- Beta measures VOLATILITY of returns used in a DIVERSIFIED portfolio and is a measure of SYSTEMATIC RISK (because it's diversified, there's no unsystematic risk remaining, just systematic).
- Beta, Volatility, Diversified, Systematic Risk, High R², Alpha (Jenson) Treynor.
28
Geometric Return vs. Internal Rate of Return (IRR)
Geometric Return (Time-Weighted Retun): Evaluates the performance of a portfolio manager. (GReat Tiger Woods).
IRR (Dollar-Weighted Return): Compares absolute dollar amounts. (IRRegular Dollars).
29
Real vs. Nominal Rate of Returns
Real: Inflation adjusted interest rate. This is the nominal rate of return, adjusted for inflation.
Nominal: Actual returns. Not adjusted for inflation.
30
Holding Period Return (HPR)
Total return (income + price appreciation and dividends - margin interest - initial cost) over the entire period, divided by the out of pocket cost of the investment.
31
Taxable Equivalent Yield (TEY)
Compares municipal bond returns to those of taxable bonds.
TEY = Tax-Exempt Yield / (1 - Marginal Tax Rate)
or
Tax-Exempt Yield = TEY x (1 - Marginal Tax Rate)
*Tax-Exempt Yield is typically the yield on a Muni Bond*
32
Duration (Principals to Remember)
Years to Maturity: Duration and Maturity are POSITIVELY related.
Annual Coupon/YTM: Duration is inversely related to both Annual coupon and YTM.
Coupon and Yield are Interest Rates - Inversely Related.
33
Zero Coupon Bonds:
- Duration?
- What is it? How does it function?
Duration is equal to Maturity.
Produces Phantom Income.
No reinvestment rate risk.
Sold at deep discount to par.
Fluctuates more than coupon bonds with the same maturities.
34
Using Duration to Manage Bond Portfolios
If interest rates are expected to rise, shorten duration. UPS = interest rates UP, Shorten duration. *Shorten by buying short maturities, high coupon*
If interest rates are expected to fall, lengthen duration. FALLEN = interest rates FALL, LENgthen duration. *Lengthen by buying long maturities, low coupon*
Small coupon, Small interest rate = Big fluctuation.
Big Maturity = Big fluctuation.
35
Conclusions to Fluctuations in Bond Prices
Smaller coupon, longer term to maturity, lower market interest rate = GREATER THE PRICE FLUCTUATION.
36
Convexity
The degree that duration changes as YTM changes.
Largest for low coupon, long maturity, low YTM bonds. This allows investors to improve the duration approximation for bond price changes.
37
What is ROE?
ROE = EPS / Net worth or Book value
38
Dividend Payout Ratio
Dividend Payout Ratio = Common Dividends Paid / EPS
This compares dividends paid to earnings available.
39
What are the three types of Efficient Market Hypothesis
EMH suggests that investors cannot expect to outperform the market consistently on a risk-adjusted basis. Security prices reflect all known information.
Strong Form: Stock prices fully reflect all information, public and private. NEITHER fundamental analysis nor technical analysis can produce superior results.
Semi-Strong Form: All PUBLICLY known information is reflected in stock prices. NEITHER technical analysis nor fundamental analysis can produce superior results over time. Only an investor with inside information may achieve superior results.
Weak Form: Suggests that HISTORICAL price data is already reflected in current stock prices. FUNDAMENTAL ANALYSIS may produce superior results.
40
Types of Indexes / Benchmarks
Dow Jones: 30 industrial stocks, PRICE weighted.
S&P 500: Large caps. Broader measure of NYSE activity. VALUE weighted.
Russell 2000: Small caps. Smallest 2000 stocks of the Russell 3000 index. VALUE weighted.
Wilshire 5000: Broadest measure of the activity and movement of the overall stock market. VALUE weighted.
NASDAQ: Broadest measure of OTC trading. VALUE weighted.
Europe, Australasia and Far East (EAFE): Equity performance of the major foreign markets. VALUE weighted.
Value Line: +/- 1700 stocks. EQUALLY weighted.
Barclays Aggregate Bond: More than 5000 US Government, Corporate, Muni, mortgage backed and asset backed bonds.
41
Tax Basis of a Mutual Fund
FIFO
Specific ID: seller must identify the shares of the fund to be sold. This allows the investor to create gain, neutralize gain, or create a loss (FLEXIBLE).
Average Cost: Allows the investor to divide the total cost of all shares held by the number of shares sold.
42
Steps to Risk-Adjusted Measures of Performance: SHARPE
Look for LOW R2 (less than 60), or a NON-DIVERSIFIED portfolio.
Look for the highest sharpe number.
43
Steps to Risk-Adjusted Measures of Performace: ALPHA (JENSON) / TREYNOR
Look for HIGH R2 (60+) or DIVERSIFIED portfolio.
Look for the highest Alpha (Jenson). Of Alpha is not given, look for the highest Treynor.
44
What is a Margin (Maintenance) Call?
The formula for calculating when an investor will receive a margin call is:
(1 - Initial Margin / 1 - Maintenance Margin %) x Purchase Price of Stock.
Shortcut: 2/3 of the purchase price if the minimum maintenance is 25%. If the minimum maintenance is 30%, take 2/3 of the purchase price and then choose the next highest number.
45
Examples of Passive Investment Strategies
Buy & Hold (EMH)
DCA
Indexing
Strategic Asset Allocation (revised every few years)
46
Examples of Active Investment Strategies
Market Timing
Tactical Asset Allocation
Technical Analysis
47
Arbitrage Pricing Theory (APT)
Pricing of securities in different markets cannot differ for any significant length of time.
Unexpected Inflation or changes in industrial production.
Unanticipated shifts in risk premium or changes in structure of yields.
If the expected value is zero, then the factor has no effect.
48
Eurobond
A Eurobond is a debt instrument that's denominated in a currency other than the home currency of the country or market in which it is issued.
49
Negotiable CDs
Issued in exchange for a deposit of funds.
Marketable deposit, issuer must sell new CDs on demand.
At maturity, holder receives deposit plus interest.
CDs are negotiable in that they can be sold in the open market before maturity.
Carry interest rate risk.
Insured up to $250,000 by FDIC.
50
Are MMMFs insured by FDIC?
NO. Open-ended investment company issue MMMFs.
Average maturity is limited to 90 days.
51
Commercial Paper:
- What is it?
- Denominations?
- Maturity?
Short-term, unsecured promissory note issued by large well-known, financially strong companies.
Denominations of $100,000.
Maturity of 270 days or less.
Normally sold at a discount.
52
When is an issuing corporation most likely to call its bonds?
When the bonds are selling at a significant premium.
If the bonds are selling at a premium, newly issued bonds are offered with lower coupons. Declining interest rates do not necessarily mean that previously issued bonds are trading at a premium.
53
OID:
- How is is issued?
- How is the accretion incorporated/taxed?
Discounted from par value when issued.
Pay no interest until maturity, but the discount must be accreted over the life of the bond.
Each year the portion of the discount that has been earned is included as taxable interest income, and basis is increased.
Must report interest income although the bond pays no interest before maturity. PHANTOM INCOME.
*Annual accretion on an OID Muni is considered to be non-taxable interest income. If held to maturity, no gain or loss.*
54
T-Bills
3, 6, and 12 month maturities.
$100-$1,000,000 issues (Discount yield basis).
Safest.
Issued at Discount, so there is no coupon interest.
Subject to Federal income tax, exempt from state/local. Fed gets Fed.
Weekly Auction
55
Treasury Notes
1-10 Year Maturities.
$1,000-$100,000 issues at Par.
RIP
Not Callable.
Semi-annual interest.
Subject to Federal income tax, exempt from state/local. Fed gets Fed
Monthly Auction
56
Treasury Bonds
10-30 year Maturities.
$1,000-$1,000,000 issues are par.
RIP
Callable
Semi-annual interest
Subject to Federal income tax, exempt from state/local. Fed gets fed.
Quarterly Auction
57
Treasury STRIPS
Zero-coupon bond.
Direct obligation of the federal government.
The discount is treated as taxable income earned annually. This is Phantom Income taxed annually that is not actually paid out until maturity
58
TIPS
Protection against inflation.
Marketable.
Principal (Face Value) is adjusted semiannually to keep pace with inflation, measured by CPI over a 6 month period.
Fixed interest rate, variable principal depending on inflation.
Sold in $1,000 denominations.
Investor is taxed annually on the interest payment plus the appreciation in face value. The increase in face value due to the inflation protection is Phantom income, but the increase is not collected until maturity. FED ONLY.
59
Are Treasury securities Marketable?
Yes. Safest securities. Have a market.
60
GNMA
Pass-through security, with a direct guarantee of the Government.
Fed/State/Local taxation.
Minimum of $25,000
Each payment received represents both interest and return of principal. No par at maturity.
61
Muni Bond insurers
AMBAC- American Municipal Bond Assurance Corp
MBIA/National- Municipal Bond Insurance Association Corp.
BAM- Build America Mutual Insurance
62
Yield Ladder
Discounts:
Y (YTC)
M (YTM)
C (CY)
A (Annual Coupon)
C
M
Y
Premium Bonds:
63
CMOs
Because principal repayments vary as homeowners refinance their homes, the amount of principal repayment received by the investor changes every month.
CMOs were developed to eliminate these risks.
CMOs do not view mortgage pools as a means of passing through payments to certificate holders in exactly the same fashion as received. Instead, the payments received are looked at on a cash flow basis.
CMOs are multi class pass-through securities with Tranches.
64
Do CDs have less risk than Treasury Bonds and GNMA securities?
Yes. They are FDIC insured up to $250,000.
65
T or F: Treasuries are government securities and only have have RIP risks?
T. No Default risk. Only Reinvestment, Interest rate, and purchasing power risk.
66
Bond IV calculation:
Always 2 P/YR unless specified.
PMT is the semi-annual amount of the CURRENT bond.
I/YR is the % of the bond being compared.
N is # of years x P/YR.
Solve for PV.
FV is 1000.
67
Bond Conversion Value formula
CV = (Par / CP) x Current market price of stock.
(1000/40) x 50
68
STRIP vs. OID
STRIPs do not distribute interest in the form of a coupon payment. The interest is accrued and phantom income, payable at maturity.
With an OID tax exempt obligation, the bonds interest could be either accreted or paid. It could be an OID coupon bond, not a pure zero.
69
Are MMDAs FDIC Insured?
Yes.
70
EE Bonds in an UTMA
EE Bonds are taxed annually in an UTMA account. Have the Interest taxed each year to the kiddie. With the child's standard deduction and low tax bracket, taxation will be minimal.
71
Preferred stock
Hybrid security, because it resembles both equity and debt.
Issued at $25 par or $100 par with a fixed stated dividend rate.
Because it is perpetual, duration is normally infinite. When interest rates change, price fluctuations often exceed those of bonds.
The typical purchaser is a corporate treasurer, C-Corp, or pension plan (for the income). If the treasurer buys bonds, all the interest is taxable. However, if the corporation buys preferred stock, 50% of the dividends received are generally excluded from taxation.
For preferred stock that pays annual dividends, if those dividends are to be qualified, the stockholder must own the stock for 90 days in a 180 day period that begins 90 days before the ex dividend date.
72
ETF
May operate as an open end or closed end fund.
Generally more tax efficient than traditional open-end mutual funds.
Marketable, non-liquid.
73
Are Mutual Funds marginable?
No.
74
UIT
No day to day portfolio management.
Has unit holders.
Passive investment as its assets are not traded, but frozen.
No new securities are purchased, and securities are rarely sold.
The trust is self liquidating, because as the funds are received, they are not reinvested, but are distributed to unit holders.
The sponsor makes a market for investors, selling units and buyers of used units, a secondary market. Units are generally redeemed at NAV.
75
Mutual Funds
Open-end investment companies.
Redeemable securities. Each day, the fund computes its NAV per share.
76
Closed-end Investment Companies
Publicly traded funds are capitalized differently from open-end funds.
These funds issue stock ones, then the books are closed. No new shares are issued.
If an investor wishes to liquidate closed-end shares, they cannot redeem them, the shares are sold in the market like any other stock at the prevailing price. The illiquid securities held by the closed end fund do not have to be sold.
76
Index Funds
Invest in stocks and/or bonds that are components of various indexes.
They emphasize tax efficiency through minimal portfolio turnover.
77
Financial reform bill:
- How did it affect hedge fund managers?
Hedge fund managers with assets under management of $100 million or more are now required to register with the SEC.
78
GIC
Similar to CDs, issued by commercial banks, but these are issued by insurance companies.
Terms range from 2 to 5 years with a guaranteed rate of interest. Do not fluctuate with interest rate, but value heavily depends on the financial strength of the issuer.
Popular investments for defined benefit plans.
79
REITs:
- What do they invest in?
- Publicly traded REITs vs. Non-publicly traded REITs
- Equity REITs vs. Mortgage REITs
- What percentage of REIT income needs to come from real estate investments?
- What percentage of Net Investment Income needs to be distributed?
Similar to a closed-end investment company.
Invests in real estate, short-term construction loans, and mortgages.
Publicly traded REITs provide the investor with DIVERSIFICATION AND MARKETABILITY. Non-public REITs and real estate LPs ARE NOT LIQUID OR MARKETABLE.
Equity REITs- income producing property. Typically uses leverage, which could negatively impact CF.
Mortgage REITs- develop property and finance construction. Higher default risk if the developer is not able to sell or lease after completing.
*At least 75% of the REITS income must come from real estate investments. If the REIT distributes 90% or more of its net investment income, it only pays tax on the undistributed portion. If it fails to do so, fully taxed on all net investment income.*
80
RELP
Non-publicly traded and are relatively illiquid, even though there is usually a thin secondary market. Typically last 10-20 years or until liquidated.
REITs are actively traded on securities markets. RELPS are generally not marketable.
81
Real Estate Mortgage Investment Conduit (REMIC):
- What do they invest in?
- How do they differ from CMOs?
Limited life, self-liquidating entity that invests exclusively in real estate mortgages, or securities backed by real mortgages.
More flexible that CMOs. Different maturity classes, and different risk classes.
REMICs may replace CMOs.
82
IV, TV, EP, P
IV is the in the money amount, TV is the amount that the MP exceeds the IV, EP is the purchase/selling price of the option, Premium is the MP of an option.
83
Bullish Option positions
Buy Call, Sell Put
84
Bearish Option Positions
Buy Put, Sell Call
85
Call Option WRITER Taxation: Lapse vs Exercise
If the option lapses, the premium received is a short-term gain.
If the option is exercised (covered call), the premium received is added to the sale price, and can be LT or ST depending on how long the underlying stock is held.
86
T or F: When a PUT option lapses, the premium received by the writer is short-term gain.
T
87
Stock/option Netting:
Be careful with holding period! Dont get fool, read the question slowly and write things down.
88
Futures Contracts:
A Long Position is held by the party who wants to buy the commodity/financial (bullish).
A Short position is held by the party who wants to sell the commodity/financial (bearish).
- BUYERS BUY! Protects from prices going up and having to buy at a higher price.
- OWNERS SELL! Protects from prices going down and having to sell at a lower price.
89
Do Natural Resources offer the advantage of portfolio diversification?
Yes. Most are negatively correlated to the stock market.
90
Are Precious metals believed to be a good inflation hedge? and how are they treated for tax purposes?
Yes. They are also treated as collectibles for tax purposes. 28%.
91
Qualified Purchaser
$5,000,000 Invested
92
Is a Futures Contract a security under the Securities Act of 1933?
No. Futures contracts are not securities, they are regulated by the Commodity Futures Trading Commission and not by the SEC.
93
Total Risk
Total Risk is the combination of Systematic and Unsystematic risk.
Total risk is expressed by Standard Deviation. Systematic risk is expressed by Beta.
Unsystematic risk can be reduced through diversification.
94
T or F: Foreign stocks are first taxed in the country of origin, then again in the US?
T. However, US taxpayers generally receive a foreign tax credit.
Foreign markets are usually less efficient.
95
Liquidity vs. Marketability
- Liquid: Cannot lose money. SPEED/PRICE
- Marketable: Can be sold quickly. JUST SPEED.
Liquidity implies that a security or commodity can be sold/purchased without DELAY and without a substantial change in PRICE. Liquid assets are convertible into cash without significant loss of principal.
Marketability REFERS ONLY TO THE SPEED OF BUYING/SELLING (NOT REDEEMING).
Having a Market, isnt the same as being marketable.
Something can be marketable, but not liquid.
*Open-end MF, Closed-end funds, ETFs, and brokered CDs are not liquid. Open-end money market mutual funds are an exception. Savings/Checking/money market accounts and mutual funds are REDEEMED rather than marketable. True marketability implies trading among buyers and sellers. REITs, closed-end funds, ETFs and brokered CDs are marketable.*
96
Normal vs. Lognormal distribution
Range of RETURNS in % for a portfolio: Normal distribution applies.
Range of possible ENDING PORTFOLIO VALUES in $: Lognormal distribution applies. This is because an unleveraged portfolio can never be worth less than 0.
97
Correlation Coefficient and COVariance:
- What are they?
- range of outcomes?
-
Correlation Coefficient "P" and COVariance "COV" BOTH express the extent to which the movements of stocks/securities in the same portfolio are similar or not.
- Correlation Coefficient: Specific Range of outcomes (+1 to -1).
- COVariance: Infinite possibility of outcomes.
Correlation Coefficient is a standardized version of the Covariance ranging from +1 or perfectly positively correlated to -1 or perfectly negatively correlated.
Covariance measures how the price movements of one security is related to the price movements of a second security.
98
Coefficient of Variation (CV)
CV = STD / Mean Return.
Indicates risk per unit of expected return. The greater the number, the greater the risk.
CV measures the relative variability used to compare investments with widely varying rates of return and standard deviation.
99
Calculating Standard Deviation
Use the calculator. Input using the E+ key.
Gold, 7 = Mean
Gold, 8 = Standard Deviation
100
1, 2 and 3 Standard Deviations
68%, 95%, 99%
101
You have two mutual funds in your portfolio. Their correlation coefficient is .25. Fund A has a return of 5.5% and a risk of 7.5%. Fund B has a return of 3% and a risk of 15%. If your portfolio value consists 45% of fund A and 55% of fund B, what is the standard deviation of your portfolio?
Shortcut: 7.5% + 15% equals 22.5%. Divide by two, and then look for the next lowest answer.
102
Risk adjusted return
Realized return / Beta
103
Does a GNMA or a corporate bond expose the investor to greater reinvestment rate risk?
Since periodic payments from mortgage backed securities include both interest and the return of principal, GNMA bondholders face greater reinvestment risk than do regular bond holders. 
104
Using multiple asset classes in an investment portfolio generally reduces what risk?
Market risk
Diversification will reduce market risk, presuming low correlation among the portfolio securities.
105
Geometric mean return
Also called time-weighted return (performance of portfolio manager).
Not effected by cashflows.
Reflects compound returns over more than one time period.
- Add 1 to returns
- Multiply the returns together, that becomes FV.
- PV is always -1.
- N is # of years.
- Solve for i.
106
Time-weighted vs. Dollar-weighted return
TW: measures investment performance as a percentage of capital at work. Eliminates effects of additions/withdrawals.
DW: measures changes in dollar values (absolute dollar amounts). Additions/withdrawals/gains/losses are considered in the return. THIS IS THE SAME AS IRR/NPV.
107
HPR
For HPR, the denominator is the actual investment made, this amount is also reflected in the numerator.
Even when margin is used, the same is true. Ex: $10,000 on margin, $5,000 would be in the denominator and -$5,000 would be in the numerator, with another $5,000 to be paid back plus interest.
(15,000 - (5,000+600) - 5000) / 5000
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IRR
The discount rate at which the present value of future cash flows equals the cost of the investment. When the NPV of the cash flow is zero, the discount rate being used is the IRR. If the NPV is greater than the the required rate of return, the investment is acceptable.
Must use the CFj function to find IRR.
109
How many compounding periods when calculating YTM?
Always use semiannual compounding (2), EVEN WITH ZERO COUPON BONDS, unless the question specifies otherwise.
110
Current Yield
Annual interest / Bonds current price.
8% coupon, selling @ $950:
80 / 950 = 8.42%
111
TEY
TAXable equivalent yield shows the taxable equivalent to a muni bond, and takes the investors marginal tax bracket into consideration.
TEY = Tax-exempt yield / (1-T)
T is the tax that the security is exempt from!! For Munis, T is your marginal tax bracket because munis are exempt from federal tax, and if the bond is issued within your states, T will also include your state tax %. For Treasuries, T would be your state tax %, because treasuries are exempt from state taxes, but subject to Fed. Fed gets Fed!
T IS THE TAX THAT THE SECURITY IS EXEMPT FROM!!
After-tax yield = tax-exempt yield (muni yield).
112
Do GNMA funds distribute principal and interest?
Yes
113
Bond Duration
PVs of cashflows are used in calculating the weighted average maturity.
Duration enables investors to compare the price volatility of bonds with equal coupons but different terms. Most important measure of how risky bonds are because it measures their sensitivity to interest rate changes.
Duration and Maturity are positively correlated.
Duration and Yields are inversely related (think of the arm, with zeros at the fist).
Investors choose duration to match time horizon.
Duration shows how a bond or a bond fund will react to a particular change in interest rates.
114
By matching duration and to the time horizon, an investor can generally offset what two risks?
Reinvestment rate risk, and interest rate risk.
115
What is the duration of a zero-coupon bond?
Zeros have durations that are equal to their maturities.
ARM ANALOGY.
116
DDM shortcut for accelerating or decelerating dividend growth rates:
- When there are two stages of growth, use the second growth rate to calculate the DDM value.
- If the first growth rate is LOWER than the second, CHOOSE THE NEXT LOWEST NUMBER. Lower, Higher, Lower.
- If the first growth rate is HIGHER than the second, CHOOSE THE NEXT HIGHEST NUMBER. Higher, Lower, Higher.
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Ratio Analysis: Current market price
Earnings x P/E Ratio.
The DDM will not work if the company pays no dividend. You can use the P/E ratio to help value a stock to see if it is undervalued or overvalued.
118
Ratio Analysis: Price / free cash flow
Similar to DDM:
FCF(1+g) / r-g
119
Ratio Analysis: ROE
EPS / Common equity (net worth or book value)
120
Ratio Analysis: Dividend payout ratio
Common dividends paid / EPS.
Determined after the preferred stock dividends are paid, but before common.
121
Do Utility stocks typically have high dividend payout ratios?
Yes
122
Expected Return E(r):
(D(1+g) / Price) + g
123
MPT
Seeks to quantify the relationship between Risk and Return.
MPT shifts emphasis from analyzing the characteristics of individual investments to determining the relationships among individual securities that comprise the overall portfolio.
124
CML
- Macro aspect of CAPM, Fully diversified Portfolio, Tangent to the Markowitz efficient frontier at B. Point B is the optimally efficient portfolio.
- First component of CAPM.
- Y-axis: E(r), X-axis: Risk
- Rf = T-Bills
CML reveals:
- Under the CML is inefficient
- The expected return on a fully diversified portfolio
- That it cannot be used to evaluate the performance of a single security or a portfolio that lacks full diversification.
125
Efficient Frontier
- A reasonable investor should evaluate portfolios based on their expected returns and risk, measured by STD.
- Y-axis: E(r), X-axis: Risk
- Any point on the efficient frontier is efficient. Anything below is inefficient, anything above is unattainable.
126
Indifference Curves:
Risk averse: Steep curve
Risk Tolerant: Flat curve
127
SML
- Micro aspect of the CAPM, can be used to value any asset, Individual security or portfolio (doesnt matter if diversified or not).
- Second component of CAPM
- Y-axis: Rate of return, X-axis: beta
- Points above the SML are undervalued, points below the line are overvalued
128
SML Formula:
Also used to calculate Required Rate of Return.
ri = rf +(rm - rf) Bi
Also called CAPM!!
129
Market Risk Premium vs. Stock Risk Premium
In the required rate of return formula, the term (Erm - rf) is the market risk premium. The term (Erm - rf)B is the stock risk premium.
Erm is the return on the market.
130
Comparing risk with the SML
A point above the SML is less risky than a point below the SML, with the same beta, on a risk adjusted basis.
131
Current Assets
Cash, cash equivalents, marketable securities, accounts receivable, inventory.
132
Current Liabilities
Accounts payable, credit card debt, taxes payable.
133
Dow Theory
Shows the direction of the overall market.
Considers both the DJ Industrial Index and the DJ Transportation Index. These two indices indicate technical confirmations or divergences.
The dow theory contradicts both MPT & EMH.
The Dow Theory is concerned with price movements and trading volumes.
Based on trends not day-to-day fluctuations.
134
Muni Bond Allocation priorities
Gross revenue pledge: requires all revenues are used to pay debt service before expenses.
Net revenue pledge: requires expenses to be paid before debt service.
135
Wash sale rule
No deduction is allowed for any loss resulting from the SALE of stock or securities if within a period beginning 30 days before and ending 30 days after the sale, the taxpayer BUYS substantially identical stock or securities. The disallowed loss would be added to the basis of the new shares purchased.
If a Bond has a different rate or maturity, it would not trigger the wash sale rule.
136
Ex date, date of record, purch date for common stock
To be on the corporations books as holder of record, and to receive the dividend, the investor must purchase the stock BEFORE the EX-DIVIDEND date.
Purchase, Ex-dividend, Date of record.
Be careful of holidays and weekends.
The date of record for the corporation is the first business day after the ex date. On that record date, settled trades are reflected on the corporation's books. To be on the corporations books as a holder of record, the investor must purchase the stock BEFORE the Ex date so that it has time to settle.
137
Alpha, Treynor, Sharpe
R2^
A I
T 60
S
R2 is the square of the correlation coefficient.
138
Information Ratio
measures the portfolio managers ability to generate excess returns relative to a benchmark, but also attempts to identify the consistency to the investor.
The higher the IR, the more consistent the manager.
Similar to Sharpe, but the IR compares active return to the most relevant benchmark index instead of a Rf asset.
139
Laddered Portfolio
Bonds are purchased with different maturity dates. As each bond matures, a new LT bond is purchased.
140
Bullets
ONLY intermediate bonds.
141
Barbells
Half in ST Bonds, half in LT Bonds. Requires periodic rebalancing.
Think of barbell. 2 10s, 2 45s.
142
Investor purchases 200 shares of X at $150 per share on margin. The initial margin requirement is $15,000. If the maintenance margin is 25%, what is the amount of the maintenance call if the stock drops to $90?
3 stepper
200 x $90 = $18,000
25% of $18,000 = $4500 Equity required
$18,000 - $15,000 = $3,000 actual equity
$4,500 - $3,000 = $1,500
143
Maintenance Call Questions!!
144
What does the Federal Reserve regulate the use of leverage on?
Common stocks.
Mutual funds and options are not marginable
145
If an investor bought foreign securities, they would want what to happen?
The foreign currency to revalue.
146
Is Fundamental analysis an active strategy?
Yes.
147
CAPM
CAPM is concerned with the equilibrium relationship between the risk and expected return on risky assets.
CML: Macro, Risk and Return on a portfolio.
SML: Micro, Risk and Return for an individual asset.
148
Callable bonds vs Put bonds
- Callable bonds: issuer has the right to redeem the bonds at a date prior to maturity if current interest rates have fallen. They can then reissue bonds at lower interests rates.
- Put bonds: holder has the right to sell the bond back to the issuer if current interest rates have risen. They can then go buy bonds with higher interest rates.
149
Qualified vs Ordinary divend tax rates
Ordinary dividends are payments a public company makes to owners of its common stock shares. It is their share of the company's profits and a reward for holding onto the shares.
A qualified dividend is an ordinary dividend that can be reported to the IRS as a capital gain rather than income.
It is a qualified dividend if you purchase it before the ex-dividend date and hold it for 61 days or more before the dividend. That qualifies it for the capital gains tax rate.
150
Collectibles
Rare objects. Typically rise in value during inflationary periods. Negatively correlated with returns on financial assets.
Taxed at 28%
151
Bond Immunization
A passive investment strategy seeking to safeguard a bond portfolio against interest-rate volatility. A portfolio is immunized (neutralized) if the duration of the overall portfolio is equal to a pre-selected time horizon.
An investor with a 10 year time horizon does not choose bonds with 10 years to maturity, but does choose a portfolio of bonds with an average duration of 10 years.
152
EPS = ?
ROE per share x Book value per share
153
Black-Scholes option valuation model
An increase in the ex price of a call decreases the call's value.
An increase in the ex price of a put increases the put's value.
154
Binomial option pricing
An alternative to Black-Scholes.
This model assumes that a stock's price can be two possible values at the option expiration. It will either increase to a given higher price or decrease to a given lower price.
155
Anomalies
P/E effect
Small-firm effect
January effect
Neglected-firm effect
Value Line phenomenon
156
Fundamental analysis:
Examines balance sheets and income statements to forecast future stock price movements. Current and past company records are also used in predicting future trends.
157
Top-down method
Upside down triangle
General economy first, then industries, then companies.
158
Bottom-up method
Upside down triangle
Individual stocks first before considering the impact of economic trends.
159
Technical analysis
Uses charts or computer programs to identify and project price trends. Unlike fundamental analysts, techs are not really concerned with the specific position of a company.
- Dow theory
- Barron's confidence index
- Odd lot theory
- Investment advisor opinions
- Advance/decline line
- Moving average
- Mutual fund cash positions
160
Sentiment indicators
Measures the bullish or bearish moods of investors.
Techs look at these indicators as contrary.
161
Barron's confidence index
Presumes that the differential between the returns on quality bonds and bonds of lessor quality will forecast future price movements.
162
Monte Carlo Simulation
- Spreadsheet simulation which randomly generates values for uncertain variables over and over to simulate a model.
One drawback is that inputs are fixed. You can only see one solution at a time.
163
Sharpe ratio (Look at formula)
This measure is expressed as the ratio of the excess return of the portfolio to its STD.
164
Treynor ratio (Look at formula)
This measure is expressed as the ratio of the excess return of the portfolio to its BETA.
165
Jenson ratio (Look at formula)
Commonly referred to as ALPHA.
This measure calculates the portfolio return actually attained and subtracts from it what the return should have been based on the risk assumed in the portfolio. !!!
This is added value!
166
Choosing the right performance measure:
Because Jenson Alpha and Treynor use beta to express risk, the portfolio must be diversified.
The Sharpe index uses standard deviation, presuming the portfolio is undiversified.
Look at R² for explanation of diversification.
167
Floating rate note collar
Specifies a maximum and minimum rate of interest that will be paid on a floating rate note. A floating rate note is debt instrument with a variable interest rate.
When interest rate exceed the max and min: the client will receive payments when interest rates are above the max and make payments when interest rates are below the min.
168
do reinvested dividends carry a sales commission?
No but it is phantom income.
169
Investing on margin
Regulation T sets initial margins at 50%.
The second level of margin regulation is applied by the exchanges and FINRA, which have their own margin requirements, normally 25%. These are called the “minimum maintenance” margins and are ongoing margin requirements after initial reg. T requirements are met.
The reg T margin is required to open the position. Maintenance margin is required to keep it. 
170
one may argue that there is no risk-free investment. If a client invests for the short-term, what risk will they face?
Reinvestment risk.
171
in Standard Deviation questions, "risk" = ____________
Standard Deviation
172
A portfolio with a beta of +1 has which risk?
Systematic risk. A portfolio with a beta of plus one moves in the same direction, and at the same rate as the overall market. Thus, the portfolio has market risk, which is a systematic risk.
173
Finding YTC on calf
2 p/yr.
N is number of years until call.
PV is the present value of current bond.
PMT is the semi annual coupon payment of current bond.
FV is call price.
Solve for I.
174
What kind of investment provides the maximum leverage and the maximum hedge against inflation?
Improved land
Mortgage REITS are highly leverage, but do poorly during times of high inflation. Common stock generally loses value during inflationary times.
175
If interest rates are increasing, what would be happening to the duration of the bond portfolio?
Duration would decrease. Duration is inversely related to the current yield on comparative bonds.
176
You have two mutual funds in your portfolio. Their correlation coefficient is .25. Fund A has a return of 5.5% and a risk of 7.5%. Fund B has a return of 3% and a risk of 15%. If your portfolio value consist of 45% of fund A and 55% of fund B, what is the standard deviation of your portfolio?
Shortcut: 7.5% + 15% Divide by 2 and then look for the next lowest answer.
Unless the securities are all perfectly positively correlated, the standard deviation of the portfolio must be less than the weighted average standard deviation of the individual securities.
177
What is investment interest?
Investment interest is any interest incurred to purchase property that is HELD FOR INVESTMENT, such as raw land. Investment interest is tax deductible up to investment income.
178
EEEs vs EEs
EEEs are owned by parents and cannot be held in an UTMA or UGMA.
EEs can be held in an UTMA UGMA but are taxed to the child.
